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.
TCP has made the best of a very challenging environment in 2018 stemming from the FERC MLP tax policy change. It did a good job significantly mitigating the worst-case scenarios while keeping leverage low and coverage healthy and has begun to develop an organic growth strategy. That said we remain concerned about the uncertainty around the EBITDA stepdown in 2019 from FERC and the Bison contract rolloffs and we are maintaining our Underperform rating.
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.
We are downgrading TC Pipelines to Underperform from Peer Perform. TCP spent most of 2018 under pressure from FERC mandates on tax reform, but the partnership was quite successful in mitigating the worst-case impacts and getting to regulatory certainty. However we expect EBITDA to drop meaningfully in 2019 from the actions related to tax reform as well as the buyout of two contracts at Bison. Based on our updated estimates we see TCP trading about in line with the group on yield and EBITDA. While the company's actions have made the best of a bad situation, the relative lack of clear growth projects, the long term potential headwind of Bison, and relatively high leverage near term suggest that a discount is warranted relative to the rest of the sector that has improving fundamentals. See our detailed sector note here.
Enbridge now our preferred Canadian midstream name. We are upgrading Enbridge to Outperform from Peer Perform and it is now our preferred Canadian midstream name. ENB executed very well in 2018: fully simplifying, repairing its balance sheet with significant asset sales, and getting Line 3 Replacement approved. It has become what we see as a prototypical large cap midstream model: high yield (7%), high growth (10% through 2020, 5%-7% sustainably thereafter), and no foreseeable need to access the equity markets. Finally, ENB is well positioned for Canadian crude takeaway given the uncertainty over TMX and KXL, and it appears headed to reduce volatility further under a long-term tariff agreement on the Mainline. We are boosting our target price to $37 from $36.
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.”
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.
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