Small- And Mid-Cap Midstream Review

Summary

• Small- and mid-capitalization midstream names are undervalued and unloved.
• Years of long-term debt growth have come to an end and free cash flow is set to double in 2021.
• The market hasn’t given any credence to retained cash flow.
• If these names simply distributed all their free cash flow, their share price would grow by 71%.
• For long-term investors, now is the time to pick up equity at bargain basement prices.

Photo by spooh/E+ via Getty Images

Although many equity names in the market are trading at bubble valuations, you can still find plenty of value in the small- to mid-cap midstream space. Many undervalued and unloved names are trading at bargain basement prices. Analyzing nine small and mid-cap midstream companies, Antero Midstream (AM), Noble Midstream (NBLX), Targa Resources (TRGP), Crestwood Equity Partners (CEQP), DCP Midstream (DCP), Enable Midstream Partners (ENBL), Equitrans Midstream Corp (ETRN), Western Midstream Partners (WES) and EnLink Midstream (ENLC), you will find that on average these names are trading at a 42% discount to their historical valuations.

How do you measure value in these companies? Although cryptocurrencies and momentum play with extreme valuations like Tesla (TSLA) are stretching the very notion of investment, traditionally investments (be they common or preferred equity, bonds, real estate, etc.) are measured on their return and risk. For example, 20 years of historical data tells us that the average yearly return for the S&P 500 based on price appreciation and dividends is 8.2%. The average price to equity ratio (P/E) based on operating earnings over those same years is 18.9, meaning on average we are paying 19 times operating earnings to own the S&P 500. The data also shows that the earnings per share are growing on average by 5.5% per year over the past 20 years.

Hence the value of the S&P 500 is highly correlated with the earnings of its constituent companies, although at times it becomes overvalued or undervalued relative to the average. The current operating earnings P/E for the quarter ending December 2020 is 30.69. That is the highest level reached in the past 30+ years including the sky-high valuation reached in 2001 of 29.55. With valuations this high, you may go looking for stocks that are more reasonably priced, and a good place to look is the midstream space.

Free Cash Flow, CAPEX & Debt Levels

The key metric we will use to evaluate our 9 midstream companies will be Free Cash Flow (FCF). Because FCF is a non-GAAP measure, it is subject to interpretation by each company so we will normalize the measure across all 9 midstream companies. Free Cash Flow is defined as money a business has left over after it has paid for everything it needs to continue operating - including (in the case of our 9 midstream companies) pipelines, plants, storage and export facilities, equipment, operating expenses, payroll, taxes and inventory.

For our 9 midstream companies, it will also include outlays for payments to joint ventures for assets they are operating and payments for preferred equity. This can be summed up with the following equation: FCF = Consolidated Operating Cash Flow - Capital Expenditures - Payment to Joint Ventures - Preferred Equity payments. The majority of the companies on our list that report FCF, subtract all CAPEX, including both maintenance and growth CAPEX from their calculation, and so we will adopt that approach across all 9 companies.

Midstream is a capital intensive business requiring capital to be reinvested into the business year after year, and this is especially true for midstream companies heavily weighted towards gathering and processing (G&P) like our 9 midstream companies. I've estimated that roughly 25% of adjusted EBITDA per year needs to be reinvested in new projects (aka growth capex) to maintain their collective EBITDA levels. This is over and above the CAPEX required by these companies to maintain (repair and service) their assets.

The reason for the 25% figure in growth CAPEX/EDITDA is related to decline in costs: stranded assets in underperforming basins, high decline rates for shale gas and oil (a shale well with a 30% decline rate per year will deplete almost 85% of the oil or gas produced over its lifetime in the first 5 years), lower re-contracted rates for firm transport for older assets, a shift away from gulf coast gas which has stranded assets, a loss of minimum volume commitments (MVCs) over time, commodity price declines which have pressurized variable pay arrangements and finally, the declining value of saleable assets. Essentially, midstream companies are getting less for selling non-core assets which helps offset other costs. (For a full analysis of these themes see EnLink To Outperform In Q4 and EnLink: 2021 Guidance Shows Weakness Ahead).

The good news for nearly all these names is that in 2020 they covered nearly all their CAPEX costs with internally generated cash flows and had some left over to pay down debt and buyback equity. In many cases, the cost of CAPEX is coming down because the great shale buildout is nearly complete and the more expensive components, like interstate and large diameter intrastate pipelines, header systems and processing and fractionation plants have already been built. In fact, there is significant excess capacity to absorb any returning volumes.

These same 9 small to mid-cap midstream companies have outspent their cash flows for years and since selling additional common units or shares in the open market went out of vogue after the first oil market crash in 2014-2016, they've simply piled on debt to cover much of their growth capex costs. Figure 1 consolidates the adjusted EBITDA and net debt across all 9 companies to highlight the trend in growing debt levels.

Figure 1, Source: Author with data from annual reports. Figures are in millions of dollars except the net debt/adj. EBITDA ratio.

Net debt is long-term debt plus current liabilities minus current assets. This is a very straightforward and consistent way to measure debt levels across companies. You can see that although adjusted EBITDA has grown by 70% for all 9 companies/partnerships from 2016 to 2020, net debt has grown by 126%.

These companies grew quickly and added debt at relatively low interest rates making the growth accretive to common unitholders. It may seem counterintuitive, but DCF on a per share basis grew during this period for most of our 9 companies despite the added debt. For example, at the end of 2016, DCP's distributable cash flow for the common shareholder was about $3.04/unit (after adjusting for the IDR) and at the end of 2020, it was about $4.08/unit. (For more details on this, see DCP Midstream - It's A Steal At $22). To help manage the debt levels, companies also resorted to joint ventures and preferred shares to absorb the capital requirements.

That was then, this is now

Now, all the presentations tout free cash flow and debt reduction. There is not a whiff of distribution increases and the debt binge has reversed. Collectively these 9 companies generated $10 billion in adjusted EBITDA in 2020 and $900 million in free cash flow after all distributions (FCFAD) including common unit distributions - see figure 2. The appearance and growth of FCFAD are due to sharp reductions in growth CAPEX and distribution cuts. For example, DCP and ENLC slashed their dividend by 50% exactly. Crestwood and Antero were the only two which raised their distributions, and at the other end of the spectrum, Targa slashed theirs by 89%. As we will see, this FCFAD will double in 2021. Let's be clear. If they had more investable projects, they would spend more, but the great shale buildout has slowed to a crawl.

Figure 2, Source: Author with data from annual reports, earnings reports and press releases. Adjusted EBITDA, FCFAD and net debt are in millions of dollars.

In figure 2, the total amounts at the bottom are all sums of the data for the individual names except the net debt to adjusted EBITDA ratio and the current dividend yield - these are averages of the data above (see blue boxes).

Adjusted EBITDA is a non-GAAP figure and the definitions and how it is calculated can change from company to company, however, it is good enough for our purposes, and I suspect the definitions aren't radically different between these companies. I used what each company reported.

As mentioned above, each company defines Free Cash Flow (FCF) slightly differently. For example, in EnLink's case, it reported $311MM in FCF after distribution for 2020, but this is based on distributions declared for 2020 versus actual 2020 distributions. The Q4 2019 distribution was higher and paid out in Q1 2020. Most companies that report FCFAD don't report it that way. To level-set FCFAD, I used the same definition and applied it to all companies. In the case of EnLink, I used the distribution that was paid in 2020 not declared.

Another good example of this is Targa. In their presentations, they reported growth CAPEX in 2020 of roughly $600MM but the actual amount is about $800MM. They offset that growth CAPEX spending figure with $200MM in asset sales. Most companies don't report that way. Again, to level-set the FCF figure, I removed the entire $800MM to arrive at FCFAD and did not include asset sales in any of the FCFAD figures. If you are selling assets, you are also reducing the cash flow from those assets so removing it from growth CAPEX is somewhat misleading.

Another subtlety with Targa's presented FCF is that they haven't taken out the Series A preferred distribution. Most of the companies have removed it by the time they get to FCF. When I adjust Targa's presented figures, it makes sense why their net debt didn't reduce in 2020 versus 2019. If you see a figure above that doesn't jive with published results, these are the reasons for it.

Adjustments aside, these companies are generating a lot of free cash flow. In some cases, like EnLink and Enable, their adjusted EBITDA fell in 2020, and they used the surplus FCF to pay down debt to maintain their debt to EBTIDA levels. In the case of Western Midstream, their EBITDA grew in 2020, but their guide warns of declining EBITDA based on the midpoint of their 2021 guide. They too were aggressive in paying down their debt. DCP's debt levels are comparatively high, so debt reduction is imperative for them. Like WES, the midpoint of their 2021 guide also points to a decline in adj. EBITDA.

If these companies are generating so much cash, why are their shares so depressed especially when the S&P 500 is at all-time highs? That's a complex question but perhaps we can dig into it a bit with the data we have.

Figure 3, Source: Author with data from company websites

One theory is that the price is simply based on the distribution yield. Reduce the yield, reduce the share price. Since we've cut the distribution by half, the share price should be cut in half. Another theory is the comparative yield theory. As the yield is compressed, yield hungry investors simply look to other, safer choices like preferred stock or high yield bonds. Another viewpoint is that any yield above margin expense for the average retail investor would be arbitraged away. If my margin costs are 7 or 8%, why not juice my returns? Conversely, with a distribution cut, these leveraged investors must cut and run. All these theories are supported by the data (see figure 3). At the end of Q3 2018 when WTI oil peaked at $77/barrel, the distribution yield on these names averaged 7.2%. Today, the distribution yields are trading at an average of 7.4%. It seems all these names are still trading as though the distribution is the only thing that matters.

Whatever theory you subscribe to, it is clear, the market hasn't given any credence to retained cash for these 9 names. They are judging them based on their distribution yield. These names are trying to change their tunes, but the market is saying if you cut your distribution, you must need to cut your distribution, and to a certain extent, these names have gotten over the skies with debt levels and EBITDA plateauing.

What's next?

Whether these names recover further remains to be seen. Two names, Enable and Noble, got scooped up by Energy Transfer (ET) and Chevron (CVX) (respectively). It seems their new parent companies know the value. Perhaps more consolidation is on the horizon. The amount of FCF these companies generate is going to double in 2021 and this will create a virtuous cycle that will further lift cash flows on a per share basis. The two names that haven't yet joined the FCFAD party are Antero Midstream and Equitrans. Equitrans Midstream's leverage ratio increased as a result of its merger with EQM Midstream in June 2020 as well as the ongoing construction of the Mountain Valley interstate natural gas pipeline, which has seen its estimated total cost creep up to $5.9 billion.

Here's a bird's eye view of 2021 guidance across all these names:

Figure 4, Author, with data from company websites, annual reports, earnings reports and press releases. Adjusted EBITDA and FCFAD are in millions of dollars

A few notes for this chart (figure 4). As mentioned before, Energy Transfer is buying Enable. They don't have forward guidance, so I simply copied their results from 2020 as a proxy. The blue boxes are averages and the rest are sums of the aggregated data. In the column entitled "total yield," I used the sum of the distribution and the per share value of FCFAD and divided by the current share price to get a total yield.

The final column shows the value of the shares if that total cash flow (common distribution plus FCFAD) were trading at a 7.4% yield. This suggests that if these names reversed course and simply distributed all their FCFAD, the shares would appreciate by 71%. Remember, the FCFAD in this chart is not the fluffed numbers that some names show in their presentations, this is a true representation of how much cash is left over after all the bills are paid. FCFAD is set to double in 2021 to $1,900MM. (For broader context on the coming FCF gusher, see Pipeline Cashflows Continue Higher).

Nearly all the names in the list are extremely undervalued and when you compare them to names trading at 70x earnings, it is shocking that the market in a zero-rate environment doesn't close that gap. But, at the end of the day, it is not charts or analysis that decide value but rather supply and demand. And in this case, too much supply (issued partnership units, leveraged shares sold due to falling equity values, bonds being issued, preferred equity & private equity) is meeting too little interest in these names. The market seems to be saying, why buy these troubled, unloved quirky partnership units stuck in a value trap when I can buy a crypto-moonshot? They are not wrong, at least not yet.

On a positive note, for the midstream sector, the capital binge is over and now the healing begins. For example, Targa with close to $600MM is FCFAD in 2021 will take a bazooka to its highly yielding joint venture in early 2022 which in turn, will create more cash flow, creating a virtuous cycle (see Targa Resources: Rewarding Shareholders). As that cash gets returned to its owner, the cash will need to find another home. It may not find as sweet a deal.

Conclusion

If you are one of those partnership owners in Enable seeing your units converted to Energy Transfer and you don't like the new landlord, feel free to dump those shares and buy another name on the list that is equally undervalued. These names seem to run together.

A multi-year capital binge and leverage bust takes time to heal. For those with underwater equity, my advice is to be patient. The coming free cash flow in 2021 will help lift equity values. For those with deep pockets from overvalued and inflated share prices, start shifting some of those funds towards value. Right now, you've got the Fed at your back, but that might not always be the case.

If you get the bug to invest in midstream energy names, for gosh sakes, stay away from the levered energy funds, use margin cautiously and be patient. It's a volatile world out there.

Disclosure: I am/we are long ENLC, 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.