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.
What should have been a constructive guidance update on the yearend earnings call got bogged down unnecessarily by a focus on the dividend and a wide capex range. Importantly, even though there was a concern on the call that management was wavering on its 9%-11% dividend growth outlook, on follow up with the company it was clear this was not the case. Bottom line, we still see the OKE growth plus operational leverage story as fully intact and one of the most attractive models in the sector – reiterate Outperform.
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.
We are initiating coverage of ONEOK with an Outperform rating and a $66 target price. OKE has established itself as one of the key integrated natural gas liquids plays in the sector. It has a dominant NGL position in the Bakken and Mid-Con which has facilitated a $6B growth program that will realize 4x-6x EBITDA multiples. The projects have significant upside as they fill up further. We see double-digit cash flow and EBITDA growth and a sub-4x leverage balance sheet with minimal equity needs. We believe the recent pullback of OKE is an opportunity to buy one of the highest quality stocks at a relative low.