For the second straight year, FERC tried to steal the spotlight from the NCAA on the first day of March Madness, but this year the consequences were not nearly as drastic for midstream companies. FERC opened an NOI for the ROE rate setting process for oil and gas pipeline companies. Among other questions, FERC has asked for stakeholders’ opinions on the validity of the current two-stage DCF methodology and whether or not to incorporate CAPM, risk premium, and expected earnings models. As FERC awaits feedback, investors are contemplating the possible outcomes. Could the expanded approach impact ROEs significantly? When would the proposed changes come into effect?
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We’re hearing a more cautious tone on the group overall after a strong start to the year. Q4 earnings were mixed and mega project risks are front and center on investors’ minds. The C-corps keep outperforming the MLPs and most dedicated midstream investors aren’t sure why. Perhaps we’re seeing new generalist buyers? We’re also hearing consistent debates on a number of key stocks from investors. Please open the full report for details.
We thought results in Q4 were solid with an average EBITDA beat of 3%. DCF/share growth of 8% YoY in Q4 was down from the breakneck double digit growth seen in Q2 (13%) and Q3 (18%), but is clearly still attractive total return when combined with safe 7% yields. Our updated forecasts still call for 5% DCF/share growth in 2019, preserving a low double digit total return investment proposition. That said, the group now seems more dependent on a valuation call near-term given more uncertainty over the pace of production growth and concerns over high levels of competition and a cyclical shift toward potential overbuild.
We thought KMI did a good job highlighting their well positioned gas assets which are benefitting from exports (LNG / Mexico), Permian growth, and strong G&P growth across basins. KMI’s transparency on their plan, backlog, and risks are admirable, and the capital discipline message resonates well. However, the implied $220M gas segment contract roll-off headwind in 2021, a CO2 segment outlook that was below our expectations, and a cautious tone on asset sales were disappointing. Overall, we saw the meeting as mixed, while the stock fell hard after CEO Kean’s description of last week’s story of a potential CO2 sale as someone dropping a rumor – i.e., fake news.
Our EBITDA estimates for Q4 are close to consensus overall and we forecast DCF/share growth of 8% on average (5% median). While not as robust as the wild 18% YoY growth in DCF/sh reported in Q3, we see continued momentum in Q4 from strong volume growth and new infrastructure investment despite some modest commodity pressures. As we wrote in our year ahead report, the group offers an attractive value proposition with 7% yields plus mid single digit growth, while a larger exposure to production volumes than commodity prices should differentiate midstream results vs. broader energy in 2019.
KMI’s Q4 results came in above market expectations primarily due to a 40% YoY decline in G&A, some of which was driven by greater capitalized overhead and timing-related items. DCF was further above our estimate on lower cash taxes and favorable interest income after the Trans Mountain sale. Pipeline volume data was strong and continues to come in above expectations. We found the call a little downbeat with more focus on some wrinkles like Ruby’s contract with PCG, rate settlement talks, and Elba delays. On a positive note, KMI did add a strong $500M of new projects to the growth backlog. We’d like to see continued progress on this front to help backfill for the ~$1.3B of projects that entered service in Q4 and the $1.2B Elba project which starts up shortly.
KMI reports earnings AMC on Wednesday (1/16) and will hold an Analyst Day on 1/23. We forecast 4Q18 and FY ‘18 EBITDA of $1,933M and $7,540M, respectively. This is slightly above consensus. KMI previously indicated they expected to beat the $7.5B EBITDA budget.
Attractive valuation, but with late cycle multiple compression risks. Midstream stocks offer low double digit total return (dividend + growth), which is attractive at this point in the cycle especially for a relatively low risk business. Relative EV/EBITDA multiples are slightly below the SPX and UTY, and P/E is now in line with the market. We saw a 10-20% compression of EBITDA and cash flow multiples in 2018. The risk is market multiple compression in 2019, which has an amplified effect on equity values for a levered sector.
Moving to neutral view on PAA as the Capline opportunity, improved valuation, and lower leverage offset our concerns on fee-based growth. We are upgrading PAA and PAGP to Peer Perform from Underperform as we now see risk-reward as balanced. We still see PAA’s crude business as highly competitive and the 2019 fee-based EBITDA outlook as too optimistic. However, PAA now only trades at a small premium on our below consensus 2020 EBITDA estimate and the Capline reversal is a unique upside opportunity that’s not in our numbers and could provide a meaningful boost in 2021. While WTI oil collapsing to $50 is unhelpful, we think investor perceptions of PAA as a higher risk stock could evolve over the next year. PAA’s volume exposure is heavily tied to the Permian which should see sustained growth even if oil stays weak. Meanwhile, the balance sheet is completely fixed with 2019 leverage of 3.7x almost a full turn below peers and the 3rd lowest in our coverage among large caps.
Q3 results were even better than we expected. None of our covered companies missed with a median EBITDA beat for the quarter of 5%. More importantly, the median DCF / share growth in Q3 was 18%!! This figure excludes companies involved in M&A and is more reflective of true growth in the business – see p. 2. While this pace of growth clearly won’t last forever, what other sector is paying a 7-8% yield and growing cash flow per share by almost 20%? The fundamental picture is very strong, balance sheets are improving, and equity needs have been dramatically reduced. EPD’s CEO Teague stated this is “the strongest business climate we have seen in recent memory.”
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