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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Overall, there was a confident tone around the financial flexibility and health of the company. Interestingly, the collapse in oil prices was not a big topic given a much stronger balance sheet and with narrower Permian differentials since Q3 partially offsetting WTI’s fall.
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.”
Q3 EBITDA was 9% above consensus excluding a $20M one-time gain. The beat vs. our forecast was driven by a sooner than expected uplift at S&L on Permian / Canadian constraints. However, fee-based EBITDA was slightly below and PAA cited a moderation in completions. 2018 guidance was raised by $150M driven by S&L strength, while fee-based guidance was maintained as adjusted for BridgeTex. 2019 guidance was consistent with prior disclosures, albeit with a stronger S&L outlook. Overall, PAA’s Q3 was another strong earnings update in the midstream space.
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.
This morning (8/21/2018), PAA and MMP announced a 50% sell-down of the BridgeTex pipeline for $1.44B to a Canadian pension fund. PAA is selling 30% of the pipeline for $863M and will retain a 20% interest. Based on MMP disclosures and our assumptions, the sale implies only a ~9x near-term EBITDA multiple, but a sky high multiple north of 20x once above-market contracts roll off in the late 2020s. Viewed differently, we would have to use a low 6% discount rate in our NPV analysis of the pipe in order to support the transaction value, although the buyer could certainly boost returns with leverage (BridgeTex has no debt). See our analysis on p. 3-4. Strategically, we view the sale positively as it allows PAA to exceed its asset sale target, accelerate de-leveraging, and redeploy capital away from a pipe with above-market rates into new assets at market rates.
PAA's Q2 EBITDA beat our estimate at the S&L segment on greater benefits from wider differentials, while fee-based segments were in line. 2018 EBITDA guidance was raised by $100M with $75M from S&L and $25M at Facilities. Looking forward, 2018 capex was raised by $550M and 2019 by $100M, primarily from new Permian de-bottlenecking projects - not a surprise given past commentary. PAA still sees 14-15% fee-based growth in 2019, which is an effective $30M EBITDA increase given a higher 2018 base. On the call, the impact of higher 2018 capex was described as more likely to boost 2020 EBITDA. This is possible given Permian constraints in '19, but investors may have questions on why 2019 isn't up more given much higher capex and faster start-up of Cactus II.
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.
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