Seeking Alpha

5 Reasons To Buy ONEOK

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About: ONEOK, Inc. (OKE)
by: Freedom in Retirement
Freedom in Retirement
Long only, value, long-term horizon, medium-term horizon
Summary

The company is expected to complete five growth projects in the next two quarters.

EBITDA, gross margin, and operating income margin continue to improve.

The operational performance is stunning.

Since my last article published on ONEOK, Inc. (OKE) in the summer, the stock has returned 5.9%, including distributions. In the previous article, I was primarily concerned regarding the distribution sustainability, mostly due to high capital expenses. Since the facts have changed, it is essential to change my mind.

Investors should consider ONEOK as a long position for income-investing for the following reasons.

  1. The company continues to add capacity.
  2. OKE is bullish on the natural gas gathering, processing, and pipeline segments for the rest of 2019.
  3. The EBITDA story from a year-over-year basis is appealing.
  4. OKE's operational performance continues to improve.
  5. The company is expecting lower capital expenses in 2020 compared to 2019.

OKE's tailwinds

One positive aspect of OKE is the completion of five growth projects between now and Q1 2020. Terry Spencer, President and CEO, mentioned in the Q3 2019 earnings call that the projects will add more than 700,000 barrels per day (bpd) of NGL transportation capacity, 125,000 bpd of fractionation capacity, and an additional 400 million cubic feet of natural gas processing capacity. The natural gas and NGL infrastructure will help to reduce natural gas flaring in the Williston Basin significantly. Also, Terry expects that the infrastructure will provide immediate earnings and volume uplift in 2020 and stable fee-based growth in the interim.

Another positive aspect of OKE is that management is thinking about deleveraging. Walt Hulse, CFO and EVP, mentioned that the company is targeting a debt/EBITDA run rate of 4.0 in Q4 2020 and Q1 2021. The company must deleverage since the debt/EBITDA has been increasing. Further discussions on the topic come in the following section.

For the end of 2019, management is bullish on the natural gas gathering, processing, and pipeline, as the company expects the segments to trend toward the high-end of the financial guidance range. Perhaps, the sections could exceed guidance, according to Walt. On the other hand, the company is bearish on the natural gas liquids segment, primarily due to lower optimization and marketing earnings from narrower than expected pricing spread between Conway and Mont Belvieu.

OKE's Revenue and EBITDA

Over the past eight years, revenue has trended slightly lower for the third quarter. In Q3 2019, the company posted revenue of $2.26 billion, down from $3.03 billion in Q3 2012, and down from $3.39 billion a year ago. Nonetheless, EBITDA has been trending upward, which means that the company is managing operating expenses. On a YOY basis, EBITDA increased slightly from $603 million to $604 million for the third quarter. More impressively, EBITDA has soared by 86% from Q3 2012 to Q3 2019.

Image created by the author. Data collected from YCharts

Image created by the author. Data collected from YCharts

Moreover, the gross margin and the operating income margin have expanded to 32.1% and 21.3%, up from 21.4% and 14.6% a year ago, respectively. What is more, is that these metrics are the highest in the past eight years. Going forward, we want to see the trend continue.

Image created by the author. Data collected from YCharts

OKE's operational performance

OKE's operational performance looks solid at first glance. However, it is essential to look at the drivers to determine if the performance improved for the right reasons. The DuPont ROE analysis is a tool to measure a company's operational performance. The ROE itself only measures the efficiency in which the company produces net income per dollar of shareholders' equity. However, it does not indicate what the drivers for such efficiency are. Hence the usefulness of the DuPont summary. The analysis gives an idea about the company's tax and interest burden, operating income margin, asset turnover, and equity multiplier.

Applying the DuPont ROE mechanically straight from the textbook is not possible due to one-time events such as discontinued operations, impairments, and asset sales. Therefore, I modified the formula slightly to produce, what I believe, is an accurate picture of the business on an ongoing basis. Below are the DuPont ROE and modified DuPont ROE formula. All amounts are in millions unless ratios or otherwise noted.

OldROEDuPont ROE formula

Modified DuPont ROE formula

If you have read my articles recently, you will notice that I also changed my methodology slightly on the way the ratios are calculated. Previously, I used to look at the ROE of one period and compare it to the same period in the previous year. The current method considers the trailing twelve-month financial data for each period. The accounts that appear in the income statement and cash flow statement are added, i.e., the interest expense is the amount that the company paid in the previous four quarters. The accounts that appear in the balance sheet are averages of the past four quarters. The primary advantage of using the new methodology is that it removes any seasonality effects.

Image created by the author. Data collected from YCharts

Image created by the author. Data collected from YCharts

Image created by the author. Data collected from YCharts

At first glance, the return-on-equity seems to be on an improving trend since Q2 2018. On a quarter-over-quarter basis, though, the ROE remained unchanged at 16.4%. Nonetheless, the ROE has improved substantially from the 10.7% reading in Q1 2018. Now, it is essential to discuss what is driving the ROE.

The first driver is the tax burden. The metric describes the ratio of EBT from continuing operations that the company keeps as net income from continuing operations after paying for taxes. As the coefficient approaches 1.0, it means that the company is paying a small amount of taxes compared to EBT. In brief, a higher coefficient is better. OKE's tax burden has improved slightly since Q2 2018 as the metric expanded from 0.6 to 0.7 in Q3 2019.

The second driver is the interest burden. The coefficient illustrates the ratio of EBIT from continuing operations that the company keeps as EBT from continuing operations after funding the net interest expense. In this case, the higher is better, with a maximum of 1.0. OKE's interest burden has remained relatively flat over the past six quarters at 0.7.

The third driver is the operating income margin, which tells the percentage of revenue that the company transforms into operating income. The higher the metric, the more efficient the company is in containing costs. Investors should be happy that OKE's operating income margin has expanded considerably from 12.8% in Q2 2018 to 17.9% in Q3 2019. The company is doing an excellent job of managing the cost of revenue and operating expenses.

Another driver is the asset turnover. The efficiency ratio measures how many dollars of revenue the company generates per dollar of asset, and higher is better in this case. In OKE's case, the coefficient has deteriorated from 0.8 in Q2 2018 to 0.5 in Q3 2019, as assets have increased while revenue has decreased. Perhaps, management should revisit its assets list and consider the possibility of selling some of the low revenue-generating assets.

The last driver is the equity multiplier, which is a form of financial leverage. The coefficient takes into consideration current and long-term liabilities. A factor above 3.0 raises questions about debt sustainability. When the factor surpasses 5.0, the company is highly overleveraged. In OKE's case, there are no concerns over the leverage level since the operating income is improving. While assets have increased, so has the shareholders' equity.

In brief, OKE's ROE has expanded for the right reasons. The company is paying a smaller percentage of taxes compared to EBT, and the operating income margin has grown substantially. Financial leverage has also increased slightly.

OKE's long-term debt

It is crucial to determine if OKE's rising leverage is sustainable. The interest coverage ratio and the debt-to-equity ratios provide hints about the company's long-term debt sustainability. The former tells if the company can cover the interest expense from operating income. A ratio below 1.5 is dangerous, and a ratio below 1.0 requires immediate attention. The later coefficient describes the company's leverage level from the long-term debt perspective.

On a positive note for OKE, the interest coverage ratio has improved substantially over the past six quarters. For the trailing twelve months ended in Q3 2019, the company produced $1.90 billion in operating income. Meanwhile, it paid $481 million in interest expense. The interest coverage ratio was 4.0, up from 3.4 in Q2 2018. In brief, OKE's ability to pay creditors from operating income is improving.

Image created by the author. Data collected from YCharts

The financial leverage from the long-term debt has increased slightly primarily due to higher long-term debt, which was partially offset by an increase in shareholders' equity, although at a lower rate. Nonetheless, the debt/equity ratio is not concerning, as the coefficient is below 2.0. However, it is worth monitoring the rapidly rising long-term debt.

Image created by the author. Data collected from YCharts

The long-term debt has also increased at a faster rate compared to EBITDA, which is not optimal. Therefore, the long-term debt/EBITDA ratio has expanded from a six-quarter low of 3.8 in Q4 2018 to 4.6 in Q3 2019. Right now, the metric is not concerning, but it is worth keeping an eye on it.

Image created by the author. Data collected from YCharts

OKE's distribution coverage is worth paying attention

The distribution coverage ratios calculated from the net income and cash flow from operations provide color on the distribution sustainability. The former tells if the company can cover the distributions from net income. The latter illustrates if the company can cover capital expenses and distributions from the cash flow from operations.

From the net income perspective, the story looks slightly bullish. While the company still does not cover the distributions from the net income, it is close. For Q3 2019, the DCR was 0.9, up from 0.6 in Q2 2018, primarily driven by an increase in net income.

Image created by the author. Data collected from YCharts

From the cash flow from operations side, the story looks slightly bearish. Due to rapidly increasing capital expenses, the company's distribution coverage ratio has been declining steadily since Q1 2018 from 0.8 to 0.4 in Q3 2019. OKE should focus on reducing capital expenses or improving cash flow from operations because the distribution may be compromised in the long term. Jeremy Tonet, from JP Morgan, brought a similar point on the Q3 2019 earnings conference call regarding capital expenses. Walt mentioned that the company is expecting a meaningful step down in capital expenses in the next year compared to 2019, which is excellent news for distribution sustainability.

Image created by the author. Data collected from YCharts

Overall, OKE's distribution sustainability is worth paying attention to. While there is no evidence that the company should cut the distribution, the company should not hike the distribution next year until capital expenses decline or CFO expands.

OKE's relative valuation

Comparing the relative value of a company to its peers is essential. However, not because a company is overvalued or undervalued, it means that investors should sell or buy. Instead, it is crucial to ask if current and future metrics justify the valuation status. Investors could use the EV/EBITDA metric for relative valuation purposes. The primary advantages are that the company's capital structure is irrelevant, it uses market values, and it does not consider the impact of debt and taxes. Investors could also use P/E or P/B. However, these metrics have significant disadvantages that render the metrics useless in some situations. For instance, the P/E metric is useless when companies post net losses. Similarly, the P/B is not-applicable when balance sheets do not accurately reflect the real economic value of the assets, which is in most cases.

The story from the trailing-twelve months and the forward-looking perspectives is the same. The stock seems overvalued compared to its peers. From the TTM basis, the company has an EV/EBITDA of 15.86, well above the peers' median of 10.03. From a forward-looking basis, OKE's EV/EBITDA is 15.59, compared to the industry median of 8.07. However, the overvalued status seems justified as OKE's operational performance is outstanding, margins continue to improve, and there are no concerns from the leverage side.

The takeaway

OKE is a dependable company. It continues to add capacity. EBITDA continues to improve despite lower revenue. On the revenue side, the company is expecting higher revenue due to the completion of the five growth projects within the next two quarters. The operational performance continues to grow, primarily driven by expanding operating income margin. Also, the company is thinking about deleveraging, and capital expenses will decrease in 2020 compared to 2019. Once capital expenses decline, the distribution sustainability should improve. OKE is a buy.

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: The opinions expressed herein are the author’s sole views, and they do not constitute investment advice in any form. Past performance may not be indicative of future performance. Always do your due diligence, and determine if the investments mentioned here suit your risk tolerance and objectives, your return objectives, and your personal constrains.