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.
We are downgrading MMP to Underperform from Peer Perform and cut our target to $56 from $61. Formal 2019 guidance was below the prior 5-8% growth indication and weak even when adjusting for MMP’s conservative assumptions. We are more bothered by the decision to pull back 2020 DCF growth guidance of 5-8% as we saw that as a stronger growth year. On the call, MMP referenced uncertainties on crude spot pipeline volumes, butane blending margins, and re-contracting risk, but these risks have been known and prior commentary implied they were baked into the low end of guidance. MMP trades at the highest multiple in the group because of its track record of execution and visibility. We think cracks were exposed in Q4 and investors will be less willing to keep valuing the stock at a big premium.
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.”
MMP reported Q3 EBITDA that was 3% above consensus and raised 2018 guidance slightly – the third increase this year. The beat vs. our forecast was mainly in the crude segment on higher volumes and margins from pipelines / terminals. Much of the call was focused on new early stage development projects, including oil pipelines from Cushing to Houston and from Houston to Corpus, as well as a crude export terminal at Corpus. Recent growth investment has leaned more toward refined products, but MMP seems to see more opportunities forming in crude again now. Regardless, progress on this front would increase visibility on the post 2020 growth outlook which we would view positively.
MMP has an incumbent refined products business with high barriers to entry, an excellent track record of financial discipline, and is well positioned for rising U.S. exports. We forecast strong growth through 2020. However, longer term MMP’s core refined products business offers a less clear growth story than peers more levered to rising NGL / crude production. At a macro level, MMP stock could see support if financial markets remain volatile and we get a flight to safety. But we would need to argue for a ~25% premium to large cap peers on EV/EBITDA to recommend the stock here, which we think is too much even for a very high quality name like MMP. Peer Perform.