2023-06-13 16:29:22 ET
Summary
- Western Midstream's distribution policy is unique in its space.
- The company aims to differentiate itself to attract investors it is currently missing out on. I expect a bias towards aggression on the payout policy.
- For those that don't have the opportunity to meet with management teams in person, this is one of the stronger teams in the space.
I always appreciate companies that try to innovate and do things differently. The midstream sector is ripe for a bit of change on both the operational and financial side, and senior leadership at Western Midstream ( WES ) is trying to do just that. I don't think smaller investors necessarily get how they are trying to tackle issues like in-field efficiency to improve margins and incentivize customer contracts, but one way that they do know Western Midstream is different is through its capital returns program. While still in its infancy, I wanted to address some concerns some might have with how Western Midstream distributes excess capital.
Enhanced Distribution
Western Midstream is unique in the midstream sector in that it has an "enhanced distribution". Mirroring capital return policies that have become more commonplace in upstream E&Ps, this midstream partnership aims to return excess free cash flow to unitholders in the form of either unit repurchases if the Board feels the units are undervalued or through a special payout over and above the base distribution. The first of these annual distributions was paid out on May 15, 2023, based on 2022 excess free cash flow. As this is annual, investors should expect another payout - if any - eleven months from now.
This payout has to be done with the balance sheet in mind, and after recently achieving investment grade, the company is going to want to ensure that it keeps that credit rating. Readers can see the leverage triggers for this down below which has become a cornerstone slide in the Western Midstream presentation ever since its implementation.
There is a clear methodology in place. A recent research note on Seeking Alpha by Gary Gambino models the 2023 payout not reoccurring until 2026, and I wanted to tackle some of those assumptions on why I think this is incorrect. Keep in mind though that the key driver is going to be repurchases. If Western Midstream is an aggressive buyer of its common units, there is going to be less capital available to shareholders.
Net Leverage Threshold Targets Are Not Fixed
I recently attended the EIC Midstream Conference and met with Western Midstream among more than a dozen other firms. The Enhanced Distribution was obviously a topic of discussion amongst me and other analysts. Interestingly, a major emphasis from senior leadership was that the leverage targets are not hard and fast constrictions. The Board takes into account market conditions, and absent any pushback from credit ratings agencies, expect some flexibility. In other words, if net debt / EBITDA is 3.23x at year-end 2023, that does not necessarily mean capital returns are off the table.
This is important. Using end of Q1 2023 net debt and my estimates for 2023 EBITDA (which are in line with the sell-side) I expect year-end leverage of 3.18x assuming no paydown. That's not a lot of wiggle room, and I can see how some analysts might see that leverage threshold as an issue. It's also important to note that this calculation is based on net debt plus the amount of any enhanced distribution. Western Midstream's recent offering of $750mm in 6.150% Senior Notes due 2033 does not impact that, because that capital has been put to work in paying down borrowings under the Revolving Credit Facility. However, the special distribution does have to be factored in.
In my opinion, CEO Michael Ure and the Board of Directors are intensely committed to the model. Given its annual nature, missing a payout (unless buffered by intense buyback activity) would be a poor reflection on the firm and a negative on investor sentiment for quite some time. Absent a market meltdown or excessive pressure from ratings agencies, expect them to lean more aggressive than conservative.
M&A Activity
Also keep in mind potential M&A activity. While management would willingly ramp leverage back to 4.0x for the right deal, I see far more opportunity for delevering than the opposite. There will be significant capital coming up for the Mentone IV Processing Plant given the ongoing ramp in NGL demand, but there are assets that could be sold. The firm owns a Marcellus gas gathering system, the Brasada Gas Plant and associated infrastructure in South Texas, and a variety of complexes in Wyoming that all make little sense in the current portfolio. Would these fetch a high EBITDA multiple? Likely not, but they also do not contribute much. If offered a price above terminal value, I don't think Western would blink at making a deal.
Depending on market positioning, it might also opt into selling its equity interests in a variety of assets: its minority interests in Saddlehorn, Whitehorn, and White Cliffs could all make sense to be sold. Current operators of these three are all major players with excess capital (Energy Transfer, Enterprise, and Magellan (potentially part of ONEOK pending merger)) that would not balk at buying out minority owners.
Takeaways
Western Midstream's dynamic payout structure is new, and management is aiming to develop a sterling reputation beyond what they have developed already. Western is not necessarily a common name among the smaller investor crowd; leadership knows they need to cultivate a track record to win these buyers over like they have with institutions. While the outlook for payout this year is tight, I expect management to bias towards lighter buybacks this year and an emphasis on paying out some sort of enhanced distribution to owners. Arguably, the 2024 environment for the payout looks far tighter given the stepdown to 3.0x leverage, but we'll cross that bridge when we come to it.
For further details see:
Western Midstream: Leading The Pack In Midstream