By: Dividend Sensei
Payout Profile: Generous And Low Risk Yield Plus Sensational Growth And Market Crushing Return Potential
The most important part of any income investment is the payout profile which consists of three parts: yield, payout safety, and long-term growth prospects.
|MLP||Yield||Distribution Coverage Ratio||Projected 10 Year Payout Growth||Potential 10 Year Annualized Total Return||Yield On Cost In 2022|
|Antero Midstream GP||2.7%||1.0||50%||25+%||11.9%|
|Antero Midstream Partners||5.1%||1.3||20%||20+%||12.7%|
|S&P 500||1.8%||2.5||6.2%||0% to 8%||2.4%|
Sources: management guidance, Gurufocus, FastGraphs, Yardeni Research, Multpl, Vanguard, Morningstar, BlackRock
While AMGP might not offer a seemingly high-yield you have to remember that it’s set to grow 162% this year and 64% in 2019. And by 2022 management is guiding for an annual payout of $2.20 which means buying today means within less than five years you’ll be earning nearly 12% returns on your investment (yield on cost) from income alone.
How safe is AMGP’s distribution? Well its coverage ratio is pegged at 1.0 by design since it exists exclusively to collect AM’s IDR fees and pass them onto investors. Thus to determine how secure AMGP’s payout is we need to look at the safety of AM’s payout. With a current coverage ratio of 1.3 and a self funding business model, both MLPs have low risk distributions. Of course there’s more to a safe MLP payout than just a high coverage ratio. The balance sheet is also critically important given the capital intensive nature of this industry and Antero’s ambitious growth plans.
AMGP has no debt of its own since it only owns the IDRs for AM. This means that we need to look at the relative debt levels of AM to determine the appropriate balance sheet strength and how it affects payout security. Fortunately AM has a very strong balance sheet which supports its low risk distribution which in turn funds AMGP’s payout.
- Debt/EBITDA: 2.3 (industry average 4.4)
- Interest coverage ratio: 15.4 (industry average 4.5)
- S&P Credit rating: BB+
- Average borrowing cost: 3.2%
Antero Midstreams’ leverage ratio of 2.3 is far below the industry average and its interest coverage ratio (operating cash flow/interest cost) is a sky-high 15.4. That’s nearly four times that of its peers. This is why, despite a junk bond credit rating, the MLP is able to borrow at rock bottom interest rates (100% fixed rate debt, non maturing until 2022) which is seven times less than its returns on invested capital.
By 2022 management expects the leverage ratio to have fallen to 2.0 and the much larger and highly stable cash flow is expected to earn Antero Midstream a strong investment grade credit rating. What about Antero Resources on whom Antero Midstream’s growth thesis hinges? Well its leverage ratio is currently 2.6 but set to fall to 1.0 by 2022, meaning it too is on track for a fortress like balance sheet and strong investment grade credit rating.
Which brings us to the core of the Antero Midstream investment thesis; epic payout growth rates. Even beyond 2022 analysts expect both MLPs to continue growing their DCF/unit and payouts at a torrid rate. That’s based on Antero Resources’ ongoing production growth potential based in both natural gas and natural gas liquids out of the Marcellus/Utica shale. The US Energy Information Administration estimates that production from these formations will grow strongly through at least 2050, giving Antero Midstream a very long growth runway.
Of course all long-term growth forecasts need to be taken with a grain of salt and I certainly think the 20% AM and 50% AMGP payout growth projections that analysts are expecting are a bit over optimistic. But even if Antero Midstream can achieve half the growth rate analysts expect both stocks should easily end up delivering 20%+ annualized total returns which means potentially increasing your investment 700+% over the next decade.
In contrast the S&P 500, from current valuations, is expected to generate anywhere from 0% to 8% annualized total returns, depending on whose model you use. For example, Vanguard expects about 4% annual returns over the next decade, Blackrock 5% and Morningstar 0% to 5%. Or to put another way, Antero Midstream, both the MLP and its GP, are offering far more generous, low risk, and much faster income growth than the S&P 500. And from today’s valuations they are likely to generate four to five times better annualized total returns as well.
Valuation: Despite Hyper Growth AMGP Remains Highly Undervalued
A stock’s total returns are based on three things: yield, long-term payout growth (proxy for cash flow growth), and multiple changes over time. This is why my investment strategy centers are maximizing all three of these factors. Well Antero Midstream has the yield and growth to generate great returns, but what about its valuation? If AMGP is highly overvalued that means that multiple compression will eat into our returns. But if it’s undervalued then multiple expansion will ensure fantastic capital gains.
When dealing with hyper growth stocks like AMGP standard valuation models tend to become unreliable. Normally in a stable business model stock like MLPs, the long-term price will track with distribution growth. However, it’s highly unlikely that AMGP’s yield will remain at just 2.7% implying its unit price will appreciate 62% annually for the next five years. That’s because the growth rate of its cash flow and payout will naturally slow over time, and so its yield is likely to move steadily higher. However, due to how fast its cash flow is growing its key valuation multiple (price/DCF, MLP equivalent of a PE ratio) is likely to also compress a lot. That ultimately means that AMGP’s price is likely to rise quickly but not as fast as its payout.
To see why, and determine just how undervalued it is, we can plug AMGP’s price/DCF into a formula pioneered by Benjamin Graham, Buffett’s mentor and the father of modern value investing. This Graham fair value formula allows us to estimate what price/DCF represents fair value
|Price To DCF||Implied 10 Year DCF Growth Rate||Graham Fair Value P/DCF||Estimated Graham Fair Value||Discount To Fair Value|
|36.7||14.1%||43.6 to 53.2||$22 to $24.5||16% to 34%|
Sources: management guidance, Gurufocus, Benjamin Graham
The Graham formula allows us to not just estimate the fair value P/DCF but also what growth rate is currently baked into the unit price. For example, while AMGP’s price/cash flow if about 3x higher than the average MLP’s, it’s also implies a 10 year DCF/unit growth rate of just 14.1%. In reality, 20% to 25% is a far more reasonable conservative assumption which implies that the stock’s fair value price/DCF, even accounting for a slowdown in future growth, should be 43.6 to 53.2 today. Or to put another way, based on conservative growth assumptions AMGP is about 16% to 34% undervalued today.
For a low risk income stock with the fastest long-term growth potential in America, that makes AMGP a very strong buy. At least assuming you’re comfortable with its risk profile.