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 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.
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.
We hope everyone had an enjoyable summer. To help get back in the swing of things and with the fall conference season ahead of us, we are publishing a midstream-focused question bank for a number of our covered companies (see table on right). Key industry topics are discussed below with a detailed listing of questions for individual companies in the body of this report.
2018 is tracking well and future equity needs are now lower. TRGP’s Q2 EBITDA came in 2% above our estimate and 4% above consensus. Volumes were close to expectations, but light in the Delaware. TRGP sees FY 2018 results on track to meet or beat expectations, which we interpret as the upper half of the guidance range (and possibly slightly above). On the financing side, TRGP issued $312M of equity in Q2 and has now met minimum equity needs for 2018, alleviating a modest overhang. Despite these positive updates, the stock underperformed by 2%. It’s been a very strong earnings season for the midstream sector, so perhaps investor expectations had gotten too high.
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.
TRGP is building an attractive integrated business that spans the NGL value chain with direct access to end user demand. We think this model enhances margins and has high barriers to entry, while a heavy focus on the Permian should drive above-average long-term growth. That said, we see some risks, namely slowing near-term Permian growth given pipeline constraints, and a concern TRGP may be biting off more than it can chew with ambitious growth plans while leverage remains high and coverage low. The stock has been strong and we prefer to wait on the sidelines pending further execution and with the key growth year in 2020 still some time off.