In my view, some of the strongest upside can be found in natural gas, which I anticipate eventualy becoming the number one domestic energy source. A little less than two months ago, Kinder Morgan (KMI) made headlines when it announced the buyout of El Paso (EP) for $21B. The transaction will create the largest natural gas pipeline or, as Kinder Morgan's CEO, Rich Kinder, said:
Putting these two companies together, strategically, is a great fit. When we put these two companies together, we’ll have 80,000 miles of pipeline, 67,000 of which will be natural gas pipes. It will create a company that, when you take the whole family of companies including the two MLPs, together will have an enterprise value of approximately $94 billion. So the result is that we will be by far the largest midstream energy player in North America, and also in terms of enterprise value, the fourth largest energy company of any kind in North America.
The buyout valued El Paso at 27.7x 2010 earnings, which implies substantial upside for competitors like Williams Companies (WMB). The Street currently rates Williams near a "strong buy," but the market has had some time to react to the takeover and still values the company at only 18.2x and 17.5x past and forward earnings. Consequentially, I see limited multiples expansion beyond 21.5x, especially since the merger will crowd out share and weaken smaller competitors' bargaining power. With that said, Williams is well positioned to increase scale and raise gross margins.
At the third quarter earnings call, Williams' CEO, Alan Armstrong, noted impressive performance:
First of all, a great quarter, solid performance and significant growth in all of our segments. And certainly, we're excited that our continued better-than-expected cash flows in our infrastructure business…
In the quarter, certainly you started to see the benefit of a lot of our projects that we've invested in the last couple of years really starting to kick in.
E&P in Bakken was favorable while the Perdido Norte project began to show promising volumes. Due to progress in Transco and Marcellus, as well as improving commodity markets, Williams is in a solid position to increase its dividend, which currently stands at 3.2%. As the United States turns to natural gas, Williams will be a main beneficiary due to its proven execution in monetizing assets and top infrastructure. Williams has created the foundation that provides critical access to markets while exploiting the spread between oil-based products and natural gas. The main catalyst for the firm going forward will be expansion in Bakken and Eagle Ford.
Consensus estimates for Williams' EPS are that it will grow by 19.5% to $1.53 in 2011 and then by 15.7% and 16.4% in the following two years. Assuming a multiple of 21.5x and a conservative 2012 EPS of $1.69, the rough intrinsic value of the stock is $36.34, implying 17.2% upside. If the multiple were to hold steady and 2012 EPS turns out to be 11.3% below the consensus, the stock would fall by 7.8%. Accordingly, while I believe that Williams has favorable risk/reward, the upside is limited for now. The Street nevertheless rates shares a "strong buy."
During the third quarter, El Paso had EPS of $0.18, which was well below the $0.26 consensus. Pipeline segment adjusted EBIT grew 4.3% over last year, partially driven by higher TPG rates. Adjusted EBIT for E&P, meanwhile, declined by 7.7% due to greater DD&A. Overall, El Paso is still a strong company with lucrative reserves and production is only likely to accelerate under the wing of Kinder Morgan.
Consensus estimates for El Paso's EPS are that it will grow by 10.2% to $1.08 and then by 14.8% and 24.2%. Assuming a multiple of 21.5x and a conservative 2012 EPS of $1.18, the stock is fairly valued. This indicates to me that Williams will see its multiple expand to upwards of 21.5x.