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.
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.”
We have worked with BNP Paribas to create a reference custom basket of 15 midstream stocks held in a C-corp structure or that file a form 1099 and are taxed as corporations. The basket can be accessed on Bloomberg (BNPBCCOR INDEX) and is customizable and tradeable – contact your Wolfe salesperson for details.
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.
Last week we had the opportunity to meet with INGAA and the staff of FERC to review the latest on the changes on the pipeline regulatory policy front and the next steps to watch for. Overall we got a better understanding of the legal constraints FERC was under that led to the decision to change MLP tax policy to eliminate the tax allowance for cost based pipelines. We came away with the view that there is not much room to change the policy. In that context it is not a surprise that in front of the 501-G filings this fall that already many pipeline MLPs are moving toward corporate structures - SEP, EEP, WPZ, BWP, and TCP. Despite the MLP tax policy change being unwelcome, we still believe the acceleration of structural changes is a good thing for the sector.
The annual MLPA conference, newly renamed as the MLP and Energy Infrastructure Conference (MEIC), will be held May 22-24 in Florida. Many MLP management teams will be in attendance. This report is a helpful guide for investors attending and includes questions to ask for covered companies, as well as summary model information. Key industry topics are discussed below with company-specific topics in the body of the report.
After a tumultuous March, MLP markets turned over the past two weeks alongside a run in crude and widening spreads. The last time we saw $70 Brent (outside a few days in early Jan) was December 2014. That said the AMZ remains an underperformer vs. the XLE, oil, and the broader market YTD and valuations remain attractive - the AMZ is still due for a catch-up trade. We see another generally constructive earnings season - Q1 DCF / unit growth up 7.4% YoY on operational leverage, projects in-service, and a more normal winter. The FERC tax order remains an overhang, but recent comments by Commissioner Chatterjee and charged industry feedback signal that more clarity might be forthcoming.
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