PAGP - Better High-Yield Midstream Buy: Plains Or ONEOK?

2023-03-20 08:00:00 ET

Summary

• Plains and ONEOK are two high-yield midstream businesses.
• Both boast investment-grade credit ratings.
• We compare them side by side and offer our take on which is a better buy right now.

Both Plains ( PAA ) ( PAGP ) and ONEOK ( OKE ) are high-yield investment grade midstream businesses.

OKE has dramatically outperformed PAA over the time period that both have been publicly traded:

Furthermore, OKE has not cut its dividend in over 25 years, while Plains has cut its dividend several times. That said, Plains has much stronger dividend growth at the moment and has significantly outperformed OKE over the past year:

In this article, we will compare them side by side and offer our take on which one is a better buy right now.

Plains Vs. ONEOK: Business Model

Plains possesses exceptional core assets, notably in the Permian Basin. Its midstream businesses that handle crude and refined products in the region generate roughly 80% of its adjusted EBITDA. The strategic location of this network is poised to deliver robust performance for the company in the future, as long as the Permian Basin remains an appealing production area. Plains' NGL assets in Western Canada are a valuable addition to its flagship Permian assets.

Furthermore, Plains has been selling off non-core assets in order to reduce debt and make opportunistic unit repurchases. It plans to continue this trend by selling around $270 million worth of assets in 2023.

OKE maintains a remarkably stable cash flow profile that is free from any unhedged exposure to commodity price fluctuations. This is mainly because around 90% of its cash flows stem from fixed-fee take-or-pay contracts, which are resilient to short-term volatility in commodity prices and/or volumes. Additionally, 85% of its counterparties hold investment-grade credit ratings. As a result, the company generates cash flow similar to that of a utility with distributable cash flow per share growth every year except for a 10.1% drop during the COVID-19 energy market crash in 2020.

Another very impressive aspect of OKE's business model is the lofty 14.8% return on invested capital that it generated in 2022.

With 100% of its EBITDA coming from natural gas and NGL assets, OKE is well-positioned to benefit from the rapidly growing demand for these commodities as the global economy transitions to cleaner energy sources. This gives OKE a pretty lengthy growth runway and helps to mitigate long-term risks facing hydrocarbon businesses.

Plains Vs. ONEOK: Balance Sheet

Plains has made impressive strides in reducing debt and deleveraging, with their leverage ratio down to 3.7x at the end of 2022. As a result, there is a growing possibility of an upgrade from a BBB- to BBB credit rating in the near future.

Plains plans to pay off $600 million in debt in 2023 while keeping adjusted EBITDA stable, resulting in a still lower leverage ratio of 3.5x by the end of the year. They may also retire some or all of their preferred equity, which has become more expensive due to higher interest rates.

Furthermore, management intends to operate below the low end of their target leverage range and may consider lowering their target range in the future. They believe that the broader energy industry's leverage should be lower than it has been historically, but they will take time to evaluate evolving macro factors before making any decisions about adjusting their target leverage range.

With ample liquidity and a BBB credit rating almost as strong as ENB's, OKE is rapidly reducing its leverage ratio through strong growth and management efforts to deleverage. As of the end of Q4, OKE had reduced its leverage ratio from 3.8x to 3.46x sequentially, something that management hailed as a "significant milestone." Subsequent to the end of the quarter, OKE redeemed $425 million of debt set to mature in September 2023 with cash on hand. Moreover, leverage is expected to drop to 3.2x by the end of 2023 and 3.0x in 2024.

As a result, both businesses appear to be on very firm footing financially, with little risk of financial distress for the foreseeable future.

Plains Vs. ONEOK: Dividend Outlook

Both businesses are in the process of growing their dividends, though Plains appears to have a much stronger outlook for dividend growth in the near-term.

Plains management announced a new dividend/distribution growth framework back with its Q3 report:

Management currently intends to recommend to the Board of Directors of PAA GP Holdings LLC ("the Plains Board") an annualized increase of $0.20 to PAA's and PAGP's fourth-quarter 2022 distribution payable in February 2023 (one quarter earlier than our standard beginning-of-the-year annual budgeting process), which would increase the annualized rate from $0.87 to $1.07 per common unit and Class A share. Beyond 2023, as part of its standard annual review process, management anticipates targeting annualized common distribution increases of approximately $0.15 per unit each year until reaching a targeted Common Unit Distribution Coverage Ratio of approximately 160%

Given that it is expected to generate $2.41 in DCF per unit in 2023 and currently pays an annualized dividend/distribution of $1.07, there is immense upside for the distribution moving forward. Moreover, analysts expect Plains to grow its DCF per unit at a 5.9% CAGR through 2027. If that proves to be correct, then it will be paying out a $1.88 dividend/distribution in 2027, implying a 15.4% CAGR for the payout over that span, making it a phenomenal dividend/distribution growth stock.

On the Q4 earnings call, OKE management made it pretty clear what their capital allocation priorities are moving forward:

What our key strategies are for capital allocation: The first one is that we want to invest in high-return organic projects that are adjacent to our existing footprint. The second thing is that we want to maintain and grow a -- what we refer to as a sustainable dividend.

And what we mean by that is we want to keep that dividend growth somewhere below our EPS growth percentage and then also focus on our payout ratio, which I would say that approximately 85% are lower. So we were above 100%. We've got it down below 100% in our 2023 guidance. And number three, we want to keep our strong investment-grade credit ratings with a target of that 3.5x debt-to-EBITDA.

And assuming that we've achieved all of those kind of capital allocation key strategies, if we do have excess cash or whatever, we could consider share buybacks.

With OKE poised to grow cash flow per share at a mid-single digit pace moving forward, we can logically deduce that OKE will likely be growing its dividend at a low to mid-single digit pace per year.

Plains Vs. ONEOK: Valuation

Based on the data below, we see that Plains is clearly cheaper relative to OKE on a comparative basis. However, OKE looks more discounted on a historical basis based on the EV/EBITDA metric:

It is also important to note that OKE's higher quality asset portfolio as indicated by its more stable cash flow profile, superior returns on invested capital, and far greater exposure to cleaner hydrocarbons like natural gas and NGLs make its higher valuation somewhat warranted.

That said, if the Permian Basin can generate strong production growth for years to come, Plains could be a very compelling bargain right now as well.

Investor Takeaway

Both businesses look attractively priced right now relative to their histories and the broader market. Plains look particularly compelling given its well-covered 9% yield and very strong distribution/dividend growth profile. On the other hand, OKE's lower risk profile makes its valuation and yield look very compelling for more conservative investors.

It is also important to keep in mind that PAA issues a K-1, PAGP issues a 1099 (but otherwise is the economic equivalent of PAA), and OKE issues a 1099 tax form. For further tax information on these and whether or not you should invest in one and in what type of account, please consult a tax professional.

Based on our midstream portfolio at High Yield Investor, we think Plains is an excellent fit for our Core Portfolio and are long PAA accordingly. While OKE is also a Strong Buy right now in our view, we have other midstream investments that we like more for our more conservative Retirement Portfolio.

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