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.
EPD’s Q4 results on 1/31 were in line without big surprises. The growth outlook is on track with some new petrochem projects in the backlog and the crude conversion project starting up early. We thought the call, greater use of traditional financial metrics, and new $2B unit buyback authorization were all positives. We think EPD will only buy back a modest amount of stock in 2019 based on capex and leverage goals (we assume $300M), but this could be much larger in 2020+ depending on the capex trajectory. We like EPD’s attempts to use more traditional, non-MLP centric metrics to better message to generalist investors. The reality is EPD screens attractive on this basis at only 14x 2019 P/E and a 5% FCF yield even after sizeable growth capex in 2019.
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.
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.
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.”
Q3 EBITDA beat consensus by 8%. The beat vs. our estimate was driven by higher NGL marketing ($50M) as EPD took advantage of tight pipeline and frac conditions, better processing volumes and margins ($40M), and stronger gas segment results. DCF / unit is tracking to grow by 30% in 2018 – that’s astounding for a $58B market cap company. Meanwhile, the growth backlog was increased materially to $6.6B through 2020 from $5.3B in recent slides, providing greater visibility on future growth which can all be funded without equity. CEO Teague said this is “the strongest business climate we have seen in recent memory". EPD stock has outperformed the AMZ by 10% YTD. But its premium valuation has actually faded materially with the stock only trading at 10.3x 2020 EBITDA on our new numbers. Improvement in the financial outlook can’t outpace the stock forever. EPD is our top idea.
We are forecasting Q3 EBITDA growth of nearly 15% vs. last year, with median DCF per share rising by 15% YoY as well. Fundamentally, the sector continues to benefit from positive dynamics as production volumes accelerate across most key basins, new projects come into service, and wide locational price differentials highlight the need for new infrastructure investment. The Q3 fundamentals are similar to Q2 which saw strong results and the AMZ outperform the market by 8% over the course of earnings season. However, unlike Q2 we see consensus as largely there; we have a roughly even split of beats and misses vs. consensus. So it’s less clear to us if Q3 will again be a positive catalyst or more neutral near term. Ultimately, we believe that as the companies continue to show above-average growth, simplify, and get to sustainable leverage, investor support for the sector will increase.
We hope everyone had an enjoyable summer. To help get back in the swing of things and with the fall conference season ahead of us, we are publishing a midstream-focused question bank for a number of our covered companies (see table on right). Key industry topics are discussed below with a detailed listing of questions for individual companies in the body of this report.
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