RBC Full Comment - Target Price $36.00November 10, 2022
Keyera Corp.
The math versus the market sentiment
Our view: While we acknowledge the negative sentiment associated with yet another cost overrun for KAPS, the reality is that the most recent cost overrun amounts to less than $0.50/share in value with no funding concerns given Keyera's liquidity and strong leverage metrics. Cutting through the short-term KAPS noise, Keyera's underlying business is performing well and Keyera is highly levered to our favoured midstream sector theme being future WCSB volume growth. While we acknowledge the stock may be range bound until KAPS is complete in Q1/23, we believe patient investors will be rewarded when the dust settles.
Key points
Another cost increase for KAPS, although it is not overly material from a value per share perspective, particularly given Keyera's solid balance sheet. The company now expects construction costs for the KAPS project to be $1.0 billion (net to KEY), which is up from the $0.9 billion guidance that was increased just last quarter. Keyera noted that it has spent $850 million so far on the project, and the remaining $150 million of spending has roughly 25% contingency built into that estimate. To frame it, a $100 million cost increase represents less than $0.50/share of value
The pending sale of Keyera's partner's interest in KAPS could provide an important read through for the project's economics. Given the contracted cash flow in place for KAPS, we believe the project would be appealing to a wide range of buyers, including both strategic and financial buyers. As such, we believe the valuation that is eventually paid for KAPS will provide a read through into the underlying economics/commercial framework for the project. Based on recent asset sale valuations for contracted infrastructure, we believe the other half of KAPS could sell for $700-800 million (less the remaining proportionate capex to complete the project) based on our estimate of the currently contracted cash flows with modest value for the ability to fully contract the system.
Will Keyera buy KAPS? We believe Keyera will exercise discipline with respect to its investment and risk framework, so based on what we think KAPS could sell for, we do not expect Keyera to buy the other half. While KAPS checks the box strategically for Keyera, we note that the acquisition would likely require an equity issuance to maintain its leverage metrics, and such an issuance could make it challenging for Keyera to deliver near-term DCF/share accretion.
Modest changes to our estimates; reducing our price target to $36.00 (down from $37.00). Reflecting the Q3/22 results and guidance updates, we have changed our 2022 and 2023 DCF/share estimates to $3.06 and $3.08, respectively (from $3.03 and $3.12, respectively), while keeping our 2024 estimate of $3.24 unchanged. Our new price target reflects the KAPS cost overrun.
Another KAPS cost increase overshadowed solid results
Keyera provided an update on the KAPS pipeline project, which the company now expects to cost approximately $1.0 billion net to Keyera (previously $900 million). The most recent cost update is one of a series of cost overruns that have been announced for KAPS in 2022, including the update in projected costs to $900 million that had just occurred in August.
The projected increase in the KAPS capital cost was attributed to weather-related challenges that affected productivity and exposed the company to inflation, supply chain issues and labor shortages. Keyera noted that it has spent $850 million so far on the project, and the remaining $150 million of projected spending is inclusive of a roughly 25% contingency. Last, the company continues to target an in-service date at the end of Q1/23 for the project.
· The pure math of the cost increase is not overly material. While costs have increased yet again, the most recent cost overrun of $100 million amounts to less than $0.50/share. Further, with available liquidity and a strong balance sheet (i.e., 2.4x debt/EBITDA at the end of Q3/22), the actual financial impact should not be overly material.
· We believe the contracting outlook is looking brighter given the WCSB rig count. While discussions are ongoing to fill the remaining initial capacity for KAPS, Keyera remains confident in the path to fill the pipeline given the trend of increasing volumes in the Western Canada Sedimentary Basin (WCSB). Specifically, the company noted that volumes through its Gathering and Processing facilities increased by 9% year-over-year and we note that the WCSB rig count remains at historically high levels (please click here for a report authored by RBC analyst Keith Mackey that includes data on the WCSB rig count). · Not much commentary on the sale process for the other half of KAPS. Keyera declined to comment directly on the process being run by its partners in KAPS who are looking to sell their 50% interest in the project. Management stated that it is "not privy" to the third[1]party run process, which we believe will be taken by some in the market as the company not being involved as a potential buyer. Further, the company noted that its general approach to M&A is to ensure acquisitions are strategic, accretive and consistent with its balance sheet management targets.
· The pending sale of Keyera's partner's interest in KAPS could provide an important read through for the project's economics. Given the contracted cash flow in place for KAPS, we believe the project would be appealing to a wide range of buyers, including both strategic and financial buyers. As such, we believe the valuation that is eventually paid for KAPS in what should be a competitive process will provide a read through into the underlying economics/commercial framework for the project. Based on recent asset sale valuations for contracted infrastructure, we believe the other half of KAPS could sell for $700-800 million (less the remaining proportionate capex to complete the project) based on our estimate of the currently contracted cash flows with modest value for the ability to fully contract the system. With that, an amount below that range would indicate to us that the current contracted EBITDA and/or the prospects for future contracting are below our expectations. Conversely, an amount that is above that range should be viewed as a signal that the existing contracts are attractive and/or that filling up the remaining capacity is a high likelihood.
Guidance mostly reiterated; some new items for 2023
· Increased 2022 growth capex guidance mostly driven by KAPS. Due to the KAPS cost overrun, Keyera now expects growth capital in 2022 to be $770-800 million (up from its prior guidance of $680-720 million). Despite the capital increase for KAPS, the company remains in a strong financial position with a Net Debt to Adjusted EBITDA ratio currently Keyera Corp. 657176_0ea983ca-d394-4706-9618-4bd1f3e7782b.pdf November 10, 2022 Robert Kwan, CFA (604) 257-7611; robert.kwan@rbccm.com 2 at 2.4x (covenant test calculation). Of note, Keyera expects to exit 2022 within its long[1]term debt/EBITDA range of 2.5-3.0x.
· Realized Marketing margin guidance remains unchanged. The company continues to guide to realized margin for the Marketing segment of $380-410 million, which implies $31-61 million of realized margin in Q4/22 (we are at $58 million). Further, Keyera made no changes to its guidance for cash taxes or maintenance capital, which remain at $55-65 million and $100-120 million, respectively.
· 2023 guidance items highlight a significant reduction in growth capex, which paves the way for free cash flow generation. Keyera noted that it expects growth capital in 2023 to be $140-180 million, which includes $50 million for KAPS as well as $45-55 million as a placeholder for the yet to be sanctioned Pipestone expansion. Also, the company expects cash taxes to be in a range of $10-25 million with maintenance capital guidance being $75- 85 million.
Strong financial and operating performance in Q3/22
In Q3/22, Adjusted EBITDA was $247 million versus our estimate $239 million and consensus of $239 million (12 estimates; range of $224-250 million). DCF/share was $0.73 compared to our forecast of $0.65. The stronger-than-expected results were primarily driven by the Liquids Infrastructure segment, which benefitted from upside in storage as well as its non-operated interest in the Dow fractionator, with DCF/share also benefitting from an unexpected cash tax recovery and lower-than-expected maintenance capex.
Modest changes to our financial forecast
We have changed our 2022 and 2023 DCF/share estimates to $3.06 and $3.08, respectively (from $3.03 and $3.12, respectively), while keeping our 2024 estimate of $3.24 unchanged. For 2022, the primary change to our forecast is to reflect the Q3/22 results, with the more modest change to our DCF/share estimates reflecting certain timing items that benefitted cash flow in Q3/22 (e.g., unanticipated cash tax recovery; lower-than-forecast maintenance capex). For 2023, the reduction in our DCF/share estimate primarily reflects the new guidance items and specifically higher maintenance capex, partially offset by lower cash taxes.
Valuation
Our $36.00/share price target is based on applying an 11.0-11.5x EV/EBITDA valuation to our forward EBITDA estimate adjusted for a full-year contribution (post ramp-up) from certain assets (e.g., KAPS, Wapiti). Our target multiple is also consistent with a blended contribution from Gathering & Processing (at 11.5x EBITDA), Liquids Infrastructure (at 12.5x EBITDA), and Marketing (at 8.5x EBITDA). The risk[1]adjusted expected total return to our price target supports our Outperform rating for the shares.
Upside scenario
Our upside scenario of $42.00 is based on a 1x increase in EV/EBITDA valuations, which would bring the valuation close to the average valuation for midstream stocks over the past 10 years leading into the onset of COVID. This scenario also includes roughly $3/share associated with upside from volumes at new facilities and the development of spare land in Fort Saskatchewan.
Downside scenario
Our downside scenario of $23.00 per share is based on a scenario where Marketing results are at the low-end of the long-term “base realized margin” range and Gathering & Processing margins are similar to 2020 levels (i.e., cyclical trough).
Investment summary
We expect Keyera’s shares to outperform the peer group for the following key reasons:
• Poised to benefit from improving basin trends. We believe that Keyera remains poised to benefit from increased WCSB volumes and demand for midstream infrastructure, at its existing facilities as well as a rising tide of future demand driving additional contracting for KAPS. On top of the potential for improved throughput and fee-driven revenue, we also see the potential for Keyera to add long-term contracts, which could help lock-in future cash flows and reduce future volatility.
• Attractive financial setup. We forecast that Keyera’s debt/ EBITDA will remain at a manageable level through the construction of KAPS and within, or below, Keyera’s targeted 2.5–3.0x debt/EBITDA range (credit facility calculation). Despite the major turnaround at AEF in 2022, we expect that the payout ratio will continue to be at or below 70% through 2024. Further, the company intends to finance its growth capex on a self-funded basis for equity (i.e., no DRIP, ATM, or discrete equity).
• Potential catalysts. Additional information on KAPS that gives the market confidence in the ability to achieve a 10–15% return on capital; Marketing results that support the company’s guidance; and new projects underpinned by long-term, take-or-pay contracts that can be financed on an equity self-funded basis.
Risks to rating and price target
KAPS delays and/or material cost overruns; low spreads and fewer opportunities in the marketing business; a material reduction in throughput at the company’s gathering and processing facilities; an inability to stem the impact of volume declines through operating cost reductions; ineffective hedges; and projects not proceeding on a time frame or with economics in line with our expectations