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.
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.”
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.
KML announced the Canadian government will buy Trans Mountain and the expansion project for C$4.5B. Investor reaction was initially positive, but the stock fell 3% on the day. The sales price is highly attractive. We estimate that the assets being sold contribute about C$220M of EBITDA. If we apply a 12x multiple, it implies $2.6B of value with the remaining $1.9B attributable to TMX, nearly double the $1.1B spent to date for a project that could have been abandoned.
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.
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