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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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.
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.
KML remains highly disciplined and conservative around moving ahead on TMX. There are discussions ongoing with the federal gov’t around financial support (investment, backstop, etc). However, mgmt. made it clear that they also need other unspecified support – possibly legislation or other actions – to help mitigate B.C. risks and keep TMX going past the 5/31 deadline. Kinder has effectively created a crisis moment for politics in Canada forcing leaders to show their final hands, but we’re not confident there’s an easy fix. After plunging on KML’s announced suspension of TMX last week, the stock has rallied hard and is only 2.4% below its pre-announcement level. We stay Peer Perform rated but do worry investors may be getting ahead of themselves as a path forward is still uncertain and ongoing risks remain.
FERC’s proposed policy change to no longer allow MLPs to recover a tax allowance in pipeline rates is an unwelcomed overhang. The timing is bad. Fundamentals had just turned more positive and Q4 results were strong, but stocks have lagged due to a lack of sustained investor sponsorship and MLP fund inflows. Near-term, the new uncertainty and downward rate pressure created by FERC’s move hardly seems likely to now inspire new buying interest in the space. We think the 4.6% drop in the AMZ is a little overdone on a fundamental basis. That said, relative stock moves seemed generally rational with C-corps outperforming and more exposed MLPs down the most.
KMI’s pause on meaningful construction of TMX makes a lot of sense. The NEB should rule on KML’s request for a federal permitting backstop within a month and the federal court challenge of the project is ripe for decision by Q2. These are key risk hurdles and it would be imprudent for KML to spend significant money before attaining clarity. That said, another 3 month delay since the timeline provided just a month ago was discouraging and leaves us without much confidence. As discussed in our KML note, we have revised our TMX base case to a 2022 in-service (1 year delay vs. KML guidance).
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