Attracted by the increasing price of natural gas and the company's increasing free cash flow, I was bullish on Equitrans Midstream Corp. (ETRN, Financial) a year ago. While I was right about natural gas prices and the cash flow, the company's stock has remained flat.
Generating a 7.3% dividend yield, Equitrans could be an interesting investment opportunity with big upside, solid current income and limited downside. The upside depends on the completion of a major project the company is working on that keeps being delayed.
About Equitrans
The midstream energy company, whose assets are predominately in the Appalachian Basin, provides infrastructure and services for the gathering and transportation of hydrocarbons (mainly natural gas) as well as water services to producers in the region. Equitrans was spun off of EQT Corp. (EQT, Financial) in November 2018, when the company separated its upstream and midstream assets to better align with specific classes of investors.
The following diagram illustrates the company's organizational and ownership structure as of Dec. 31, 2021.
Source: Company presentation.
At approximately 185,000 square miles, the Appalachian Basin covers most of New York, Pennsylvania, eastern Ohio, West Virginia, western Maryland and parts of northwestern Georgia and northeastern Alabama. The primary producing subsurface shale formations in the basin currently are the Marcellus Shale and below that the Utica - Point Pleasant formations. Marcellus and Utica are both "super giant" gas fields making them respectively the second and the third largest in the world (after the Qatar/Iran gas field). They are expected to keep producing gas for decades. Shale gas is accessed with unconventional technology (i.e. with horizontal drilling and fracking which is much more expensive than conventional drilling), so natural gas prices need to high enough to justify on-going expenses.
Once built, pipelines provide stable cash flow to investors over many years decades. Regulatory and environmental challenges make it very difficult to build new pipelines. In addition, rocky and hilly terrain, along with weather-related challenges, make the Appalachian area a difficult place to build in. This gives the company a strong moat as it is almost impossible for competitors to break into the space. First movers, literally and figuratively, get dug in.
Equitrans provides a majority of its natural gas gathering, transmission and storage services under long-term contracts that generally include firm reservation fees. It maintains a stable cash flow profile, with approximately 64% of the company's operating revenue for 2021 generated from these reservation fees.
The take-or-pay contract structure enhances the stability of the company's cash flow and limits its exposure to customer volume variability.
Mountain Valley Pipeline
Equitrans has several major projects in the works, the most important of which is the Mountain Valley Pipeline. The project, which is over 80% complete, has been mired in regulatory and environmental challenges and, as a result, has seen progess slow considerably. The pipeline is a joint venture with Nextera Energy (NEE, Financial) and other players with operations in the region.
However, given Europe's current energy crisis, chances are the pipeline will finally be completed to increase U.S. natural gas exports and eliminate dependence on Russia. I am optimistic this strategic imperative will overpower any remaining regulatory and legal barriers, but one cannot be sure.
The percentage of Equitrans' revenue that is generated by the firm reservation fees is expected to increase as the pipeline comes into service. The estimated in-service date is now late 2023, but may be further delayed.
The costs of the project continue to escalate because of the delays, which is a major risk for the company that I believe is fully reflected in the current share price of around $8.13.
Balance sheet
Below is a snapshot of the company's balance sheet.
Equitrans has high leverage, mainly due to its ongoing capital projects.
Equitrans' debt is high but well spread out. Once the Mountain Valley Pipeline begins to operate, increased cash flow will reduce leverage quickly. The company expects to complete the project with its current revolving credit facility and free cash flow.
Cash flow and Dividend
The company took large non-cash writedowns in 2019 and 2021 for the delayed pipeline project and may be forced to do so again. However, Equitrans is currently generating ample free cash flow, which covers its dividend.
While the company has a short operating history, it has ramped up dividends rapidly. The dividend yield is currently 7.3%. Even if the stock price goes nowhere, like it did in the last year, investors are receiving the dividend.
Valuation
The average analyst 12-month price target for Equitrans is $9.70.
Independent investment advisor Morningstar is bullish on the stock with a $14 longer-term fair value and five-star rating. It says the company has a narrow economic moat despite a poor record of capital allocation, mainly because of the problems it has encountered on the Mountain Valley Pipeline project, which were compounded by management missteps.
Conclusion
Equitrans appears to be an interesting but high-risk stock with great capital appreciation potential. Much of the company's future depends on the Mountain Valley Pipeline beginning operations. If and when it does, the stock will likely double from current levels. If not, there is some minor downside potential.
Overall, given the signficant upside and the limited downside, Equitrans looks like a reasonable bet. Investors can collect a 7.3% dividend as a consolation prize while waiting for the pipeline project to finally be completed.
