Investors may be pleasantly surprised to learn of midstream companies’ compelling free cash flow yield relative to other income-generating investments.
A recent poll from VettaFi showed most advisors underestimate midstream companies’ free cash flow. When asked the trailing 12-month free cash flow yield for midstream/MLPs, just 12.5% of respondents accurately selected 12%. The majority of respondents selected 9% or 5%, according to How the US Energy Outlook Benefits Midstream/MLPs (Date: August 9, 2023. Sample size: 122 respondents, 30% RIAs).
“People don’t fully appreciate the type of free cash flow that these companies are throwing off,” Stacey Morris, head of energy research at VettaFi, said during the Webcast.
Midstream companies had to spend a lot of money in years past when U.S. energy production was growing tremendously. However, now that production is growing at more modest levels, capital spending has come down significantly, Morris said.
“The decline for some of these companies is measured in billions, if you compare 2019 capex to where we are today,” she added. “That’s a lot of free cash flow.”
Midstream companies generally have fee-based business models, meaning their operating cash flows tend to be more stable. This is an upside to the midstream space, Morris said, as broader energy companies’ cash flows tend to fluctuate with commodity prices.
Broader energy companies generated significant free cash flow last year when commodity prices were high. However, that has declined this year alongside softer commodity prices. Conversely, midstream’s free cash flow generation has been more stable. This enables these companies to continue to grow dividends and execute on buyback programs.
How Free Cash Flow Generation Benefits Midstream Investors
There are many tailwinds from free cash flow generation, Morris said. A large component is dividend growth.
Comparing second quarter dividends to the prior quarter (1Q23), the Alerian MLP Infrastructure Index (AMZI)saw five constituents increase their payouts, representing about 40% of the index by weight. The Alerian MLP ETF (AMLP) tracks the MLP index.
See more: “Midstream 2Q23 Dividend Recap: MLPs Drive Growth”
Meanwhile, the Alerian Midstream Energy Select Index (AMEI) saw five names increase their payouts for the second quarter, representing 24.4% in the index. The Alerian Energy Infrastructure ETF (ENFR) provides exposure to AMEI.
Over the last four quarters, about 82% of AMZI by weight has increased their payouts. During the same one-year period, 89.5% of AMEI by weight has increased payouts.
Notably, it’s been over two years since a name in AMZI or AMEI has cut its dividend – important context considering MLP and midstream yields are 7.8% and 6.4%, respectively.
“We feel really good about the dividend trends that we’re seeing in this space,” Morris said. “The way that companies are delivering dividend growth while focusing on growing their payout sustainably and not just growing for the sake of growing.”
Opportunistic Equity Buybacks
The other thing that companies are doing with excess cash flow is buying back equity. Morris said buyback activity has been widespread in the midstream space.
Notably, about 77.5% of AMZI has buyback authorizations, while about 68% of AMEI has buyback authorizations.
“Buybacks have been a nice tool for management teams to use when they see disconnects in the marketplace,” Morris said. “If MLP or midstream equities may be getting beat up because of broader market news or volatility in energy, companies can use those opportunities to come in and buy their equity.”
Last quarter, Cheniere Energy (LNG) was leading the way in terms of buyback activity, Morris added. Other names that were actively buying back equity in the second quarter include Enterprise Products Partners LP (EPD), Kinder Morgan Inc. (KMI), Targa Resources (TRGP), and Williams (WMB).
Morris said buybacks continue to be a tailwind for the midstream space. “I think investors can appreciate that companies are not only focused on income and providing dividends, but also total return and using buyback programs opportunistically,” she said.
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