CA - Keyera Underperforms TC Energy: How To Play It For A 14% Yield

2024-01-15 15:00:00 ET

Summary

• Keyera Corp. had been downgraded to a Hold, on account of relative valuation favoring other midstream companies.
• TC Energy Outperformed Keyera by about 14% over this timeframe.
• We examine the setup today in light of the extremely disciplined spending outlook from Keyera and tell you how we would play it.

Note: All amounts are in Canadian Dollars and all stock and option prices refer to the TSX side.

On our last coverage of Keyera Corp. ( KEY:CA ) (KEYUF), we downgraded it to a hold as the bull thesis appeared to have run its course. The stock had just finished delivering 17% total returns from our earlier buy point back in June 2022, but things had shifted materially in the midstream space. Our rationale was as follows.

So, on a relative basis, it is harder to argue that Keyera is as undervalued, especially when you pitch it against Enbridge Inc. ( ENB ). TC Energy Corporation ( TRP ) of course has its own issues, but even that is now looking quite appetizing all things considered. So, if you held it from the last buy call, you have a different decision than if you are deciding which one to buy today. On the latter, we are quite clear that Keyera would not be your number one or even number two choice today. On the former, well, that is harder. But we cannot give it a buy rating with the plethora of midstream choices available today. We are downgrading this to a hold.

Source: Dividend Hike Finally Comes Through For This 6% Yielding Stock

Relative valuation battles can be hard to win in an era of FOMO and blind chasing, but we did get this one right, at least over this timeframe. Keyera flatlined on total returns while ENB and TRP delivered a better bang for your buck.

We update our outlook as we roll into 2024-2025 numbers and tell you where we would buy this.

2024 Guidance

Keyera updated its 2024 plans late in December 2023 and there were a few notable surprises. The first was that marketing guidance was substantially increased versus previous years. The marketing realized margin was set at $330 million (midpoint), well above where the street was and well above where the company had previously guided. The upside came from what management cited as a permanent change in the business from higher volumes that allowed it capture more margins. Keyera now expects to hit the high end of its guidance over 2022-2025.

Usually, higher margins and higher EBITDA mean one thing and one thing only for companies. More spending. Keyera surprised here again with one of the lowest growth spending outlooks (relative to market cap) that we have seen from any company in this space.

Keyera plans to spend just $90 million on growth projects, leading to some big free cash flow after dividends.

This $90 million is about 1.3% of its market capitalization and one quarter of free cash flow after dividends. For comparison, ENB's growth plans were for 3% of its market capitalization and all of the free cash flow after dividends. Let us not forget that the Keyera's dividends already provide a 6% yield, so all that extra free cash flow offers a lot of flexibility. This comes as Keyera has finished KAPS and decided that less is more at this point of the game.

Valuation & Outlook

With interest rates broadly higher than what they were in the last decade, investors would prefer a company with low debt and a lot of financial flexibility. That is exactly what Keyera provides.

We will still take issue here, as we have previously done, with Keyera's net to EBITDA calculation. That number excludes those large hybrid notes.

If you add those back in, which you really should, you get to 3.37X debt to EBITDA ($3.64 billion divided by about $1.08 billion EBITDA for 2024).

But the overall picture is still quite compelling here in the midstream space and the S&P upgrade was well deserved.

Even that 3.37X number is second lowest in the peer group with only Pembina Pipeline Corporation ( PBA ) ( PPL:CA ), doing better. The only issue here is that the adjusted funds from operations (AFFO) yield is a bit lower than the peer group. Looking at 2024 estimates show that all of its competitors, sport higher AFFO yields and all except PBA, also sport higher dividend yields.

Verdict

If you are looking for a safe 6% yield, then you got it with Keyera. As management shows continued discipline, you are unlikely to get a big hit out of left field. There is some room for valuation expansion here that moves up your total returns but based on our macro outlook , you are unlikely to get it in the next 12 months. On our last coverage, ENB and TRP looked compellingly cheaper. Since then, ENB did a rather large and unnecessary acquisition and that has made us slightly less bullish on it. TRP has done all the right things but it also outperformed KEY by 15% and closed a good portion of the valuation gap. So we are now relatively neutral on all three of them. For those looking to play Keyera here and sold on the bull case we would suggest covered calls on the TSX for a sweet setup. An at-the-money covered call gives you more than twice the yield and reduces your downside risk substantially for this low-beta stock.

This is in essence what we do for almost all our positions and that helps reduce volatility while delivering good income . We don't have a position at present but might get involved if we see a $30 price.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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