I wasn’t sure I’d be engaging in any more activity this month. The initiation of a positionin Walt Disney Co. (DIS, Financial) just last week was, in my view, a great long-term investment at the current valuation. And I was very content with that being it for the month, due to the fact that I have to stay pretty vigilant on rebuilding my emergency fund after raiding it for stocks over the last couple of months.
But the energy sector continues to get hammered and some stocks within that sector are getting very interesting here. I think the odds are somewhat high for continued volatility over the near term, but you never really know where these things are going to end up. The best one can do is value a company based on all known information and try to buy in with a margin of safety.
Some of the largest supermajors are starting to trade near my cost basis in them, which means continued weakness will allow me to average down. The opportunity to pay less for equity in a high-quality company is always welcome.
However, I noticed one particular stock in my portfolio was down more than 8% yesterday after already pulling back rather substantially over the last few months. This seemed to be an opportune time to add to my position.
I purchased 20 shares of ONEOK, Inc. (OKE, Financial) on 12/10/14 for $44.56 per share.
Overview
ONEOK, Inc. is a diversified energy company. It is the sole general partner and 38.3 percent owner of ONEOK Partners L.P. (OKS). OKS is a leader in the gathering, processing, transportation, and storage of natural gas. It also owns and operates a large natural gas liquids system, connecting NGL supply in the Mid-Continent and Rocky Mountain regions with key market centers.
OKS is a midstream master limited partnership. OKE, on the other hand, operates as normal corporation. Its a pure-play general partner, whose purpose is to own the GP and limited partner units in OKS. Its growth is highly tied to OKS’s growth.
The MLP owns and operates more than 18,000 miles of natural gas gathering pipelines. They also own and operate 19 active processing plants. For NGLs, they own and operate more than 4,000 miles of NGL gathering pipelines, six fractionators, and eight NGL product terminals.
Fundamentals
OKE is a vastly different company today than it was just a decade ago. Up until 2004, it was primarily a utility company. However, in 2004 it purchased the majority of the general partner of Northern Border Partners, the precursor to OKS. In 2006, it became the sole general partner and renamed Northern Border under the ONEOK banner.
As such, it’s difficult for me to use 10-year numbers because the business has transformed so much. In addition, OKE’s growth is fueled by OKS. Lastly, net income isn’t really a good barometer for an MLP’s financial stability or growth due to substantial depreciation charges. So, like a REIT, EPS is not really accurate for valuing an MLP. When looking at MLPs, one would be wise to look at the distributable cash flow (DCF), which measures how much cash flow the partnership is generating, and the distributions themselves.
Most importantly, as the general partner, OKE is entitled to incentive distribution rights. If you’re unsure as to what the IDR is or how it works, this site includes a nice explanation. The IDR ensures the GP receives a growing piece of the cash flow pie as the partnership grows. This is accomplished through tiers:
- 15 percent of amounts distributed in excess of $0.3025 per unit
- 25 percent of amounts distributed in excess of $0.3575 per unit
- 50 percent of amounts distributed in excess of $0.4675 per unit
The top tier has already been reached, meaning OKE will continue to collect the lion’s share of DCF. In addition, they collect distributions through their ownership of limited partner units in OKS. I’ll show you what that looks like.
So we’ll look at some numbers and see what we’re working with here. OKE’s fiscal year ends December 31.
First, we’ll look at revenue over the last five years for OKE. It increased from $11.112 billion in fiscal year 2009 to $14.603 billion by the end of FY 2013. That’s a compound annual growth rate of 7.07%.
The distributions, which funds OKE’s dividends, have grown substantially. Notably, the GP interest has accounted for more of that growth. In 2010, the total distributions declared from OKS to OKE amounted to $311 million. Of that, $120 million was the GP interest, while $191 million was the LP interest. Fast forward to 2014, and total distributions declared from OKS to OKE should finish at $636 million. Of that, $351 million was the GP interest and $285 million was the LP interest. So you can see the growth there, especially in the GP interest. Over that five-year period, that’s a CAGR of 19.58%.
Management states succinctly and accurately how the growth of OKS will especially benefit OKE:
Nearly two-thirds of every incremental ONEOK Partners adjusted EBITDA dollar, at current ownership level, flows to ONEOK as ONEOK Partners distributions.
OKE has increased its dividend over the last 12 consecutive years.
But perhaps more impressively is the rate at which the dividend has increased. The dividends paid for 2010 amounted to $0.91 For 2014, that total came out to $2.125. That’s a compound annual growth rate of 23.54% over that period. You’ve got to love a dividend that more than doubles over the course of five years.
And the dividend growth is anticipated by management to continue at an aggressive rate. Through a combination of acquisitions (like the recent acquisition of NGL assets in the Permian Basin) and growth projects that are coming online between now and 2017, OKEexpects to grow the dividend by 14 percent in 2015. It has also estimated annual dividend increases of 12 percent to 15 percent between 2014 and 2017.
Factoring in a yield of 5.3% here, and you can see where the investment and income case is compelling.
OKE is targeting a long-term dividend coverage ratio of 1.0x to 1.1x.
OKE and OKS are both heavily leveraged, as these are capital-intensive businesses with a lot of exposure to large, expensive, and long-life assets. As such, there’s a lot of debt on the balance sheets. OKE sports more than $7.7 billion at the GP level and OKS records more than $6 billion. However, OKE maintains investment-grade ratings: Baa2/BBB.
Qualitative Aspects
OKE is a long-term bet on natural gas’s future, in my view. It’s a fairly clean source of energy, and I think we’ll be using it for the foreseeable future and beyond. Demand projections vary substantially depending on the source, but, like most other forms of energy, it appears fairly obvious to me that energy needs will increase over time. You combine an increasing global population with increasing access to wealth and thus energy from rising middle classes across emerging and developing markets, and that leads you to increased energy demand.
I think it’s possible the forecasts may actually be on the light side, like the most recent report from the US Energy Information Administration. For an instance where the prediction was woefully inaccurate, NaturalGas.org cites:
The Energy Information Administration, in its Annual Energy Outlook 2011, projects that natural gas demand in the United States could be 26.55 trillion cubic feet (Tcf) by the year 2035.
But you can see we’ve already surpassed this.
A substantial competitive advantage lies in the barriers to entry, as ONEOK’s pipeline assets can not be easily replicated. Furthermore, their size gives them economies of scale, and the geographical locations are fantastic. The MLP has been heavily concentrating on the Bakken, and approximately half of producers’ rigs currently operating in the Williston Basin are drilling on acreage dedicated to OKS’s systems. So their position is firmly entrenched to where it would be exceedingly unlikely that a competitor could come in and replace them.
Their natural gas gathering growth has been substantial, up from 1,067 BBtu/d to an estimated 1,720 BBtu/d from 2010 to 2014. And OKE is predicting 2,010 BBtu/d for 2015. This growth will come from current exposure as well as new projects. OKS has $3 billion in growth projects in various stages of completion as well as a backlog north of $4 billion.
Perhaps most remarkable, the majority of ONEOK’s cash flow is based on long-term, fee-based contracts. So this insulates the partnership somewhat from wide swings in commodity pricing. And it gives them long-term visibility on cash flow and its ability to pay and increase distributions and dividends, which is why you see growth projections going out a few years.
Risks
There are a number of risks to consider here with OKE, and I consider it a rather aggressive investment from a standpoint of risk and reward. Primarily, the MLP structure could come under pressure if there are any material changes at the federal government level insofar as taxation. Though highly unlikely, it’s a risk that, if it were to occur, could have a substantial effect on the business (and others like it). Rising interest rates are also a risk, due to the amount of debt that OKE and OKS carry. Although OKE is largely insulated from major swings in commodity prices, they are exposed through their processing business. In addition, lower natural gas prices can reduce demand for transportation. One other potential risk is a dividend cut, as like a lot of other MLPs, the dividend coverage is pretty tight. Finally, I view black swan events as a risk, such as a fire or other disaster at one of their pipelines or plants.
Valuation
Though ONEOK has corporate history dating back more than 100 years, its current structure and business model is somewhat new for them. That said, they’ve been incredibly successful with it over the last decade.
As aforementioned, net income isn’t a viable way to gauge profitability. So I won’t be using the P/E ratio for comparative purposes here.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6% long-term growth rate. That rate seems particularly conservative considering we know it’s highly likely going to exceed that for at least the foreseeable future. However, I like to always model in a margin of safety. The DDM analysis gives me a fair value of $62.54.
So shares appear substantially undervalued here, as the stock has corrected more than 35%over the last three months. OKE was trading above $70 not that long ago. As I stated above, there could be continued volatility moving forward, but I believe OKE has fallen too far in too short a period, especially considering that their business isn’t tied heavily to oil prices and natural gas is higher now than it was three years ago. In management’s predictions, they cite that commodity pricing shouldn’t have a large impact on their results, though they do release forecasts with varying prices on oil, NGLs and natural gas. Even the low-end numbers result in significantly higher DCF year-over-year.
Conclusion
I first initiated a position in OKE last summer around this same price and the stock kind of took off from there. I never got a chance to really add to my stake in the company until just now. I’m certainly glad to have the chance to add to one of the premier midstream MLPs at what I feel is a severe discount. This purchase was smaller than my usual transaction amount due to being a bit light on cash after a buying spree over the last few months, but I think this was sufficient seeing as how the intrinsic risk is somewhat elevated in comparison to most of the companies I invest in. However, I believe the valuation compensates for that risk.
This is one of the few stocks on the market where you can get yield and a growth rate that are both well above the average. Furthermore, it appears the valuation also offers a margin of safety.
I’m going to include a couple of other valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates OKE as a 4/5 star value, with a fair value estimate of $59.00.
S&P Capital IQ rates OKE as a 2/5 star “sell”, with a fair value calculation of $50.80.
This purchase adds $47.20 to my annual dividend income, based on the current $0.59 quarterly dividend.
I’ll update my Freedom Fund in early January to reflect this recent purchase.
Full Disclosure: Long OKE.
Have you looked at OKE here? What are your thoughts?
Thanks for reading.
