Antero Midstream (AM) has been a hot topic of discussion for midstream investors - especially after the official completion of its corporate simplification closed in March. This transaction moved the firm away from the master limited partnership model and corporate conversions, while all the rage, are quite often missing this kind of high octane growth story. Coverage has been universally bullish on Seeking Alpha and, for once, professionals agree: most investment banks have a “Buy” rating on the firm and the share price is currently below the lowest target on the Street.
To be clear, I’m also within the Antero Midstream bull camp and do have it rated as a “Buy” as well. Simply put, the tailwinds more than overcome the risk of a one trick pony asset base. The growth story for Appalachian shale gas, especially after all the recent production guidance cuts, is just too strong. While I will review the bull thesis at a high level, I wanted to also pin down the risks for investors to consider as I believe this will also add some context to my current modeling for 2019 and 2020 and what I will be watching for over the coming quarters. Overall, Antero Midstream makes for a great midstream investment versus the basket of alternatives but I do think investors need to be careful around some pieces to the story.
History, Asset Overview
Antero Midstream was formed explicitly to manage the current and future midstream energy assets of Antero Resources (AR). The company began trading publicly late in 2014 at around the same time as many midstream firms. There was a veritable deluge of midstream public offerings that hit the market in 2013 and 2014. Antero Midstream priced an upsized offering 25% higher than the above marketed range, following the hot offering of Shell Midstream the week before. Both equities priced at lower than 5% initial yields on roughly 1x coverage. Imagine that today.
Company assets include gathering pipelines, water delivery, compressor stations, and the ownership of processing and fractionation plants. All of these assets handle natural gas produced in the Marcellus and Utica shale in Ohio and West Virginia. As many know, I’m a major bull on the region when it comes to production growth. In my view, substantially all of likely net production increases in natural gas domestically will come from either Appalachian shale or from within the Permian Basin. While I am more of a skeptic on the potential for meaningful natural gas pricing improvement over time just due to low breakevens and ever-improving technology, what matters most for midstream energy is volumes. In my opinion, the demand growth potential, whether that be through the generation of electricity and industrial use or the growth of the nascent liquified natural gas (“LNG”) industry, is extremely solid. Midstream players that are set to serve the areas where that production will come from will benefit heavily. This view is not unique and remains the base case for most market research, including the EIA in their reference cases:
*Source: EIA, 2019-2050 Energy Production Outlook, Page 77
Antero Resources is one of the largest players in this region (trailing only EQT Corporation (EQT)) and is the fourth largest natural gas producer domestically, making this one of the strongest natural gas relationships in the midstream space. Outside of EQM Midstream (EQM), which I own personally, there is perhaps no better way to invest in this area as a pure play. In fact, given the focus on riskier gathering and processing (“G&P”) assets, Antero Resources is perhaps more levered to the success of the region than EQM Midstream.
Antero Resources management is also forecasting massive growth. Current scenarios call for at least 10% annual increases in production through 2023 (Slide 13) but perhaps greater than that if oil (which correlates with natural gas liquids) and natural gas pricing moves upward to justify expansion. With breakevens in the low $2s per mmbtu, pricing improvement will result in significant free cash flow that will most likely be reinvested in the business via acreage purchases or further development on current assets.
*Source: Antero Resources, March 2019 Investor Presentation, Slide 6
This slide encompasses the leverage most Appalachia E&Ps have to incrementally higher gas prices. United States production - not just Antero Resources - would likely increase significantly if prices moved meaningfully above $3.00/mmbtu.
If there is significant free cash flow that is used to add to acreage holdings, that would add to an already dominant position. As of the end of 2018, Antero Resources was sitting on nearly 20 trillion cubic feet of energy of net proved reserves, more than half of which are currently developed. Based on 2018 production, Antero Resources has more than two decades of reserves in place. That, at face value, provides substantial guaranteed flows on Antero Midstream assets.
In October of 2018, Antero Midstream GP announced that it would be acquiring all of the outstanding Antero Midstream common units – including those owned by Antero Resources – in a stock and cash transaction valued at $31.41/unit. After close, Antero Midstream GP would assume the Antero Midstream name as well as the prior ticker, trading as a corporation versus as a master limited partnership (“MLP”). Additionally, this transaction resulted in the outright elimination of the incentive distribution rights (“IDRs”) as well as Series B profit interests which had been given to co-founders and private equity sponsors. Both valuations looked fair by my eye and the IDR elimination actually came in slightly below comps despite the strong expected growth profile. Unlike many simplification transactions, this was one was well received by the market.
Adding to that strong reception, there were a lot of positives that came out of this deal beyond simplifying that ownership structure. Perhaps most striking was that Antero Resources agreed to slightly lower payout for each common unit it owned; smaller shareholders came out ahead of the general partner (“GP”) on a strict basis. Dividend growth projections were hiked due to the accretive nature of the deal on a pro forma basis and overall income payout remained stable if shareholders took the full stock election. In other words, this did not result in a “backdoor cut” to the dividend that has been common in other simplification transactions. For those that had a lower cost basis due to the tax-deferred nature of the MLP structure, the partial cash payout option also gave an option to raise funds to cover that burden. Overall, the end result was a more investor-friendly firm, raising the attractiveness for institutional investors that shirk the corporate governance issues that can be prevalent within MLPs. The only negatives that could be latched onto are the long term negative tax implications – the tax shield from the basis step up likely expires by 2023 – and the projected jump in leverage in the short term. On the whole, I held (and still hold) a very favorable view of this transaction.
Culmination Of The Bull Thesis
If the past is any indication, there has been clear value created here. At the time of the initial public offering (“IPO”) late in 2014, Antero Midstream was generating just enough distributable cash flow (“DCF”) to cover the $0.36/unit in annualized payments. Five years later and DCF per share (since the company is now a corporation) is up nearly 300%. This has not been a growth only story that has come at the expense of unitholders but that has not shown up in the share price. Unitholders that bought at the IPO, besides the quarterly payouts, saw only a 25% return over the prior five years heading into the recently announced simplification.
*Source: Antero Midstream, March Investor Presentation, Slide 8
We are concerned with future returns – not the past. No slide perhaps more encompasses the bull thesis of Antero Midstream than the above and its a loaded one. When comped against the largest midstream firms – both natural gas and crude oil – the newly simplified Antero Midstream has:
- The lowest leverage profile of the peer group, particularly based on forward EBITDA which is not done here.
- Arguably the highest distribution growth projections (using the low and high end of management guidance).
Using the Industrial Insights MLP Live Tracker as a base, the firm is expected to generate 13.2% DCF yield in 2019, a small premium to the midstream average despite having a growth profile that will outstrip nearly all peers over the next five years if management projections are to be believed. In my view, how the market currently values Antero Midstream is too cheap. However, there are some issues to highlight before I get into my models and overall view of valuation.
The Problems With Single Party Concentration
Antero Midstream has historically been managed explicitly for the benefit of its sponsor. Substantially all the revenue generated by this company comes from Antero Resources. This means that the business not only a direct call on Northeastern shale gas production growth but also on Antero Resources specifically. Much of the concern from the market revolves around this single party risk aspect. Unfortunately, there has been no interest from management in moving into more diversified revenue streams. Contrast this with EQM Midstream which recently made the billion dollar acquisition of Eureka Midstream, a header pipeline system that serves a multitude of customers. Likewise, the firm’s Mountain Valley Pipeline (“MVP”) project, once completed, will be an in interstate pipeline yielding much-needed takeaway capacity for Appalachia. This type of diversification is often well received but has been largely ignored by Antero Resources as a viable path.
I am not sure you would see us going out there and competing with other third-party midstream where we are paying high multiples to service somebody else. So we are pretty conscious that it’s a highly competitive market and oftentimes midstream companies overpay in order to be able to provide services for people. So, we look at it, but we don’t see it as quite as attractive as servicing AR.
Paul Rady, Antero Midstream (and Antero Resources) CEO, Q3 2018 Conference Call
There is little reason for this to change. Backlog, outside of the joint venture with MPLX (MPLX) at Sherwood, are Antero Resources directed. Further, Antero Resources itself states that the gathering and compression fees paid to Antero Midstream are below the average in Appalachia by more than 10% (Slide 36). The E&P makes it abundantly clear that it is in the driver’s seat when it comes to asset planning and helping guide infrastructure development and notes it is a major beneficiary of the single customer model and is being catered to. Should fees really be lower than average given this? Strong argument to be made that perhaps it should not. Even though Antero Resources is a major holder of the common units, I think many are skeptical that transactions being done here are truly arm’s length and at fair third-party valuations. This is unlikely to change and it is quite likely that the firm trades at a perpetual discount because of it.
The vast majority of current Antero Resources acreage, as well as any future purchased acreage, is dedicated to Antero Midstream. There is a lot of capital spending to be done to support that, particularly given the goal of Antero Resources to, at minimum, increase production by more than 60% by 2023. If that acreage requires new builds, contracts mandate that Antero Resource agree to pay roughly three quarters of overall capacity through minimum volume commitments (“MVCs”) for the next ten years. All good right? Many view this as a strong positive.
Of note, any and all low pressure gathering lines are not subject to MVCs.Remember that low pressure systems are located near the wellhead, giving them the shortest useful lives as production is exhausted. Pipelines are much like the human body: low pressure gathering lines are the smallest veins which flow into header pipes (larger veins) which flow into transmission pipelines (arteries). The highest value puzzle pieces are those arteries. Short term economics on low pressure gathering are often extremely attractive but can lack staying power due to well decline rates. At some point, gas in an area is exhausted and it makes more sense to build new low pressure systems logistically versus tieing in.
*Source: Author calculations.
The risk from low pressure has only grown with time. The current four year identified project inventory ($2,000mm) shows only $225mm in high pressure gathering spending; low pressure is double that. In short, the culmination of risk factors here include:
- Antero Resources remains substantial source of revenue; management lauds below market rates.
- No plans to diversify into other basins or other producers; capex budget significantly tilted to support Antero Resources.
- Continued focus on riskier assets with lower MVC contract protection if production rates fall.
- Asset useful lives are shorter here than with other MLPs that focus on interstate pipelines; risk of DCF overstatement.
Cuts Forecasts... Will It Be The Last Time?
Early this year, Antero Resources disclosed plans to keep drilling and completion spending within cash flow for 2019. This was done in response to lower pricing, in particular the fall in natural gas liquids (“NGLs”). Just about every $5.00/bbl change in C3+ NGL pricing has a near $200mm impact in revenue for Antero Resources. With Mont Belvieu benchmarks falling to $30.00/bbl in December (a fall of more than $20.00/bbl) there was a near billion dollar implied cut in the cash flow outlook for 2019. Yes, Mount Belvieu spot rates have since recovered half of that fall. However, I would not expect an upward revision in guidance. A return to the low $30s/bbl for C3+ would likely drive negative free cash flow even on the announced slash to the budget – Antero Resources had already built in some of a reversion in NGL pricing when announcing its 2019 guidance.
Tying back into recent Range Resources coverage, lowered production growth has been the trend for Appalachia E&Ps as they try to reduce reliance on credit markets, conserve reserves in the hope of better prices, and as they try to convince shareholders that they are not destroyers of capital. This cut was, on the net, a large deceleration from the prior guidance of 20% near term production growth to 12.5%. While not a surprise given Antero Resources started to move towards the “spending within its means” mantra late in 2018 alongside other E&Ps, the breadth of the cut took many by surprise. Antero Resources is, as I’ve reinforced, the sole driver of Antero Midstream revenue. Any pullback in upstream drilling activity by its sponsor negatively impacted its earnings prospects and, by extension, distribution coverage and growth. This might not be the last time Antero Resources is forced to lower its production guidance. CFO Glen Warren stated that the company has “built in the flexibility to adjust our development plan accordingly”. On the net, this is balanced by the firm transportation agreements that Antero Resources has entered into. Takeaway capacity was hard to find in recent years in Appalachia; management entered into long term agreements based on higher production.
*Source: Author calculations.
Antero Midstream will only pay out $1.24/share and $1.50/share in my view for 2019 and 2020 but the DCF would be there for higher payments – even if comprehending a normalized tax rate for the firm in a world where the tax shield does not exist. While Antero Resources does own weaker assets with shorter useful lives, it’s likely that asset utilization is maintained on most of the company’s portfolio for quite some time given the Appalachia outlook.
My price target is $17.50/share, representing a 9.0x EBITDA multiple on 2020 expectations. This is a 0.5x turn discount compared to the MLP sector as a whole and roughly 1.5x turns cheaper than my targets for well-capitalized large caps such as Kinder Morgan (KMI) or MPLX (MPLX). I believe this accurately weighs the strengths of the firm (low leverage, attractive asset positioning) versus the risk profile. There is upside here but investors do need to be cautious on setting expectations too high and understanding that this an asymmetric play that will live and die by Antero Resources execution. Other single party failures (Sanchez Midstream (SNMP)) or those with depressed valuations (Oasis Midstream (OMP)) illustrate why caution is needed.
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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.