Midstream traders awoke to the information yesterday morning that one other MLP can be exiting the market, as ONEOK, Inc. (NYSE:OKE) introduced a deal to amass Magellan Midstream Companions, L.P. (NYSE:MMP). Within the proposed deal, every MMP unitholder will obtain $25 in money and 0.677 shares of OKE inventory for every MMP unit they personal. The supply got here at a 22% premium over MMP’s earlier day’s closing value. OKE expects the deal to shut within the third quarter.
The deal values MMP at 11.8 occasions our estimate of 2024 Adjusted EBITDA. By comparability, we estimate earlier than the announcement, MMP was buying and selling at 10.4 occasions 2024 EV/Adjusted EBITDA and OKE was buying and selling at 9.7 occasions 2024 EV/Adjusted EBITDA. MMP’s increased a number of displays its comparatively excessive return on capital, although its a number of has been depressed by the low cost its fairness receives from being an MLP. Based mostly on our estimate of 2024 free money stream, the supply value represents an roughly 8.1% distributable money stream yield on MMP’s market cap.
The deal can be absolutely taxable for MMP unitholders. Administration negotiated a big money part within the deal in order that unitholders can fund the tax obligations triggered upon the switch of possession.
For OKE, the deal pushes again the impression of the company various minimal tax till 2027, representing tax financial savings with a internet current worth of $1.5 billion. The deal’s tax advantages might enhance if OKE completes new initiatives or acquisitions.
We presently maintain MMP items however do not personal OKE shares. MMP items had been one in every of our first buys on December 13, 2020, for our HFI Analysis Power Revenue portfolio at $46.58. Assuming MMP’s present value of $63.00 and the $9.3475 of distributions we’ve got obtained since our buy, our MMP funding generated a 55.3% undiscounted complete return, or a 19.96% compound annual return.
Since we imagine the deal will undergo, we plan to promote our MMP items and reallocate the proceeds into varied bargain-priced income-generating power equities.
The Market Penalizes OKE
OKE shares traded down 9.1% yesterday, presumably as a result of MMP would not supply OKE considerable prospects for operational development funded by capex. Nonetheless, we imagine the deal is enticing for OKE.
We have seen all too typically that in midstream that operational development fails to translate into extremely worthwhile internet earnings or free money stream development. However MMP is a singular operator. Its property have an essential function most midstream property lack, specifically, pricing energy. So whereas MMP’s property will not be an appropriate vacation spot for OKE’s marginal development capex greenback, their pricing energy is all however sure to contribute a few years of development to OKE’s EBITDA and money stream at very low danger to shareholder returns.
MMP’s pricing energy was most just lately on show within the firm’s first-quarter 2023 earnings report on Could 4, the place it disclosed its refined product transportation charges had been set to extend by a mean of 11% starting on July 1, 2023. The speed hike is the biggest in an extended succession of annual fee hikes.
MMP’s pricing energy derives from the entrenched place loved by its irreplaceable refined product pipeline property, which limits competitors from different pipelines. The regularity with which it has boosted charges signifies that its excessive return on capital is sustainable. It additionally signifies that its property are shielded from the impression of rising inflation. In an inflationary setting, MMP’s property will generate increased revenues coupled with minimal capex necessities and low working bills. Because of this, a higher proportion of income can drop to the underside line.
Operational Diversification Additionally Advantages OKE
Along with providing OKE low-risk development, the deal enhances OKE geographically, with MMP’s and its personal midstream system spanning the midsection of the U.S.
Supply: ONEOK Magellan Midstream Companions Acquisition Presentation, Could 14, 2023.
The deal brings fascinating diversification to OKE’s operations. The corporate will lengthen its gathering and transportation capabilities outdoors its legacy pure gasoline and NGLs markets and into crude oil and refined merchandise.
Supply: ONEOK Magellan Midstream Companions Acquisition Presentation, Could 14, 2023.
Elevated operational diversification ought to permit OKE to extend its service choices to clients, however it is going to additionally enhance the soundness of the corporate’s money stream. Moreover, MMP’s steady refined product throughput volumes will make the mixed entity’s money flows much less susceptible to power market cyclicality.
The principle knock in opposition to OKE from long-term shareholders is its NGL transportation system’s overreliance on Bakken volumes. Bakken oil and gasoline manufacturing has entered a mature part of its life cycle. Over the subsequent few years, the basin’s oil, NGL, and pure gasoline manufacturing is prone to plateau after which decline.
Supply: EIA, Could 2023 Drilling Productiveness Report.
Declining Bakken volumes would adversely impression OKE’s monetary outcomes. Since OKE’s Bakken and Midcontinent NGL system is the primary supply of its mid-teens return on capital – which ranks among the many highest in midstream – and, by extension, its inventory’s premium valuation a number of, administration can be prudent to handle the looming prospect of Bakken manufacturing declines as quickly as potential. By buying MMP’s property, that are characterised by indefinitely lengthy helpful lives, OKE can allay shareholder issues relating to Bakken declines.
Lastly, the addition of MMP property will increase OKE’s systemwide return on capital. OKE possesses one of many few administration groups in midstream that has persistently excelled in capital allocation, so we anticipate the MMP property to retain their high-return profile within the arms of OKE’s succesful administration.
An MMP Unitholder’s Perspective on the Deal
Should you’re a long-term MMP shareholder like we’re, you may discover it troublesome to half with such enticing property and high-caliber administration. We thought-about our MMP funding to have an indefinite holding interval, over which we anticipated rising distributions. We do not share issues that MMP’s property will fall out of use as a consequence of an power transition, and we think about MMP administration among the many greatest capital allocators in any cyclical, capital-intensive business. If MMP remained impartial, we had been assured that its items would generate sturdy returns for unitholders for a few years to return.
Whereas we might desire MMP to stay impartial, we’ve got to face the truth that the midstream sector will consolidate, and MMP is among the many most engaging acquisition candidates for the biggest operators. So whereas we discover the deal’s value to be decrease than we’d have appreciated in an acquisition state of affairs, we anticipate it to achieve approval from OKE shareholders, MMP unitholders, and regulators. Consequently, we plan on promoting our items and reallocating the proceeds into one of many many discounted income-generating power equities.
As for the arbitrage alternative the deal presently provides, potential returns will rely on the course of OKE’s inventory value. With OKE buying and selling at round $58 and MMP at $63, the deal’s consideration, mixed with MMP’s August $1.0475 distribution, deliver the undiscounted potential return over the subsequent six months to 2.8%. We imagine the chances are higher than 80% that the deal can be authorized and that it’s going to shut within the third quarter. The first danger to the deal stems from OKE shareholders’ failure to approve it. In that state of affairs, MMP would fall again to its pre-deal degree of $55, or maybe barely increased, because the deal highlights MMP’s substantial worth to an acquirer.
In mild of the slim return on supply and the slight danger that the deal fails, we do not imagine the present premium provides ample compensation for unitholders in search of a low-risk arbitrage return. However that would change if MMP’s unit value stays subdued and OKE’s inventory rallies over the approaching weeks.
Professional Forma Financials for the Mixed Entity
OKE reported within the deal’s press launch that it will likely be accretive to earnings per share in 2024 and ship an extra 3%-to-7% increase from 2024 by means of 2027. Administration expects synergies of roughly $200 million. It additionally expects OKE to finish 2024 with a leverage ratio of roughly 4.0 occasions.
The next desk reveals our professional forma estimates for the mixed entity for 2024 and 2025. We imagine leverage will finish 2024 at 3.8 occasions, decrease than administration’s estimate. The mixed entity is buying and selling at an EV/EBITDA of 9.6 occasions for 2024 and a free money stream yield of 12.4% on its market cap at $60 per share.
At OKE’s present value of $60, the mixed entity’s fairness is being priced at a reduction to OKE’s current historic common EV/EBITDA, which is within the vary of 11-to-12 occasions. The addition of MMP’s property ought to increase its EV/EBITDA a number of as a consequence of MMP’s considerably increased return on capital. In reality, if we assume EBITDA grows by 5% from 2024 to 2025 and that the corporate allocates all of its 2024 money stream surplus towards paying down debt, at $60 per share, the mixed entity’s EV/EBITDA falls to a traditionally low 9 occasions in 2024.
If the mixed entity traded at an 11 occasions a number of, OKE shares would commerce at $74 in 2024 and $81 in 2025. Clearly, OKE shares are too low cost within the neighborhood of $60 per share. The corporate provides regular development and steady money stream. We fee the shares as a Purchase with a value goal of $66. We imagine our value goal is conservative, making an allowance for the slight chance that the deal fails and the enticing prospects for the mixed entity.
MLPs Are Too Low-cost
The 22% premium paid on this practically $19 billion deal is a testomony to the undervaluation that exists within the MLP area. Midstream oil and gasoline MLPs are low cost relative to each different inventory market section, significantly in mild of the prime quality of their money flows.
The sector’s low cost is not attributable to poor fundamentals. Full-year 2022 outcomes for MLPs had been sturdy. First-quarter 2023 outcomes had been arguably the strongest among the many oil and gasoline sub-sectors.
Traders have grown accustomed to criticizing the MLP entity and its related buying and selling low cost out there. However corporations like MMP have used that low cost to their unitholders’ benefit by repurchasing massive portions of items at discount costs. The 11.5% discount in MMP’s unit rely that has occurred because the finish of 2019 boosted unitholders’ returns from this acquisition.
The Magellan Midstream Companions, L.P. acquisition is an efficient deal for ONEOK, Inc. shareholders. We imagine the selloff in OKE shares presents a horny long-term shopping for alternative. The OKE that may emerge from this deal may have higher scale and diversification. It would have a return on capital and money stream stability on par with the highest-quality midstream operators. In reality, its return on capital will far and away be the very best amongst its friends and among the many highest within the midstream sector.
Whereas the deal shouldn’t be pretty much as good for MMP unitholders, it supplies them with an exit right into a high-quality mixed entity. For MMP traders looking for to stay within the MLP area, we suggest Enterprise Merchandise Companions L.P. (EPD) and MPLX LP (MPLX) as two midstream operators with operational and monetary stability on par with MMP. Their distribution security, distribution yield, inflation resistance, and distribution development prospects make them interesting alternate options to MMP.
We sit up for snatching up some high-quality bargains with the proceeds from our MMP unit sale. With investor sentiment towards the power sector within the dumps, fairness valuations are depressed and power earnings traders are spoiled for alternative. Fundamentals are on the upswing in each oil and pure gasoline, and we imagine now is an efficient time to purchase.