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.
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On Friday (11/30/18), Equitrans announced the simplification of its MLPs. It will acquire EQGP for $20 (a 17.5% premium from the 11/29 close) and has proposed to swap its EQM IDRs for 95M LP units. This will leave EQM as the surviving MLP, surprising consensus (and us), which believed that an EQM rollup into EQGP was more likely. EQM fell 5.5% on the day, given the expectation that it would be rolled up and on the potential dilution from the IDR swap. ETRN, which is a net beneficiary of the transaction, fell 3%, and EQGP rose 17.5% to reflect the takeout value. Bottom line, we still believe the overall complex is attractive.
We are upgrading EQM Midstream to Outperform from Peer Perform with a $66 target price. The MLP has underperformed the AMZ by 29% YTD on two main factors: the complications of the EQT spin of ETRN, and the delays and cost increases of Mountain Valley Pipeline. With the spin of ETRN complete there can be a focus on structural streamlining, growth in the underlying business, and completion of MVP. EQM now trades at a turn discount to the midstream group despite significant growth, below average leverage, and strategically appealing assets. We also initiated on ETRN at Outperform – see our detailed initiation here.
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.”
EQM underperformed the AMZ by 300bp on Wednesday despite a solid updated financial outlook where 2020 EBITDA guidance of $1.7B topped consensus and its previous $1.6B guidance. We believe the stock was down on concerns on the EQT standalone operational and production growth outlook (EQT fell over 12%), a lower distribution growth outlook (8%-10% vs. 15% previously), and lingering concerns over the MVP timeline. We believe that the updated outlook makes EQM more intriguing given the low EBITDA valuation and 9%+ yield with 10% distribution growth, but we are still cautious given the potential shareholder dislocation from the spin of ETRN.
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.
EQM had a solid quarter, and has completed the first steps on simplification. The company reduced its distribution growth to 15% from 15%-20% through 2020; the cash flow outlook is the same but EQM wants to be conservative on coverage as it is in elevated capex years. This appears reasonable to us. While we continue to like the asset positioning and growth visibility, we believe the ownership dynamics around the EQT spin of Newco later this year adds complication. We remain Peer Perform on EQM and prefer EQGP given its better alignment with control over the structure.
Last night (7/18/2018) FERC issued a final rulemaking on how to handle tax reform in regulated gas pipeline rates as well as a clarification of the policy statement that eliminated the tax allowance for MLPs. These stemmed from initial orders in mid-March. While FERC did not change the fundamental position that MLPs (in a vacuum) still can’t collect an income tax allowance it appears that under the final rule natural gas MLPs that are consolidated by a parent corporation can claim that they are taxpayers. Bottom line, this appears to be a significant change from the initial ruling in March for a number of pipeline MLPs that are consolidated by C-corps.
With U.S. production increasing fast, several big simplification announcements, and oil prices much improved, the fundamental tone was positive at MLPA. Turnout was reportedly higher than last year even with each of the large C-corps still sitting out of the event. That said, FERC and structure were clear overhangs. On FERC, we heard more questions than answers. Structure / simplification was discussed at nearly all our meetings and often overwhelmed the conversation. We think continued (and speedy) resolution around FERC / structural issues should help bring investor focus back to a strong fundamental set up, but there will be uncertainty in the meantime.
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