Targa Resources (NYSE:TRGP) excelled in 2020 and will reward shareholders with higher distributable and free cash flow through 2023. Unlike many midstream companies, Targa's performance doesn't need a full recovery in commodity volumes because the majority of their gathering and processing is in the Permian basin where drilling has been robust even through the downturn. They are benefiting from ongoing efforts to simplify their expensive capital structure, using free cash flow to reduce equity, both preferred and joint venture. When considering the full value of Targa, we must measure both the dividends and retained earnings which are growing substantially. For these reasons, Targa is a strong buy at the current market price.
Like most midstream companies, Targa had a turbulent 2020, but their long term planning set them up to break records in 2020: record EBITDA, free cash flow, Permian natural gas inlet volumes, NGL production and transportation volumes, fractionation volumes and LPG Export volumes. While many of the shale basins struggled to maintain production, the Permian basin, for the most part, kept on chugging.
The story of Targa’s outsized Permian footprint really begins in 2015 with the $7 billion mostly stock deal to acquire Atlas Energy and Atlas Pipeline midstream. In addition to midstream assets in the Mississippi Lime, the SCOOP, Arkoma and Eagle Ford, Atlas gave them a sprawling gathering and processing operation in the Midland Basin which, in conjunction with their other Permian operations in the Central Basin Platform, helping them build a leading position in the play. Their Permian basin footprint served them well in 2020 as it received the lion’s share of attention from E&P companies’ severely depressed drilling budgets.
Today, despite the challenges, they process 2.5 Bcf/d of Permian natural gas (about 15% of the total volume produced in the Permian) and 350 Mbbl/d of NGLs (natural gas liquids) – both record volumes for them. Over the last several years, they’ve taken this baseload of production in this basin and others, and built a fully integrated value chain, incorporating interstate pipelines for transporting Y-grade NGLs and processed natural gas, fractionation plants in Mont Belvieu to take the raw grade NGLs and process them into purity products like ethane, propane, butane and natural gasoline. They’ve also grown their export facilities to put more barrels on the water for overseas transport. As we will see, the growth party will continue into 2021 and 2022.
Midstream is ending a blistering 10 years of investment in which they grew and invested so rapidly that it was nearly impossible to understand the value of the company. Compounding that issue, are complex financial structures that challenged (and still challenge) even savvy investors. However, midstream is simplifying those capital structures and the pace of midstream infrastructure growth has slowed to crawl, giving us a rare and birds-eye view into the true value of these companies. (Hint: the value is nowhere near the eye-popping stock values we saw in 2014; and the lows we saw in March of 2020 are equally ridiculous. The truth in somewhere between those values.)
Targa Resources Corporation purchased the last of Targa Resources Partners in 2016, simplifying into a standard C-Corp, and while they’ve added joint ventures and preferred stock since 2015, the year 2020 marked the first year where investment slowed, distributions were cut and free cash flow soared, giving them the ammunition to resume simplifying their capital structure. Here’s a summary of what they’ve done and the base case for their plans:
Figure 1: Author with data from Targa investor presentations and 2020 annual report
Scanning the list of accomplishments here, Targa took advantage of every market dislocation. They bought $300MM of long-term debt for $240MM - $60MM below par value. They bought 5.5 million common shares at an average price of $16.72, essential half of what it trades at today. They issued $1 billion of senior unsecured notes at 4.875% due in 2031 and retired $1.1 billion of senior unsecured notes due in 2023-24 with an average yield of 6%. They bought back all their TRP (Targa Resources Partners) preferred shares for $125MM – these were yielding 9% - and they bought $46MM of TRC (Targa Resources Corporation) Series A preferred shares which yield 9.5%.
Now Targa is setting their sights on their Stonepeak Infrastructure Partners (“Stonepeak”) joint venture equity. Leveraging joint ventures for capital allows a midstream company to invest in assets without overcommitting capital, adopting too much risk and exceeding their debt covenants. Usually, but not always, they retain operatorship in the assets and receive the lion’s share of the profits. In the case of Stonepeak, Targa did something interesting. They allowed Stonepeak to receive outsized returns on their invested capital in exchange for the flexibility to buy it back in relatively short order, a layaway plan for billion-dollar midstream assets. The terms for that buyback become more favorable in Q1 of 2022, and that is Targa’s base case for their buyback timeline. Targa will pay Stonepeak between $900-950MM to buy back Stonepeak’s portions of 3 joint ventures and reap a return of 5-6x EBITDA or $168MM/year at the midpoint.
Figure 2: From Targa’s 2020 annual report
Here’s what they will be buying back. Grand Prix is an NGL (Y-grade natural gas liquids) interstate pipeline operated by Targa that pulls NGLs from the Permian basin, Barnett basin in North Texas and various basins in Oklahoma and transports those barrels to their extensive fractionation assets in Mont Belvieu Texas – the fractionation and petrochemical capital of North America (see figure 3). Grand Prix Pipeline LLC is collectively owned in a joint venture in which Targa’s owns 56% percent, Blackstone Energy Partners (“Blackstone”) owns 25% and Stonepeak owns 19%. The $350MM extension into Oklahoma is fully owned by Targa.
Figure 3 Source: Targa’s investor presentations
As Targa’s obligations on other third-party NGL pipelines expire, they will move those volumes onto Grand Prix, saving the firm transport payments and driving additional revenue for Grand Prix. Grand Prix’s extension into the STACK play in Oklahoma is supported by significant long-term transportation and fractionation volume dedications from Williams (WMB) which has already come online. The pipeline’s throughput can be increased by adding additional pump stations and Targa will benefit from additional third-party commitments. The full cost of the pipeline is $1.3 billion. In a buyback scenario, Blackstone would retain their ownership, and Targa would buy Stonepeak’s 19% share.
The Gulf Coast Express Pipeline (GCX) is a natural gas interstate pipeline operated by Kinder Morgan (KMI) that delivers natural gas from the Waha area in West Texas to Agua Dulce near the Texas Gulf Coast. Fully subscribed under long-term contracts, GCX provides approximately 2.0 billion cubic feet per day of incremental natural gas capacity to the Texas Gulf Coast markets. KMI owns 35%, DCP and Altus Midstream (ALTM) own 40%, Targa owns 5% and Stonepeak owns 20%. The full cost of the pipeline is $1.75 billion. In a buyback scenario, Targa would purchase Stonepeak’s interests and increase their overall share to 25%.
Finally, there is the 100 Mbbl/d, Targa operated fractionation train, simply labeled Train 6 which is 20% owned by Targa and 80% owned by Stonepeak. A fractionation train is a series of fractionators that take the mixed NGLs from a pipeline like Grand Prix and separates the stream into purity components (ethane, propane, butane, iso-butane and natural gasoline). The price per BTU rises as you move from natural gas to ethane to butane, etc. This is, in part, why natural gas plants remove the NGLs from gas streams at their processing plants, move them through a pipeline like Grand Prix and fractionate the mixed NGLs for use further downstream. The full cost of Train 6 was $350 million.
The beneficiary of all this capital buyback is the common shareholder, who will see distributable cash flow grow significantly through 2022. Before we review that, let’s explore one more piece of the midstream puzzle.
Given the complexities with midstream assets and all the individual contributors and detractors of EBITDA, it has been historically challenging for investors to gauge how much growth capex is required to maintain current EBITDA levels. This leads financial analyst to occasionally ask, how much gas do we put in the tank to keep the boat afloat. To which senior leadership provides the obligatory vague and unsatisfying answer – neither defining it nor clearly answering the question. Here’s the challenge. How much growth capex is invested to keep EBTIDA flat depends greatly on (1) where and how that capital is deployed, (2) the rate of return on that capital (3) commodity prices, (4) whether firm transport contracts are being renewal, (5) the re-contracting rates for various projects, (6) the amount of shortfall payments for minimum volume commitments, (7) their hedges (8) how quickly inlet volumes are declining (9) the intensity of competition (10) whether you can further leverage assets to create more income downstream...and on and on. While companies would find the task nearly impossible because they must answer with precision, investors and financial analysts can certainly take a crack at it.
The dirty little secret in North American midstream is that shale wells decline rapidly. While it is true that produced natural gas declines slower than oil and Permian wells become gassier over time, all wells decline, and shale wells (unlike conventional wells) decline more rapidly. A shale well with a 30% natural gas decline rate per year will deplete almost 85% of the gas produced over its lifetime in the first 5 years. You can sift through a lot of midstream investor slides and while a few slides talk about the need for global investment, you will rarely (if ever) see a slide or 10K report that quantifies how rapidly the wells tied to their gathering and processing operations are declining and how much midstream growth CAPEX is required to maintain their EBITDA levels.
Declining field production has a knock-on effect, reducing the income from gas processing plants, marketing revenue and any downstream assets like fractionation plants. Moreover, as entire regions decline, the available takeaway capacity for intrastate and interstate pipelines becomes under-utilized leading to reduced firm-transport re-contracting rates. Firm transport is just rented space on a pipeline. If I need to move molecules from one area to another, I rent space on a pipeline from a midstream company. Typically, these are multi-year contracts. As the available space on pipelines increases, the law of supply and demand reduces the return on those pipelines. For pipeline companies looking to rationalize their investments, losing revenue from re-contracting is an ever-present danger.
A great example of this are the Louisiana assets held by Targa that exist to serve GOM (Gulf of Mexico) shallow and deep-water wells. The average breakeven point for natural gas wells in the GOM is $4.50/MMbtu and above. As E&P companies moved onshore where the returns improved, the volume dropped from 8.5 Bcf/d in 2006 to 2.7 Bcf/d today. Their coastal Louisiana G&P operations have steadily declined over the years, although volumes have recently stabilized (see figure 4).
Why do midstream companies like Targa retain ownership in underperforming assets like these coastal straddle plants and those in the ever-declining Barnett shale region? Three reasons: one, they require very little investment and thus generate a lot of free cash flow; two, a new buyer will pay very little for these assets; and three, they provide a hedge on future production. The hot basins of today, like the Permian and the Haynesville, and to a lesser extent, the SCOOP and STACK regions, will become oversaturated and begin to decline. When these regions decline, commodity prices are going up and that will lead to a rebirth in some of these dormant production areas.
Figure 4, Source: Targa investor presentation
Ultimately, to combat these declines, midstream companies need to invest in other basins and in other projects. How much does Targa need to invest in Growth Capex to maintain their EBITDA? First, a quick word on terminology. Midstream maintenance capital is money spent to maintain their existing infrastructure - to keep the physical assets (plants, pipes, compression, etc.) running and replace any degraded components. Targa spends in excess of $100MM/yr on maintenance capital. This spending does nothing to ensure that the revenue stream is maintained. Growth capital expenditures are what they spend to build new pipeline and infrastructure, and some level of growth capex is required to maintain their EBITDA in the same way that research and development for other companies prevents their revenue streams from drying up.
Targa’s 2021 Capex budget for 2021 provides a good proxy for growth capital required each year to keep EBITDA at current levels long term. They will spend $350-450MM, primarily on well connects, and a $90MM project to move a 200 MMcf/d processing plant from Barnett to the Permian basin. At the midpoint, $400MM in growth capex represents 24% of 2020 EBITDA of $1637MM. This spending ratio is similar for two other midstream companies to maintain their EBITDA. For example, I’ve estimated that EnLink (ENLC) requires about $225MM or 22% of their 2020 adjusted EBITDA of $1039MM, and past figures are closer to 25%. (For a thorough analysis of ENLC, see EnLink: 2021 Guidance Shows Weakness Ahead) A similar calculation with Kinder Morgan (KMI) using the Growth CAPEX and adjusted EBITDA numbers for KMI for the years 2016 through 2019, reveals a similar ratio of 27%. The 24% figure for Targa is a reasonable placeholder and let’s face it, we’re not trying to land a Rover onto the Martian surface, we just want to get a sense of this figure.
A key point in Targa’s 2021 investor slide decks is that this level of spending will keep their field production flat for 2021. As mentioned before, their field production feeds their natural gas plants, their interstate pipelines, their fractionation plants and export facilities, so if the inlet volumes are flat (across their entire US footprint), it implies that their overall EBITDA will be flat at these spending levels long term. Any additional dollar spent beyond this level is truly growth. Their EBITDA levels will grow from 2020 to 2022, but that growth is primarily from fully contracting their existing fractionation assets (especially train 7 and 8) and Grand Prix which is expected to continue adding firm contracts in 2021 and 2022. They are also receiving an EBITDA uplift by paying down debt, exchanging debt, buying back shares and replenishing their hedges with higher commodity prices.
Let’s put all the pieces together to get a sense of the value of Targa:
Figure 5: Author with data from Targa annual reports. Values are year-end.
This is a busy chart and there are several things to note. One is that Targa’s distributable cash flow (as they report it) is how much cash flow is available for distribution to both common and TRC preferred equity, and included in the chart is a row that calculates how much DCF is available for common shareholders, netting out the payment for this preferred equity (see red box). Targa has $1 billion in outstanding TRC preferred stock, and they issued $92MM/year in dividends, now down to $90MM/year due to the small repurchase in 2020.
For 2021 and 2022, the chart lists the midpoint of Targa’s guide for 2021 EBITDA and calculates EBITDA for 2022 assuming Targa purchases the joint venture equity owned by Stonepeak on Jan 1st, 2022. We assume no other growth (or EBITDA decline) for 2022.
For 2022, I’ve listed Growth CAPEX at the estimated amount to maintain their production and EBITDA levels in the long term (yellow box), 24% of the prior year’s EBITDA. In the bottom right, I’ve calculated the theoretical yield based on these assumptions with a flat share for 2021 and 2022. This yield is simply the DCF per common share divided by the current share price of TRGP ($34/share). Based on this analysis, TRGP shares are currently yielding 9.6%, and the yield grows to 11.2% in 2022.
There are some tailwinds that might boost the returns in 2022. The outlook for commodity prices is favorable. For example, the Mont Belvieu weekly NGL composite has risen to $8/MMbtu. This is a price level we haven’t seen since Q4 2018. NGL production grew in 2020 especially as new petrochemical cracking capacity came online in late 2019 and throughout 2020, adding the need for more ethane and other purity products which will help Targa’s fractionation business. Also, butane, iso-butane and natural gasoline are used as blending components in motor gasoline, so as gasoline demand recovers in a post-Covid world, it will help boost NGL demand. Targa’s growing export facility (and similar facilities) are also driving NGL demand.
Natural gas prices as measured by Henry Hub are at levels last seen in early 2019 and late 2018 and the EOS storage levels should support natural gas prices throughout 2021. Due to the surplus takeaway capacity in the Permian, the basis spreads between Permian production hubs and Henry Hub have narrowed significantly. Although Targa is 90% hedged and largely locked in for 2021 and part of 2022, over time, they will replace realized hedges with new hedges at higher prices. We should see an uplift in 2022.
Finally, the consensus around public E&P spending in 2021 is that public companies will keep spending and production levels relatively flat, but with the forward WTI curve above $55/bbl as far out as January 2023, private companies may choose to hedge and drill in the coming months.
Figure 6 & 7: reprinted from Primary Vision Network
The primary concerns with Targa and other midstream companies tied to shale is the long term outlook. The Permian is the most economic basin for oil, but at some point it will peak and begin a long and relatively slow decline. When that occurs is up for debate, but it could be as soon as 8-10 years according to the EIA. Targa has hedged this by maintaining several footholds in other basins, including the gulf coast. As mentioned, if the Permian basin declines, commodity prices are going up, and this will revive interest in other basins. In addition, Targa can weather this process by moving or selling assets and/or consolidating with or acquiring other midstream companies.
A second concern is the pace of the energy transition. Others have written extensively on the subject. Many argue this will be a slow and challenging process. Long-term bond holders, the most conservative of investors, don't seem concerned. Targa's long-term debt is selling above par value and as mentioned, they recently issued more at very attractive rates.
For the years 2016 to 2019, Targa, like many midstream companies, distributed all their available cash flow (see green box in figure 4) and used the capital markets to fund their growth CAPEX including the growth CAPEX required to maintain earnings. This model of distributing all your cash flow is a throwback to the MLP (Master Limited Partner) structure that required this. This model is unhealthy for companies, especially those with flat to declining cash flows. The high payouts invite leverage both at the fund and retail investor levels, and increasing the supply of capital assets, whether common and preferred shares or debt, can saturate the relatively small market for these securities.
Both the leverage and the lack of backstop for falling share prices can lead to a freefall as was seen from mid-2014 through 2015 and again in 2020. Although it is possible for Targa to raise their common share dividend, I don’t think that will happen in 2021. In fact, I would argue that it is healthier to leave the distribution alone and monitor the share price through 2022. As we’ve seen, retained earnings are powerful and the soaring DCF per share proves this. In fact, the entire energy sector is more focused on retained earnings, and this will help shrink the available supply of securities and raise equity values.
In 2021, after paying all dividends (both common and preferred), Targa will generate $654MM in additional free cash flow. Targa’s base case is that they will largely pay down their revolvers and use the extra liquidity to buy Stonepeak’s share of joint ventures in early Q1 2022. Looking further out in 2022, (assuming they buyout Stonepeak), they will generate $780MM in after distribution free cash flow. They could take-out their preferred equity in 2022 (generating another $90MM/year in FCF), or use it to fund new growth CAPEX, or buy another small midstream company or buy a significant swath of common equity. This is the power of retained earnings. Whatever they choose to fund, the net result is growing DCF which will benefit common shareholders. I suspect that $34 per share will be a waystation on the road to higher prices.
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Disclosure: I am/we are long TRGP. 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.