3 Interesting Midstream Payouts; Industry Starting To Emphasize Free Cash Flow

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Includes: EPD, KMI, MMP
by: Valuentum
Summary

US midstream observers believe the space appears to be fundamentally well-positioned moving forward, thanks to the robust growth of North American onshore E&P activity in recent years.

An optimistic picture of the long-term potential of midstream operators is not to say that the US energy space is not without its fair share of challenges.

Regardless of the health of the US energy space as a whole, an individual assessment is necessary for any idea found within.

Let's take a look at three of the most intriguing ideas within the US midstream space: Enterprise Products Partners, Kinder Morgan, and Magellan Midstream Partners.

We applaud the industry for starting to emphasize free cash flow, as Enterprise Products revealed on its most recent conference call.

Image Source: Maureen

By Valuentum Analysts

Introduction

The US midstream energy space has struggled for the better part of four years, as measured by the share price performance of the Alerian MLP ETF (AMLP), and you're probably familiar with Valuentum's call on the space in mid-2015, which may go down in history as one of the most prescient calls we've seen. We also would like to applaud the industry for taking the steps forward to emphasize the importance of free cash flow when it comes to helping investors make better decisions. S&P Global wrote up a fantastic piece here that walks through this important difference, and Enterprise Products Partners (EPD) seems to be taking the lead in improving communications with the investment community. Here's what Enterprise Products Partners had to say on its most recent conference call (text as follows):

Most of my questions have been hit, but I have a follow-up for Randy. You obviously announced the buyback today. And in your comments, I noticed that there was a lot of focus on free cash flow. Is this a structural shift perhaps in how you sort of see messaging your financial flexibility going forward? Are you sort of shifting away from DCF and having an increasing focus on free cash flow? Is that something we should expect going forward?

Randall Fowler

Well, we -- I think the transition that we're making is from the MLP-centric model that, if you would, we had our own specialized financial metrics. And as we come in, the incremental valor of investment is from more traditional funds, institutional investors that are not accustomed to our MLP language. And I guess, 2 things. One, with us going more to a self-funding model, we can come in and utilize traditional financial metrics. So a little bit, we're just making that transition from an MLP-centric model, consuming a lot of capital and really trying to appeal to generalist investor. And we need to talk their language, which is GAAP measures, whether it's earnings per unit and price on earnings per unit, whether it's multiple of cash flow from operations or in terms of free cash flow.

Source: Seeking Alpha

US midstream observers believe the space appears to be fundamentally well-positioned moving forward thanks to the robust growth of North American onshore E&P activity in recent years. Production growth has routinely surprised to the upside recently and continues to do so, and natural gas liquid, crude oil, and natural gas pipeline capacity are all very tight as of late 2018, suggesting there are opportunities for attractive expansion in the near term. The number of drilled but uncompleted wells, most notably in the prolific Permian Basin, continue to grow, which indicates tightness in completion services, labor, trucking, and concerns regarding transportation of extracted energy resources.

The optimistic picture of long-term potential is not to say that the US energy space is not without its fair share of challenges. Commodity-based businesses always have a large degree of price-taking risk related to the inherently cyclical nature of commodity prices as delicate global supply/demand balances drive price realizations regardless of how well any single operator may execute. Concerns regarding the ability of the Permian Basin to continue delivering previously anticipated production growth and efficiency levels underscore the unpredictability of operations in the space as well. US hydraulic frac activity has disappointed to a degree of late, but this may indicate an opportunity for the once-beleaguered midstream space to catch up to the production growth experienced in the space.

Regardless of the health of the US energy space as a whole, an individual assessment is necessary for any idea found within. With that in mind, let's take a look at some of our favorite ideas in the midstream space.

Enterprise Products Partners - Dividend Yield: ~6.3%

Image Source: Enterprise Product Partners Fact Sheet

Enterprise Product Partners boasts one of the most integrated midstream energy systems in the US, with pipelines connecting to ~90% of refining capacity east of the Rockies. The entity continues to invest billions in new natural gas, NGLs and crude oil infrastructure, including in the Eagle Ford, Rockies, and Permian Basin. Enterprise Product Partners has raised its annual distribution in 20 consecutive years. The MLP also boasts a strong credit rating by the agencies (Baa1/BBB+). Still, investors should be cognizant that its business model remains dependent on the healthy functioning of the capital markets for new equity issuance, which is never guaranteed.

There are a lot of things going right for Enterprise Product Partners, including steady performance from its fee-based operations and the increase in energy resource production in the US of late. The company stands to benefit from expectations for the US to become a major crude oil exporter in the years ahead. Management is targeting debt-to-normalized EBITDA at 3.5x over the long term.

Though we have significant reservations about the use of 'distributable cash flow' in our valuation analysis (we prefer enterprise free cash flow), Enterprise Product Partners' distributable cash flow has shown excesses above its distribution in recent years but has faced pressure more recently. Such strength should pave the way for future distribution expansion, as long as the market continues to find comfort in this metric. We don't, however, as distributable cash flow excludes an assessment of growth capex, which is a material driver behind future net income expansion (which is included in distributable cash flow, a severe imbalance).

Here's what we say about its distribution in the dividend report, and as for its valuation, we think there could be upside based on our fair value estimate range (see image that follows):

Key Strengths

Enterprise Product Partners boasts one of the most integrated midstream energy systems in the US, with pipelines connecting to ~90% of refining capacity east of the Rockies. The entity continues to invest billions in new natural gas, NGLs and crude oil infrastructure, including in the Eagle Ford, Rockies, and Permian Basin. Enterprise Product Partners has raised its annual distribution in 20 consecutive years. The MLP also boasts a strong credit rating by the agencies (Baa1/BBB+). Still, investors should be cognizant that its business model remains dependent on the healthy functioning of the capital markets for new equity issuance, which is never guaranteed.

Potential Weaknesses

Though management has worked diligently to extend its debt maturities, it's hard to overlook the tens of billions of dollars raised via debt since 2009. The MLP has ~$5.7 billion of capital growth projects under construction with more to come through 2019, and spending related to such projects will continue to weigh on free cash flows. Total debt sat at ~$24.6 billion as of the end of 2017. The past several years have been bolstered by non-core asset sales, and reinvestment risk remains a concern. Borrowing capacity on its revolver mitigates risk to a degree, but we would like to see more cash on the books. The firm's unadjusted Dividend Cushion ratio is the most appropriate measure of the risks of the payout, in our opinion, given its capital market dependence.

Image shown: Enterprise Product Partners is currently trading at $28 per share. We think shares are fairly valued at $30 each.

Kinder Morgan (KMI) - Dividend Yield: ~4.4%

Image Source: Kinder Morgan investor presentation

Kinder Morgan is one of the largest midstream energy companies in North America, with ~80,000 miles of pipelines and 152 terminals. It re-consolidated its holdings in Kinder Morgan Energy Partners (KMP), El Paso Pipeline Partners (EPB), and Kinder Morgan Management (KMR). Kinder Morgan's operations are conducted through the following business segments: Natural Gas Pipelines (56% of EBDA), CO2, Products Pipelines, Terminals, and Kinder Morgan Canada. Management estimates that ~96% of cash flows are derived from take-or-pay and other fee-based contracts or are hedged.

Kinder Morgan's business strategy is to 1) focus on stable, fee-based energy transportation/storage assets, 2) increase utilization of its assets while controlling costs, 3) leverage scale from incremental acquisitions and expansions of assets that fit within its strategy, and 4) maximize the benefits of its financial structure. The company is doing a good job executing upon its strategy, but its capital structure has worked against dividend growth plans, creating a not-so-virtuous cycle for stakeholders. The firm targets a net debt-to-adjusted EBITDA ratio of 4.5 times over the long haul, and the measure was 4.6x at the end of the third quarter of 2018.

Kinder Morgan boasts an investment-grade credit rating, but mostly because it slashed its dividend payout a few years ago, much to the dismay of income investors. Though it continues to work to improve its balance sheet health, management is looking for significant growth in the payout through 2020. A $2 billion share repurchase program began in December 2017. It expects distributable cash flow and annual dividends per share to be $2.20 and $1.00, respectively, in 2019.

Here's what we say about the company's payout in the dividend report, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands in the lower half of our fair value range (see image that follows):

Key Strengths

Kinder Morgan is one of the most well-known midstream players in all of our coverage, and management continues to garner respect among the investor community. Though free cash flow has come under pressure as of late, the company is still free cash flow positive, but it was not sufficient in covering pre-cut dividends. After a ~75% dividend cut in late 2015, however, the future may be nothing like the past for Kinder Morgan. Management returned to aggressive dividend growth in 2018 and projects continued high dividend growth for the coming years, and it expects to full fund 2019 dividend payments and the majority of 2019 growth capex with internally-generated cash flows with no need for equity capital.

Potential Weaknesses

Kinder Morgan is in much better place with respect to financial leverage and capital allocation policy today than in the time leading up to its massive distribution cut, but we're watching its robust dividend growth plans with a cautious eye. Capital market dependence remains a key risk to its business model, and the company is more exposed to energy resource pricing than some may realize. Kinder Morgan is targeting debt-to-adjusted EBITDA of 4.5x over the long haul, (was 4.6x at the end of the third quarter of 2018). Expectations for 2019 dividends and a majority of growth capex to be covered by internally-generated cash flow is a great sign, but we would like to see this sustained before being impressed.

Image shown: Kinder Morgan is currently trading at ~$18 per share, which is firmly in the lower half of our fair value range. We think shares are fairly valued at $23 each.

Magellan Midstream (MMP) - Dividend Yield: ~7.0%

Image Source: Tony Webster

Magellan is a partnership that owns the longest refined petroleum products pipeline system in the US. It can access ~50% of the country's refining capacity, and profit is driven by throughput volume and tariffs. The MLP's distributions continue to advance at a nice pace, though it has no incentive distribution rights. In 2006, its annualized distribution was $1.17/unit, which is dwarfed by today's payout. Magellan's assets consist of the following: 9,700-mile refined products pipelines with 50+ connected terminals; 2,200 miles of crude oil pipelines and storage facilities; and marine terminals along coastal waterways. The entity's business is much more resilient than upstream companies, for example.

Magellan's management continues to point to strong trends in the industry-specific term distributable cash flow. Based on its project backlog, however, the entity continues to raise growth capital spending, with ~$2.5 billion targeted in 2018-2020 as well as $500+ million potential projects under evaluation. The MLP has raised only ~$260 million in equity over the past 10 years despite spending $5.4 billion in growth capex.

For MLPs, our valuation considers only maintenance capex (as opposed to total capex) in the derivation of enterprise free cash flow, consistent with the definition of 'distributable cash flow'. This peculiarity results in MLPs' fair value estimates receiving a boost for future operating cash flow growth without organically subtracting the growth capital associated with driving such expansion. Investors should be aware that, under a scenario in which all capex is deducted, our fair value estimate would be considerably lower. Future fee-based, low risk activities are expected to comprise 85%+ of its operating margin.

Here's what we say about the company's payout in the dividend report, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands in the lower half of our fair value range (see image that follows):

Key Strengths

Magellan likes to point out that it is an investment-grade MLP with no incentive distribution rights, allowing it a lower cost of capital. Its portfolio is rather diversified between refined products (~54% of operating margin), crude oil (~38%) and marine storage (~8%). As with many of its peers, the MLP notes that it expects future fee-based, low-risk activities to comprise a high percentage of its operating margin. Though economic returns on such investments should be watched closely, the company continues to evaluate more than $500 million of potential growth projects on top of the $2.5 billion projects in progress for 2018-2020. Magellan is targeting 5%-8% distribution growth in 2019-2020 and distribution coverage of 1.2x through 2020.

Potential Weaknesses

Magellan is committed to maintaining a solid investment-grade rating, and at BBB+/Baa1, the MLP is one of the highest-rated among its peers. Distribution growth ahead of core business expansion will drive lower coverage in coming periods, and the MLP is leveraged, albeit not as much as peers. We doubt management will mess with its proven history of distribution expansion, and the MLP has a revolver should near-term needs warrant. It has advanced the quarterly payout for 60+ consecutive quarters since its IPO, but total debt outstanding stood at roughly $4.5 billion as of the third quarter of 2018. Magellan's cost of capital may be lower than some peers' thanks to the lack of incentive distribution rights, but it is still dependent on the capital markets.

Image shown: Magellan Midstream is currently trading at ~$57 per share, which is in the lower half of our fair value range. We think shares are fairly valued in the high-$60s.

Conclusion

Since mid-June 2015, for example, the price of an ETF tracking the midstream MLP energy space has fallen more than 40%, while the S&P 500 (SPY) has rallied more than 30%. As Brian Nelson wrote a few years ago, the master limited partnership space is one that is fraught with risks. However, fundamentally, the backdrop is starting to improve, and many distributions are on firmer footing than in years past. Dozens of MLPs have already cut their distributions since mid-2015, and now, approximately 40% of energy infrastructure has transitioned to C-Corp from the MLP business model, up from practically 0% prior to the Kinder Morgan re-consolidation. In this article are just three ideas to keep on your radar screen. Most of all, however, we are forever pleased to be able to help investors make better decisions by warning about the MLP business model several years ago. Today, it's really good to see midstream companies starting to embrace free cash flow, too. Investors only win when there is more transparency! Thank you for reading.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: EPD and MMP are included in Valuentum's simulated High Yield Dividend Newsletter portfolio.