ONEOK – An Alternative Dividend Growth Idea

I am adding a group of alternative income growth investments to the VSL sheets. Here is one that is on my radar as I am very familiar with the company going back about a decade. ONEOK (OKE) was one of the pipeline companies that has helped get oil out of the Williston Basin, which I traveled to a few times earlier this decade to study the Bakken oil play. 

Here is the majority of an article by Dividend Sensei from Seeking Alpha. I am posting it here so it is accessible to you when the firewall goes up. I won’t post many of these, but this one is relevant to us and it doesn’t make much sense to me to write an essentially similar article. 

My quick take on ONEOK is that as a C-Corp and not an MLP, it is one of the few companies best positioned for the emerging slow growth, high volumes, better pricing environment for midstream companies that is just emerging. 

As there is more need for midstream, but development is slow due to government, financing and management seeking to maintain margins, it is the C-corps that have the best outlook. Not only are they not impacted by the recent FERC tax ruling, but they have better access to capital as needed.

As investors, we can hold these with no problem in an IRA, versus MLPs where we have to be careful of violating IRA tax rules. If you are looking for another income play in the midstream space, ONEOK is one to look at.

Here is Dividend Sensei’s piece…

ONEOK

ChartOKE Total Return Price data by YCharts

In recent years, the midstream sector has fallen deeply out of favor with Wall Street. That’s thanks to a perfect storm of negative factors, including the worst oil crash in over 50 years, interest rates rising off their all-time lows, a market correction, and a FERC tax rule change for certain MLP contracts.

ONEOK (OKE), one of my favorite midstream stocks, and one of the few C-corps in the space (meaning it uses a 1099 instead of a K1), has held up far better than most midstream peers. That being said, it has still badly underperformed the broader market, thus creating the opportunity for value-focused high-yield growth investors to profit from the company’s dominant presence in two of America’s largest future energy trends.

Let’s take a look at why ONEOK is potentially set to soar, and offers a good source of generous, safe, and fast growing dividends that likely mean market-crushing total returns in the coming years.

ONEOK: Strong 2017 Is Likely Just The Beginning

(Source: ONEOK Fact Sheet)

Founded in 1906 in Tulsa, Oklahoma, ONEOK is a large midstream company with about 38,000 miles of natural gas and natural gas liquid or NGL pipelines. That’s thanks to over $9 billion in investment between 2006 and 2016.

The company’s assets serve some of the most important and fastest growing shale formations, including the North Dakota Bakken/Williston basin, Oklahoma SCOOP/STACK, and West Texas’ Permian basin.

The company has three main business segments: natural gas gathering, natural gas transportation, and natural gas liquids or NGLs.

Natural Gas Liquids

  • 7,100 miles of gathering pipeline
  • 4,300 miles of distribution pipeline
  • 26 million barrels of storage capacity
  • 7 fractionators
  • 840,000 barrels per day of net fractionation capacity (contracts 7 to 10 years)
  • Connect to nearly 200 processing plants (90% of plants in core markets)

The company also owns a lot of vitally important natural gas assets including:

Natural Gas Gathering And Processing

  • 20,400 miles of gathering pipeline
  • 21 processing plants
  • 1,830 million cubic feet per day of processing capacity

Natural Gas Pipelines

  • 6,600 miles of transmission pipeline
  • 58 billion cubic feet of storage capacity
  • 95% fixed-fee long-term (six to 25 years), contracted revenue

(Source: ONEOK Fact Sheet)

Nearly all of the company’s cash flow is derived from fee-based contracts on its midstream assets, with just 10% of its distributable cash flow or DCF (midstream equivalent of free cash flow and what funds the dividend) exposed to commodity prices or spreads. What commodity exposure it does have is largely hedged, including 80% through 2018 and about 2/3 through the end of 2019.

In fact, ONEOK has spent the last few years focusing its projects on more fee-based contracts, in order to ensure more stable cash flows.

(Source: ONEOK Investor Presentation)

(Source: ONEOK Fact Sheet)

The relatively stable nature of its cash flow is what has allowed ONEOK to reward investors with steady and rising dividends during both boom and bust cycles. That includes the great Oil Crash of 2014 to early 2016 when energy prices plunged 76% peak to trough.

In 2017, ONEOK saw massive growth in its top and bottom lines thanks mostly to increased production in volume growth, courtesy of rising energy prices resulting in much larger gas gathering and NGL demand from its key basins.

Metric

2017 Results

Revenue Growth

36.5%

Distributable Cash Flow Growth

42.6%

Share Count

44.7%

Dividend

10.6%

Dividend Coverage Ratio

1.34

(Source: Earnings release)

ONEOK Natural Gas Gathering Volumes

(Source: ONEOK Investor Presentation)

ONEOK NGLs Volumes

(Source: ONEOK Investor Presentation)

Note that the high increase in share count was due to ONEOK simplifying its corporate structure by buying out its MLP, ONEOK Partners, in a $17.2 billiondeal in June 2017. This eliminated its MLP’s incentive distribution rights and has lowered its cost of capital two ways.

The first is that IDRs by the nature of redirecting 50% of marginal DCF to the sponsor, automatically raise costs of capital and make future projects less profitable. The second is that midstream stocks without IDRs usually trade at a premium resulting in lower costs of equity.

Remember that midstream stocks are pass-through entities meaning that they generally retain far less cash flow than regular C-corps to reinvest in growth. That means that most tap debt and equity markets to fund their growth capex needs.

Ultimately, the merger allowed the company to raise its dividend 21%immediately upon closing and then issue 9% to 11% dividend growth guidance through 2021. Another benefit is that due to the step up value of its midstream assets purchased during the merger, ONEOK won’t pay any corporate taxes through 2021.

ONEOK has announced $4.2 billion in organic growth projects, mostly pertaining to NGLs, since its June 2017 buyout of its MLP. In 2017 and early 2018, the company sold $1.6 billion in new equity to help fund its fast rate of growth.

However, it’s important to realize that ONEOK still enjoys relatively low costs of equity, about 7% based on 2018 guidance. When combined with its relatively high amounts of retained DCF, this means it has some of the industry’s lowest overall cash costs of capital.

Approximate Cash Cost Of Capital

4.6%

Historical DCF Yield On Invested Capital

9.6%

Gross Investment Spread

5.0%

(Source: earnings release, F.A.S.T. Graphs, Gurufocus)

For example, most MLPs retain 9% to 17% of DCF to grow, but ONEOK retained 25.4% in 2017. That means it has smaller than average reliance on external capital markets and enjoys a cost of capital of about 4.6%. Combined with a historical DCF yield on invested capital of about 9.6% this creates a gross investment spread of 5.0%. For context, most midstream stocks have gross spreads of about 2% to 3%. This tells us that ONEOK has above-average profitability on its projects even with Wall Street being bearish on the sector as a whole.

Note that management believes it won’t have to tap the equity markets again until “well into 2019.” That means that the 24% increase in DCF management is guiding for in 2018 should result in 24% increases in DCF/share.

This ability to avoid equity markets for now is thanks to paying off its revolving credit facility, partially with the most recent equity issuance. ONEOK now has an untapped $2.5 billion amount of low cost, (LIBOR + 1.1%), source of borrowing. The current rate on that debt is 3.46% and the company’s total liquidity to fund growth is $2.54 billion.

The good news about that is that since the dividend is only expected to grow at 9% to 11% annually through 2021, ONEOK dividend coverage ratio (DCF/dividends) should could rise over time. That in turn means the company will be retaining more DCF and lower its cost of capital even further.

ONEOK is likely to hit about 1.48 dividend coverage in 2018 and management has a long-term target of maintaining coverage over 1.2. A coverage ratio of 1.2 to 1.4 is usually what’s required to self-fund, meaning covering the equity portion of a growth capital budget with retained cash flow. Or to put another way, ONEOK has both the potential to grow its dividend quickly but safely and continue decreasing its reliance on fickle equity markets as well.

However, the key reason to own ONEOK is due to the two strong growth catalysts that could potentially drive strong dividend growth far longer than management’s current guidance.

2 Big Growth Catalysts Make ONEOK A Great Long-Term Dividend Growth Story

Ironically enough, OPEC’s price war with US shale producers has made the US energy boom stronger than ever. That’s because the decline in energy prices forced producers to become more productive than was believed possible before the crash.

(Source: Enterprise Products Partners Investor Presentation)

For example, for oil wells in the Permian basin (over 70 billion in recoverable reserves), productivity rose by nearly 500% between 2010 and 2017. Meanwhile, gas production too saw huge increases in productivity that resulted in far lower break-even costs.

(Source: Enterprise Products Partners Investor Presentation)

For example, at $3 gas prices, gas producers in ONEOK’s core SCOOP/STACK formations are earning about 70% internal rates of return. In addition, most gas formations are generating strong enough returns to justify continued expansion in production.

(Source: Enterprise Products Partners Investor Presentation)

This is why US gas production is expected to grow about 34% over the next five years. More importantly, with natural gas comes natural gas liquids, meaning chemicals like ethane, butane, propane, etc.

These can be converted into petrochemical feedstocks for the creation of high margin and exportable products (like plastics) that are in enormous demand in fast-growing emerging markets in Asia.

(Source: Enterprise Products Partners Investor Presentation)

And since US NGL prices are far below the cost of our global rivals, this creates a major competitive advantage. Which is why US NGL production is expected to boom as well.

Over the long term, the US Energy Information Administration expects US gas production (and NGL production) to continue growing strongly for decades. That’s because of the strong demand pull from emerging markets like China and India creating enormous opportunities for US energy exports.

(Source: Energy Information Administration)

ONEOK is well-positioned to take advantage of this boom thanks to its strong positions in the Permian, STACK/SCOOP, and Williston/Bakken formations.

(Source: ONEOK Investor Presentation)

The company currently has $4.2 billion in projects it is constructing, 86% of which are focused on serving the fast-growing NGL industry.

(Source: ONEOK Investor Presentation)

Management expects most of the company’s cash flow will be derived from NGLs in 2018.

(Source: ONEOK Investor Presentation)

More importantly for long-term investors management is confident that its long-term investment runway remains large and strong. According to CEO Terry Spencer:

as we look beyond 2020 …many of our projects are being designed with the ability to expand immediately with minimal capital investments….we continue to develop opportunities in and around our asset footprint to expand even further.” – Terry Spencer

Given that analyst firm IHS estimates that the US energy boom may need up to$900 billion in new midstream infrastructure investment by 2040, it seems reasonable to assume that ONEOK’s growth runway remains very long. That spells potentially great things for its long-term dividend growth potential.

Dividend Profile: Generous, Safe, and Fast Growing Payouts Mean Strong Total Return Potential

Company

Yield

2017 Payout Coverage

10-Year Projected Potential Dividend Growth

10-Year Potential Total Return

ONEOK

5.10%

1.34

8% to 9.6%

13.1% to 14.7%

S&P 500

1.90%

3.1

6.20%

8.10%

(Sources: Gurufocus, earnings release, F.A.S.T.Graphs, Multpl, CSImarketing)

Ultimately, the most important component of deciding whether or not to invest in a dividend stock is the payout profile which consists of three parts: yield, dividend safety, and long-term growth potential.

ONEOK’s generous yield makes it a highly attractive alternative to the S&P 500’s paltry payout. More importantly, the dividend is well-covered by the stable DCF.

However, there is more to a safe dividend than just a good coverage ratio. You also need a strong balance sheet to ensure that the company can continue investing in growth while maintaining the dividend.

Company

Debt/Adjusted EBITDA

Interest Coverage Ratio

S&P Credit Rating

Interest Rate

ONEOK

4.5

4.1

BBB (stable outlook)

5.60%

Industry Average

4.4

4.5

NA

NA

(Sources: Gurufocus, earnings release, F.A.S.T.Graphs)

The company has managed to do a good job deleveraging its balance sheet in recent years. For example, the leverage ratio was a very high 6.7 in 2016, but has now fallen to about the industry average (which has also been falling rapidly).

Note that ONEOK’s relatively high interest costs are largely a result of assuming higher cost ONEOK Partners’ debt after its buyout of the MLP. Management has been refinancing its debt at lower corporate rates and expects the interest coverage ratio to rise to about 4.9 in 2018.

For example, in July of 2017, the company sold $1.2 billion in new bonds which indicates that the new simplified ONEOK continues to enjoy strong access to low-cost debt.

  • $500 million in 10-year bonds at a 4% interest rate
  • $700 million in 30-year bonds at a 4.9% interest rate

This ultimately tells me that ONEOK’s balance sheet, while not as strong as some industry blue chips, (which have BBB+ credit ratings) is good enough to make for a low risk dividend.

As for dividend growth potential, there is where ONEOK is above average for the industry. Management’s medium-term guidance of 9% to 11% dividend growth through 2021 is likely to generate very good returns over that time. Over the long term (10 years), analysts expect that the company should be capable of roughly the same growth rate, 9.6%. However, I prefer to err on the side of caution and think that a slight slowdown to 8% long-term growth is to be expected.

Still, when taking into account the current generous yield that should be more than capable of generating strong double-digit total returns. That’s likely far more than today’s overvalued stock market is capable of.

Valuation: Not The Cheapest Midstream Name But Still Undervalued

ChartOKE Total Return Price data by YCharts

ONEOK has managed to not just crush most of its peers, but even beat the S&P 500 over the past year. That means that it doesn’t trade at the kind of fire sale prices of some midstream stocks.

Forward P/DCF

Implied DCF Growth Rate

Yield

Historical Yield

14.1

4.60%

5.10%

4.10%

(Source: earnings release, Gurufocus)

Still at a forward price/DCF (midstream equivalent of a P/E ratio) of just 14.1, ONEOK still looks like a potentially attractive buy. That’s because this valuation multiple implies about 4.6% DCF/share growth over the next decade. Given the company’s strong growth catalysts and current project backlog, I think that is a very low bar to clear.

Meanwhile, the yield is trading nearly 25% above its 13-year median yield. That tells me that ONEOK is indeed undervalued. One final valuation method I like to use for my portfolio is to compare the yield against its five-year average yield.

(Source: Simply Safe Dividends)

That’s because over such time periods, yields for stable business models are generally mean-reverting. Or to put another way, they tend to fluctuate around a level that’s a good proxy for fair value.

Currently, ONEOK is trading slightly above its five-year average yield. Which is further confirmation that, while it may not be as much of a bargain as some rivals, it’s likely a good long-term buy today. That is assuming that you are comfortable with the company’s risk profile.

Risks To Consider

First, I’m sure that all midstream investors want to know how the March 14thFederal Energy Regulatory Commission or FERC rule change will affect ONEOK. That rule change disallowed income tax allowances for MLP cost of service contracts for FERC regulated interstate pipelines (mostly natural gas), starting in 2020.

The good news is that as a C-corp. the FERC ruling doesn’t affect ONEOK. Meanwhile, management has previously discussed the potential impacts of tax reform on its business model.

The rates charged on substantially all of our regulated natural gas pipelines have been established through shipper specific negotiation, discounts and negotiated settlements, which do not ascribe any specific cost of service elements. The rates charged on substantially all of our regulated NGL pipelines are established through negotiated transportation service agreements that are not adjusted based on a traditional cost of service.” -ONEOK 10-K

The bottom line is that ONEOK expects little to no material impact from tax reform, and the FERC ruling doesn’t apply to it, due to its status as a corporation.

That being said, ONEOK does face some risks, as do all midstream companies. For one thing, in a highly capital-intensive business such as this, rising interest rates are always a potential concern.

For example, only $1.3 billion of ONEOK’s $2.5 billion revolving credit facility is hedged via interest rate swaps. This means that rising interest rates could raise its short-term borrowing costs. LIBOR rates have risen by 1.19% in the past year. Chances are that they won’t continue rising this quickly; however, any increase in borrowing costs could raise the company’s cost of capital and reduce the profitability of future investments.

Meanwhile, as 10- and 30-year Treasury yields rise, that will mean that ONEOK fixed cost borrowing and refinancing costs will also rise. That could translate into smaller DCF growth and could reduce the long-term dividend growth (and total return) potential.

In addition, while ONEOK’s cash flow is only 10% sensitive to commodity prices and spreads, its contract mix isn’t as good as some other midstream rivals. For example, while 90% of its revenue is fee-based, just 20% is take or pay, meaning with no volume risk.

Most of those contracts are for gas gathering whose contracts are for two- to three-year duration. However, the intrastate contracts for gas transportation have an average remaining contract term of six years, ensuring strong cash flow predictability from that business. The company also owns 50% of the Roadrunner natural gas pipeline system which exports gas to Mexico, under a recently signed fixed-fee 25-year contract.

Be aware that ONEOK’s NGL business (seven to 10-year contracts) is smaller than that of rivals such as Enterprise Products Partners (EPD). EPD’s much larger and more well-connected pipeline system means that it enjoys higher utilization rates (about 90%). For instance, at the end of 2017, ONEOK’s NGL capacity was running at about 75%, which is expected to rise to 90% in coming years. This shows that ONEOK has more upside potential than EPD but also higher short-term cash flow volatility potential because in order to achieve its cash flow growth targets the company needs the NGL market to remain strong. That includes stable or rising NGL prices.

This means that should another energy crash happen and NGL prices plunge, the company’s heavy NGL dependency could result in a decrease in DCF. The good news is that management’s plans to maintain a DCR above 1.2 mean that the dividend likely wouldn’t be put at risk of a cut. However, its ability to grow it safely in line with its current guidance might become impaired. That would likely badly hurt the stock and make it harder to raise attractively priced growth capital in equity markets.

Finally, like all midstream operators, ONEOK faces execution risk. For example, periodic accidents and weather events, such as hurricanes, can disrupt its cash flow temporarily. Meanwhile, management’s ability to grow DCF in line with guidance is based on being able to bring projects in on time and on budget.

Fortunately, the biggest construction execution risk is usually on the interstate side of most midstream projects, specifically oil and natural gas projects. ONEOK has essentially no exposure to these kinds of projects, since its current growth initiatives are 100% focused on simpler intrastate gas gathering systems and NGLs.

Bottom Line: ONEOK Is A Great Choice For Those Seeking Generous, Safe, And Fast Growing Income

ONEOK is a well-run, and well positioned high-yield midstream stock with two major growth catalysts that are potentially set to drive very strong dividend growth for the foreseeable future.

And while it faces its fair share of risks, overall I consider it a good source of generous, safe (low risk), and fast growing income. That’s due to its strong balance sheet, good access to low-cost capital, and long growth runway. That’s why, at the current valuation, I would have no problem adding it to my own dividend growth portfolio. In fact I plan to buy ONEOK in the coming weeks or months, savings permitting.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own a registered investment advisory but publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.

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