EnLink's Earnings Drought Is Over
Summary
- Midstream G&P companies like EnLink with exposure to energy prices are revising their guides higher.
- Even at $6.25/unit, EnLink is extremely undervalued and has a lot more room to run.
- In value investing, conviction is everything. If we don’t have conviction, we will sell too early.
The purpose of this article (and several previous articles) is to help teach us how to value trade. (I say “us” because one of the strongest ways to learn is to teach.) Let's do this by focusing on one such trade, EnLink (NYSE:ENLC).
Raising the Guidance
EnLink published a couple of major announcements last week, so we’re going to start with an in-depth discussion of the announcement and how it impacts the trajectory of its common equity value. Then we’ll talk about perceived terminal value, what it is, how it impacts EnLink’s unit value. In a future article, we’ll discuss what their management team is doing to combat terminal decline, tying these themes together with a discussion of carbon capture utilization and sequestration [CCUS] and why this is so critical to EnLink’s future. There is a tremendous amount of information to unpack, so let’s get started.
We discussed in Storm Uri Doesn't Freeze EnLink's Q1 Earnings that if commodity prices remained supportive, EnLink would raise their net EBITDA guidance for 2021 in August. Commodity prices have remained so supportive that this announcement came surprisingly early. On June 3rd, EnLink raised their net EBITDA guidance from a range of $940-1000MM to $1020-1060MM (figure 1). This is primarily driven by stronger than expected commodity prices and increased drilling in their Midland basin footprint. Also helping are very strong Permian natural gas prices. The additional takeaway capacity of Permian natural gas pipelines which were completed in 2019 and 2020, and the reduced drilling in 2020 have led to tight differentials relative to Henry Hub. This is boosting their payments from percentage of proceed contracts which are directly affected by gas prices in the basin.
Note EnLink’s new commodity price assumptions as indicated by the green box in figure 1. WTI increased to $55 from $50/bbl, the Henry Hub natural gas price was lowered from $3 to $2.75/MMBtu and the NGL basket was raised from $0.55/gallon to $0.65/gallon. WTI is currently in backwardation and trading from $70.78 in the front month down to $67.75 for Decembers’ contract. Natural gas is trading at a spot price of $3.27/MMBtu. The price of the 12-month strip averaging the natural gas futures contracts from July 2021 through June 2022 as reported by the EIA is currently at $3.11/MMBtu. The prompt month NGL basket is trading at $0.76/gal even as far out as December. Although they are heavily hedged for the balance of 2021, with commodity prices trading well north of their assumptions, the guide is still conservative.
Figure 1: Source, EnLink’s operational report.
Adding Context to the Numbers
Plugging all the numbers into a grid and comparing them to supply and demand of US natural gas and oil (figure 2), you can see that oil production in the US is down by nearly 10% in 2021 versus 2019 (first red box), and natural gas production is down by 2% versus 2019 (second red box). Global oil demand is recovering fast in 2021, and in 2022, it will surpass 2019 levels according to the EIA in 2022 (blue box). With OPEC+ withholding barrels and US shale down, we have a very tight market. Throw in some speculative fever and WTI is pushing $70+ a barrel with natural gas trading above $3/MMbtu. These are healthy mid-cycle prices.
With that in mind, you can see that their net EBITDA recovers to 2019 levels in 2022 and net of minimum volume commitments (for an explanation of MVCs see EnLink to Outperform in Q4), their EBITDA grows by 3.9% (see purple box). If $1060-1080MM is their mid-cycle net EBITDA, how much growth CAPEX and investment does it take to maintain their net EBITDA? It’s roughly $200MM per year (green box). That’s a question that has come up a couple of times on their earnings calls. It’s an important number because it tells us how much money the company is making. If we take their distributable cash flow [DCF], estimated at $676MM for 2021, and subtract the $200MM, we get $476MM or $0.96 per diluted share which is a 15.4% yield based on a per share price of $6.25. In 2022, that grows to $516MM or a 16.6% yield. That’s how much cash EnLink generates for its common shareholders. That’s how much money is left over after all the bills have been paid. Most of it has and will go to debt reduction, close to $900MM by the end of 2022, unless they find a better use for it. As we discussed in Small And Mid-Cap Midstream Review, debt reduction is a primary objective for midstream companies that have binged on debt and equity.
Figure 2, author, with data from EnLink’s 10-K and most recent operational report and commodity price data from EIA. Net debt is long-term debt plus current liabilities minus current assets.
In a zero-interest rate world with trillions of dollars of liquidity sloshing around the world, why wouldn’t the investing world close that gap? I’ve written about several of those reasons in previous articles (for example, in DCP Midstream - It's a Steal at $22), and you can probably come up with 10 more, but we’re going to discuss just one more of those factors.
Terminal Value
One issue with EnLink is the terminal value perception of energy and midstream in a net-zero world (net carbon emissions by 2050). As one commenter to a previous article put it, “pipelines are not going to be around in 10 years, so why should we invest.” As we will see, nothing could be further from the truth. A net-zero world needs more pipelines, not less. While McKinsey predicts that oil will begin to decline in 2029 (see figure 3), and hence some oil pipelines will be underutilized, natural gas and NGLs have a longer runway, and new pipelines for new products and CO2 transport will need to be built or converted from old pipelines.
Figure 3: Source, Mckinsey: Global Energy Perspective 2021
First, let’s back up and define what we mean by terminal value. A good example of this is the bolt-on acquisition in the Barnett basin that EnLink bought in 2019 in Hood county. It was a small, bolt-on natural gas system and they paid $25MM for it. It had a yield of about $4MM/year and the Barnett declines on average by 8% per year. They sold off about $12MM worth of redundant natural gas processing and compression equipment, and on a net basis, they paid about $13M. At that rate, they will pay for the investment in 4 years and the rest is gravy. Had they not been able to sell that equipment, it would have taken 9 years, longer if you consider the interest payments, maintenance capex, etc. On a net basis, they bought it for 3 times present cash flow with an 8% per year decline rate. That’s a terminal value, a value assigned to an asset whose cash flow will decline over time. Conversely, they bought the Amarillo natural gas system in the Midland Basin in Q2 2021 for $60MM, and it will yield a cash flow of $10MM for EnLink in 2022. It’s an asset that is expected to grow, so they assigned a 6x value or 6 times cash flow.
When we account for debt, cash, and preferred equity, EnLink currently has an enterprise value to net EBITDA ratio of 8 which is exceptionally low compared to how midstream companies have traded historically and against the S&P500, REITs, etc.. Part of the reason that EnLink is trading so low is that some folks don’t think midstream will be around in 20 years. To illustrate this, let’s walk through a decline scenario. Let’s say that the next few years are good for energy and things go downhill from there. Let’s say 2022 is a peak year and they hold that for two more years and then all commodities start a permanent decline. Cars, boats, airplanes, and trains are increasingly run on pixie dust. Not only do drillers drastically cut back but there is very little for EnLink to invest in – relatively few tuck-in acquisitions or adjacent low-carbon markets to invest to help rescue their declining EBITDA. EnLink has purchased three tuck-in acquisitions in 3 quarters, and they just announced a new venture in carbon capture utilization and sequestration, but let’s say in our example, almost nothing is compelling – it nearly all turns to trash and even a terminal value can’t be put on it. All they do is collect cash, connect a few wells, pay off debt and preferred equity and survive.
Let’s say that equates to a spend equal to 10% of their declining EBITDA in growth CAPEX per year for well connects and an EBITDA decline rate of 4% per year. They stubbornly continue to pay the dividend of $0.375/share per year, and they continue to issue EnLink common shares to their employees at a rate of 5MM shares/year despite the dismal performance. Assume all debt and preferred equity are paid out at an average of 5.5%. What does that look like? That looks like figure 4.
Figure 4, author with data from EnLink’s 2021 operational reports.
Debt and preferred equity is substantially paid off in 20 years leaving just $875MM. Common equity holders have received $7.88 per unit in total dividends. The company is now sold for a 5x terminal value and after paying off the remaining preferred equity and debt, common unitholders are given $3.26 per unit. Combining that with the dividend, our shareholders received about 3% per year on their initial $6.25 investment. While not a great return, at least the common equity holders aren’t wiped out. Is this a realistic scenario? As we will see in a future article, a net-zero world requires a lot more pipelines and potentially more natural gas.
A Brighter Outlook
The terminal value scenario isn’t what unitholders of EnLink, including Global Infrastructure Partners [GIP], their largest shareholder, have in mind. (And it isn’t what we value hunters are lured to either.) GIP invested $3.1 billion in EnLink and own over 224 million units or roughly $13.84 per common unit. Based on their documentation for GIP IV, their 4th and largest fund to date, they typical hold an investment for 5-7 years and plan to earn a targeted gross return of 15-20% IRR which means that they intend to sell EnLink at a substantial premium to their entry point. How do they achieve this? By finding 6x EBITDA opportunities and reinvesting their retained cash flow to grow the business.
Let’s run the matrix again, but this time, assume that every spare dime [FCFAD] is invested in 6x EBITDA opportunities, and assume they halt the debt payback after the first year. Let’s also assume 20% of EBITDA is required to maintain the previous year’s EBITDA, and all other factors are the same (see figure 5). This is clearly what investors want to see: adjusted EBTIDA growing 4.5x in 20 years. In truth, some of that invested cash would unknowingly go to failed projects and EnLink's future value probably lies between the feast and famine scenarios.
Figure 5, author with initial data from EnLink’s operational reports. Amounts are in millions of dollars except the ratio of (Debt + preferred equity)/adjusted EBITDA in the next to last column, and DCF/unit in the final column which is expressed in dollars.
Due to the declining nature of oil and gas, EnLink’s success is a function of having enough projects to reinvest their excess cash flow and grow the business. As we will see in a future article, the net zero carbon world offers plenty of investable opportunities.
One question that arises often, both in the comments section of my articles and on earnings calls is “why doesn’t GIP just purchase the remaining units at the deflated share price?” I believe the problem with this approach is that it sets a bad precedent. In some cases, GIP owns partial interests in publicly traded companies. If they short-change the common shareholders, I believe the value of any of their public, partially owned holdings would drop in value. That holds true for both current and future public holdings in which they have a partial interest. Their reputation is everything, and this ties their interests to the common shareholder. They must drive value the old fashion way, by future-proofing their cash flows (reducing risk), reducing expenses, and growing the business on a per share basis.
Conclusion
As value investors, our job is to find the gold that everybody else thinks is trash. To do that, often we need to do hundreds of hours of research, have a long-time horizon, money to invest, and 100% conviction, because as a contrarian, our opinion will come under assault. Misconceptions are powerful. With a couple of sentences, I can dismiss midstream: green revolution = no oil = pipelines dead. Conversely, I can deny net-zero: cars don’t run on pixie dust = no green revolution.
If we are going to sift through the trash bin of energy equity, we want to invest with companies that are future-proofing their cash flows in a scenario in which net-zero wins and doesn’t win. If oil loses in a net-zero world as McKinsey predicts, what wins and how do we take advantage of it? EnLink announced a major revision to their earnings for 2021 and that’s exciting, but there was a subtler announcement that might be more valuable. Did you catch it? In our next article, EnLink – Down the Net-Zero Rabbit Hole, we’ll discuss how EnLink is future-proofing their cash flows.
This article was written by
Disclosure: I am/we are long ENLC. 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.