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.
TRGP today (2/20/2019) reported in line Q4 results if we exclude the benefit from the splitter contract cancellation. Updated 2019 guidance was below our pro-forma expectations on lower volumes, a Grand Prix delay, and the Badlands sale structure. The lack of disclosure on Blackstone’s preferred interest in the Badlands yesterday exacerbated a two-day rollercoaster for the stock and created confusion. TRGP has very attractive assets and a great long-term growth profile. The problem is the $1.35B midpoint of 2019 EBITDA guidance is slightly below 2018A, coverage this year of 0.9x is down from 1.04x in 2018 and way below the peer average of 1.6x, while debt / EBITDA increases to 5.4x in 2019 from 4.9x in 2018. Peers are all moving in the other direction. We think it will be hard for TRGP to regain a premium valuation in 2019 – they need to show more execution on growth first. Peer Perform.
This morning (2/19/2019) TRGP announced a sale of a 45% interest in the Badlands assets to Blackstone for $1.6B. This was well above the $1B hurdle often cited by investors and implies an impressive 15-16x EBITDA on our 2019 estimate. If we assume $500-600M of debt paydown is needed to offset the EBITDA being sold and stay leverage neutral, the sale creates $1B of equity capacity. TRGP has $2B of growth capex and a ~$300M Outrigger earn-out payment this year, so $1B of new equity capacity would fund over 40% of this. TRGP stated the sale “satisfies a substantial portion” of 2019 equity needs. More broadly, this is yet another example of private equity paying big values for midstream assets – the public companies should sell more assets proactively.
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 week, TRGP reported a solid Q3, raised 2018 guidance and gave a refreshed 2019-21 EBITDA view that was close to consensus in 2019 and 7% / 9% above consensus for 2020 / 2021. That said, it came with a ~$1B increase to 2019 capex and baked in $1.8B of 2020-21 capex for future projects. Overall, TRGP’s outlook has improved and the company is well positioned for growth. But a 3% / 15% increase to 2019 / 2021 EBITDA relative to the June 2017 view, in part driven by new capital projects, didn’t stand out to us relative to peers in the current midstream “boom times”. We prefer EPD and ET as better value amongst NGL players. Stay Peer Perform on TRGP.
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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