As part of our process at Valuentum, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies in our coverage universe. In Boardwalk Pipeline's (BWP) case, we think the firm is fairly valued at $32 per share, materially higher than where it is currently trading.
Valuentum's Report on Boardwalk Pipeline
• Boardwalk Pipeline's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
• Boardwalk has a significant portion of revenue backed by long-term contracts with credit-worthy customers. This offers some stability to cash flow.
• The company boasts an investment-grade profile and a track record of revenue expansion in a volatile gas price environment. Its sponsor Loews Corp is also well-capitalized.
• The firm sports a very nice distribution yield of 8%.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Boardwalk Pipeline's 3-year historical return on invested capital (without goodwill) is 6.5%, which is below the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Boardwalk Pipeline's free cash flow margin has averaged about -0.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Boardwalk Pipeline, cash flow from operations increased about 13% from levels registered two years ago, while capital expenditures fell about 83% over the same time period.
The estimated fair value of Boardwalk is $32 per share, which represents a price-to-earnings (P/E) ratio of about 25.2 times last year's earnings and an implied EV/EBITDA multiple of about 13.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 13.2%. Our model reflects a 5-year projected average operating margin of 35%, which is below Boardwalk Pipeline's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Boardwalk Pipeline, we use a 9.7% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Boardwalk Pipeline. We think the firm is attractive below $24 per share (the green line), but quite expensive above $40 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Boardwalk Pipeline's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Boardwalk Pipeline's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $35 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.