Western Midstream: Growth Moderating, Bonds Looking Competitive

insagostudio

Recovery Phase Over, Now Steady Performer

After covering Western Midstream Partners (NYSE:WES) on Seeking Alpha for the past three years, I have seen the partnership evolve through several phases. At first, it followed the typical MLP model, aiming to grow distributable cash flow by acquiring assets financed by new stock or debt issuance. I predicted back in Nov 2019 that this would be unsustainable, and WES would follow the same path Kinder Morgan (RMI) did a few years earlier, cutting the distribution and funding growth out of free cash flow. A few months later of course, the pandemic arrived, forcing the company to do exactly that.

The partnership took the right steps to survive, cutting capex and the distribution and getting debt levels down. Operationally, WES became more independent from its majority owner Occidental Petroleum (OXY), putting its own management team in place and doing more business with third party upstream customers. Unit price staged a remarkable recovery, back to around $27.50 from the $3.00 level in March 2020. By early 2022, WES was processing nearly half its gas volume for companies other than OXY. The partnership also raised its distribution to $2.00/year, 60% above 2020 levels but still about 20% below 2019 levels. WES also announced a framework for annual special distributions tied to leverage targets and free cash flow.

WES Price Chart

Seeking Alpha

For most of this year, price has been mostly steady, suggesting a transition to a slower phase of growth compared to the rapid recovery since 2020. With the 3Q 2022 earnings release, WES announced record gas throughput in the Delaware basin, new firm volume commitments agreed with OXY, a buyout of the half of the Ranch Westex processing plant it did not already own, and the sale of its interest in the Cactus II oil pipeline.

In spite of this busy quarter, WES also guided to the low end of their target range on 2022 EBITDA and free cash flow. Higher operating costs played into this, but volume growth is also lower than initially expected, at least for oil and water. In the 1Q earnings presentation, the partnership expected low single digit volume growth for oil and low 20’s% growth for water. We see in the latest presentation these have been revised to flat and high teens% growth rates.

WES 2022 guidance

Western Midstream 3Q 2022 Earnings Slides

With this moderating growth, I expect unit price appreciation to also slow, even with the prospect of special distributions at the start of 2023 and 2024. Even with these distributions, the partnership’s bonds are now looking competitive with the equity, yielding only 100-200 basis points less despite the guaranteed return of capital at maturity.

Distribution Outlook

Recall that in early 2022, WES announced its new distribution framework, featuring a regular distribution of $2.00/unit, with the possibility of a special distribution at the start of the following year depending on hitting leverage and free cash flow targets. For 2023, the leverage target is 3.4x net debt/EBITDA which looks achievable as I will show below. The free cash flow target requires positive excess free cash flow after the base distribution and any buybacks. This excess free cash flow target is also penalized if the partnership added debt or enhanced if they reduced debt. Finally, paying the distribution itself may not cause the net debt/EBITDA to exceed the leverage target. As an example, WES worked out what the special distribution would look like if calculated now instead of after 4Q.

WES Special Distribution Calculation

Western Midstream 3Q 2022 Earnings Slides

In estimating the special distributions for the next couple years, a few assumptions have changed since my earlier articles. First, WES has been doing more buybacks than I expected, with $447 million worth bought back through the end of 3Q. The partnership also increased its total buyback authorization through 2024 by $250 million to $1.25 billion, returning the proceeds from the sale of the Cactus II pipeline stake. Also, the partnership did not reduce net debt as I expected. When they paid off $500 million of senior notes earlier this year, they just added $620 million to the revolving credit facility. The debt increase and buybacks both reduce the special distribution, along with the reduction in the EBITDA forecast to the low end of the range. All together, I estimate a small special of $0.192 per unit in 1Q 2023.

WES cash flow model 2022-24

Author Spreadsheet

Subsequently, I am now assuming WES does work to complete its $1.25 billion buyback program by 2024. There is also $213 million of debt due in 2023. Paying it off does not reduce the amount allowed for the special distribution under the current formula.

Compared to the 7.3% forward yield at the time of writing, WES would yield 7.6% in 2023 and 8.7% in 2024 , assuming unit price increases in line with the reduction in share count.

Debt Looking More Attractive

The equity WES partnership units were a no-brainer in 2020 and 2021 when distribution yield was high thanks to low unit prices at the same time interest rates were low. Now, however, bonds maturing in 2028 have a yield to maturity around 6.5%. This is only 1-2 percentage points below the expected distribution yield of the partnership units in 2023 and 2024 even with the special distribution included. Credit quality is right on the border between investment grade and high yield, with ratings of BBB- by S&P and Ba1 by Moody’s. With this credit rating, return of capital at maturity is a high probability outcome while the price of the equity at that time is impossible to predict.

Western Midstream bond availability

Charles Schwab

Note that longer maturitys are available in 2044 and 2048 yielding above 7% but with the longer duration, prices can fluctuate almost as much as the equity. I would stick to the medium term for now unless interest rates become even more attractive.

Conclusion

Western Midstream partnership units have come a long way since March 2020, reflective of the moves taken by the partnership to expand business and strengthen the balance sheet. The downshifting of growth expectations we see this quarter indicates that WES is settling into a mode of steady performance and reliable slower-growing returns. The partnership units appear safe to hold for the long term, but based on my latest estimates of future special distributions, the 2028 bonds offer more safety for only a little less yield.

Author: admin

Leave a Reply

Your email address will not be published. Required fields are marked *