Summary
- In contrast to the prior midstream business model that emphasized a grow-at-all-costs mentality reflected in both dividends and capital spending, midstream has been shifting to a more sustainable growth model that is not dependent on raising equity for funding.
- The upshot of pressured equity performance blended with resilient EBITDA estimates is significantly discounted EV/EBITDA valuations for midstream companies relative to history, creating the opportunity for capital appreciation as multiples expand.
- Rather than enjoying yield alone, midstream investors can benefit from total return as a result of the more balanced approach taken by midstream companies, the potential for capital appreciation, and possible shareholder-friendly returns as free cash flow generation takes hold.
The midstream space has historically been known for attractive dividends/distributions with yields exceeding those of other income-oriented investments. While the income remains generous, the midstream business model has been tilting toward a greater total-return focus for some time (see this piece from June 2019). Even prior to the impact of COVID-19 on energy markets, companies were emphasizing more sustainable dividend growth, capital discipline, balance sheet improvements, and free cash flow generation. Admittedly, despite the focus on total return, the space has not been able to deliver with equity prices battered by macro headwinds and persistent selling pressure. However, midstream’s substantial income could be complemented by capital appreciation going forward as improvements pay off and free cash flow gains traction. Increasing free cash flow generation means investors could potentially benefit from shareholder-friendly returns such as buybacks when the macro environment stabilizes. Today’s note discusses midstream’s ongoing shift to a total-return focus and what it means for investors.
Midstream companies have improved financial flexibility and positioning.
In contrast to the prior midstream business model that emphasized a grow-at-all-costs mentality reflected in both dividends and capital spending, midstream has been shifting to a more sustainable growth model that is not dependent on equity capital markets (read more). Midstream companies in the past would frequently issue equity to finance prolific growth projects. In the wake of the oil downturn from 2014-16, issuing equity became challenging due to the cost (high yields) and market conditions (weak demand). With the equity market no longer a viable source of financing, companies had to find new ways to fund projects, and in some cases, names had to cut their dividends to shore up their financial positioning. Over time, midstream companies began to shift to equity self-funding, or in other words, using retained cash flows to fund the equity component of growth capital expenditures instead of issuing equity.
While Magellan Midstream Partners (MMP) was ahead of the curve in not relying on equity capital markets, the tide for the rest of the midstream space really began to shift in late 2017. Specifically, in October 2017, Enterprise Products Partners (EPD) revised its distribution policy at the time to grow by a smaller $0.0025 per unit sequentially each quarter with the goal of increasing distribution coverage and achieving equity self-funding. Moderating dividend growth, or cuts in some cases, was key to generating excess cash flow to fund growth capex. Today, equity self-funding has largely been achieved, though ONEOK (OKE) serves as an exception given its recent common stock offering in June. Overall, the lack of equity issuances among midstream marks a significant shift from the old days with the added benefits of alleviating investor concerns around dilution and helping to enforce capital discipline.
For MLPs, a singular focus on distribution growth has also been eased by the widespread elimination of incentive distribution rights (IDRs). Most MLPs have eliminated their IDRs in response to investor distaste for them. In the past, IDRs encouraged MLPs to rapidly grow their distributions during their formative stages but became increasingly burdensome on their cost of equity as time went on. Eliminating IDRs not only lessens the emphasis on distribution growth but also reduces the cost of equity capital and helps better align the interests between the limited partners and general partner, improving corporate governance. As of September 25, 85.9% of the Alerian MLP Infrastructure Index (AMZI) by weighting had gotten rid of their IDRs compared to just 38.1% in December 2016.
Discounted valuations lend credence to midstream’s capital appreciation potential.
In addition to generous income, midstream also offers potential for capital appreciation – the other side of the equation for total return. Performance for midstream companies has been challenged year-to-date through September 30, with the AMZI Index down 48.4% and the Alerian Midstream Energy Select Index (AMEI) off 36.8% on a total-return basis compared to a 47.7% decline for the Energy Select Sector Index (IXETR). While performance has been weak, consensus EBITDA estimates for full-year 2020 and 2021 have been resilient, decreasing only modestly from the end of January to September 18 (read more). The stability in earnings estimates despite the pandemic reflects the contracted, fee-based revenue that is a hallmark of midstream companies. In short, the upshot of pressured equity performance blended with resilient EBITDA estimates is significantly discounted EV/EBITDA valuations for midstream companies relative to history. Current valuation discounts are steep at about 3.5 turns below the ten-year average for the AMZI Index and nearly three turns below the average since inception in April 2013 for the AMEI Index as of September 18. With that level of discounts, even an improvement of a turn or two in valuation multiples would be constructive. More broadly, investor preference for growth over value has been a headwind, and value coming back into favor could also be supportive. While investors may be drawn first to the attractive income provided by midstream companies with yields elevated relative to history, midstream’s prospects for capital appreciation are also worth a second look.
Free cash flow generation adds to total-return potential.
Another important change recently has been a focus on more restrained, capital-efficient growth following years of significant spending to build out infrastructure in support of transformational North American oil and gas production growth. Capital discipline has been emphasized over the past few years as projects were placed into service and project backlogs began to moderate. The market headwinds in 2020 have further accelerated the downshift in spending plans. Meanwhile, midstream companies have benefited from the increase in steady, fee-based cash flows from the completion of new pipelines and other assets. Combined with lower capital spending, the ingredients are ripe for midstream to generate significant free cash flow, and many of the largest midstream companies are expected to generate positive free cash flow after dividends in 2021 (read more). The contracted nature of midstream assets and fee-based business model also heightens the predictability of free cash flow generation compared to other sectors of energy that may be more sensitive to commodity price swings (read more). Free cash flow generation represents a sea change in the sector because it will provide the flexibility to strengthen balance sheets amid an uncertain macro environment and the potential for more capital returns to investors, including buybacks. The table below summarizes the 2021 consensus free cash flow estimates for the top five names in the AMZI and AMEI by weighting per Bloomberg, with several of these companies expected to generate free cash flow next year even after generous dividends.
What does a shift to a total-return focus mean for investors?
As midstream moves to a more mature and sustainable business model, there are several implications for investors. Income is going to remain substantial in midstream, but the days of lofty dividend growth are likely behind the space as the sustainability of dividends takes priority over the growth rate. Midstream companies are also focused on growing through capital-efficient and high-return projects, though lower spending levels overall are positive for free cash flow generation. In general, the slowdown in production levels means that projects are likely to be under greater scrutiny in today’s environment with a higher hurdle rate required. Rather than enjoying yield alone, investors can benefit from total return as a result of the more balanced approach taken by midstream companies, the potential for capital appreciation, and possible shareholder-friendly returns as free cash flow generation takes hold and the macro environment stabilizes. As long as midstream valuations remain at considerable discounts relative to history, buybacks are likely to screen even more attractive and provide greater support to equity prices. While current macro headwinds pose a challenge, midstream companies have made numerous improvements in recent years, and investors can benefit as these changes come to fruition.
