One Reason Why Midstream Is Not 'Junk High Yield'

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Includes: AMID, BPL, BX, CBL, CG, CTL, CXO, D, DKL, ENB, EPD, ET, GME, HCR, IPPLF, KKR, KMI, MMLP, MPLX, NBL, NBLX, SEMG, SHLX, SKT, SMLP, TGE, WMB
by: Michael Boyd
Summary

High yield often brings heavy pain and eventual shareholder losses. Why is it different with midstream?

I understand the trepidation from many but continue to see midstream energy as the most compelling long-side trade in the market today.

There are key differences impacting this space versus others. One of them is continued interest from some of the largest "smart money" institutionals, like BlackRock, KKR, and others.

Put a couple of these in your portfolio. Five years from now, I doubt you'll be disappointed with the returns.

In a low yield world where investment grade corporate bonds and US Treasuries often pay out less than 3%, Seeking Alpha has become a lightning rod for high yield income recommendations. Many of the most popular companies that have attracted author attention have seen outright awful performance almost no matter the entry point: CBL & Associates (CBL), CenturyLink (CTL), Hi-Crush (HCR), GameStop (GME), Tanger Factory Outlet Centers (SKT), etc. Given that backdrop, I often get asked questions from investors on why I’m so bullish on midstream energy and why I think these distribution yields are sustainable. On the surface, it looks nuts and many readers are “once bitten, twice shy”. Once you have gotten burned in this area of the market once - and many have - it is tough to maintain composure in yet another high yield sector facing weak price action. There is also no question that there has been plenty of junk in midstream universe as well that needs to be avoided: Summit Midstream Partners (SMLP), American Midstream Partners (AMID), Martin Midstream Partners (MMLP), and several others have all gotten big red flags thrown from me. It’s a tough world to navigate.

For any of the companies above, readers might have been left puzzled: “I see the deep value! Look at all of these cheap financial metrics! But... where are all the hedge funds, endowments, and pension funds? Don’t they see the value? Are they stupid?” While some might think that quite often these major players are not, in fact, bumbling idiots and it is just an investor not seeing - or at least overly discounting - the risks.

This is one important differentiating aspect (one of many, in my view) for midstream energy. There is continued interest from institutional capital, in other words, the so-called “smart money”. Interest in energy infrastructure, particularly from U.S.-based private equity, is at all-time highs. In my opinion, seeing whether there is some large buyer support behind a stake is an important question to ask. While a lack of institutional interest is not a death knell for a distressed firm, it is an incredibly poor signal that many should have heeded for firms that litter the high yield graveyard.

Energy Infrastructure and Big Investors

I'm not here to pitch a "pie in the sky" view. The outlook for institutional capital for the energy sector is not all sunshine and roses everywhere you look. The clear (albeit long-term) shift towards greater renewable energy market share alongside the debate on the “morality” of fossil fuel exploitation given climate change has led to many institutions pledging to divest their investments in the sector. Pension funds, insurers, and others continue to feel pressure from all sides to show that they can manage climate-related risks alongside the myriad other issues they handle on asset management. Divestiture has been the knee-jerk reaction, and in sum total, trillions of dollars have or will be leaving the space. I do think it is important that this exodus from some investors is framework-driven, not financial. We have seen the same thing occur in the "sin stock" category (tobacco, alcohol, firearms) and in financials in the past. It is not the end of the world, and results matter.

Thus, not everyone is taking the moral high ground. The steep free cash flow yields on both public equities and greenfield projects, coupled with long-term asset durability, is incredibly attractive for private capital that holds no bias. In 2018 and 2019 alone, hundreds of billions of dollars of deals will be made between publicly traded firms and private capital. As a few examples:

  • In January, Blackstone (BX) agreed to acquire 100% of the general partner (“GP”) of Tallgrass Energy (TGE) and associated assets for $4.8 billion, giving it a publicly traded midstream vehicle that it intends to potentially use as a lever for dropping down its owned assets. Over the past fifteen years, Blackstone has invested more than $50 billion in energy infrastructure projects.
  • In May, IFM Investors announced its intent to acquire Buckeye Partners (BPL), representing more than $10 billion in enterprise value. As one of the largest owners of product terminals and tank storage capacity, the deal catapulted IFM Investors into an even larger position in the space; the pension fund already controlled more than $50 billion in infrastructure worldwide, not including its listed equity investments.
  • Partnerships between public and private money is also common. Early in the year, SemGroup (SEMG) announced a partnership with KKR & Co. (KKR) to form a joint venture focused on Canadian assets, subsequently acquiring Meritage Midstream to further build out its footprint in natural gas production. This was another billion-dollar deal.
  • Concho Resources (CXO) sold its Oryx oil gathering and transportation system to Stonepeak Infrastructure Partners for $2 billion. Like many other private institutions here, Stonepeak manages quite a lot of money: over $15 billion at last report.
  • In the race for the build-out of crude oil export terminals in the Gulf, private equity is everywhere. Jupiter MLP has private equity backing for its 1,000 mbpd facility near Brownsville, Carlyle Group (CG) is going its own on its Corpus Christi project, Cresta Fund Management has backed privately held Sentinel Midstream, and Blackstone is involved through its ownership of Tallgrass Energy, which is trying to build the Plaquemines Liquids Terminal at the mouth of the Mississippi. Cumulatively, if completed, these projects represent billions of dollars in investment.

These are just a few deal highlights, and more are on the way. As three likely rumors that might see fruition, Global Infrastructure Partners and Williams Companies (WMB) are reportedly interested in bidding for Noble Midstream (NBLX), buying out sponsor Noble Energy (NBL). Inter Pipeline (OTCPK:IPPLF), a Canadian oil midstream play, also recently received an unsolicited takeover bid. SemGroup is also reportedly fielding takeover interest from a private equity consortium. Surprised? Investors should not be. Infrastructure fundraising totaled $85 billion last year, according to Preqin, and is forecast to reach a similar level this year. In total, more than $40 billion of deals like the above have been announced in 2019 year to date.

Steep Valuations, Private/Public Disconnect

Importantly, these deals are being done at or above public market comps and valuations. Last Summer, Dominion Energy (D) sold its 50% interest in Blue Racer Midstream (Appalachia pipelines) to First Reserve for 15x EBITDA. A common mention here, SemGroup sold a 49% interest in the Maurepas Pipeline for 13x EBITDA to Alinda Capital. Rumors continue to swirl that Energy Transfer (ET) might sell its interest in the Rover Pipeline for a multiple in the teens. That is an incredibly solid sign that there is plenty of capital flowing in for the right assets despite the outlook.

Coupled with the shift to the “MLP 2.0” model by senior executives, a trend which has brought some rationality to a sector once built on leverage and aggressive payouts. Gearing is on the decline, coverage is up, and overall asset quality continues to tick higher. Further consolidation is on the way. In my opinion, on the aggregate investors are left with an investment opportunity that comps extremely well against the S&P 500 on free cash flow yield while maintaining significant institutional backing.

Importantly, while it has its place, investors do not have to go dabbling in small partnerships to find the prospect of fat returns, even though I find several alluring (Shell Midstream (SHLX), DKL Logistics (DKL)). Potential investments in operators like Enbridge (ENB), Enterprise Product Partners (EPD), Kinder Morgan (KMI), MPLX (MPLX), and many of the largest companies by market cap all look incredibly attractive. In many (most) cases, these are investment grade companies with high cash flow visibility across most of their base. If you asked me to pick between AT&T (T) versus one of the above over the intermediate term, no question what recommendation I would make.

Conclusion

There is no question that the energy sector as a whole is going through growing pains. Commodity volatility, coupled with elevated expectations from equity and bondholders, has the upstream E&Ps adjusting their production. That will have implications for many. On the other hand, the relative underperformance versus benchmark indices and outright multiple compression in the sector has now gone too far, in my opinion. I have gone overweight energy, in particular midstream, heavily.

Disclosure: I am/we are long SEMG, MPLX, ET, SHLX. 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.