RBC Comments - Price Target now $49.00
March 2, 2022
Pembina Pipeline Corporation
Expanding the assets and shrinking the share count
Our view: We positively view Pembina’s ability to structure a transaction that enhances and diversifies its gathering and processing footprint while financially delivering immediate AFFO/share accretion (underpinning a proposed 3.6% dividend increase), providing incremental proceeds to fund share buybacks and roughly maintaining proportionate debt/EBITDA (i.e., no material change in leverage).
Key points:
Expanding and diversifying the G&P footprint. Pembina announced a series of transactions that will ultimately result in Pembina holding a 60% interest in a new company (Newco) and KKR owning the other 40%. As part of the transaction, Pembina will vend its gathering and processing (G&P) assets (about 15% of its 2022E EBITDA) into Newco, combine those assets with G&P assets held by KKR, and Newco will also buy out the 51% interest held by Energy Transfer that it had in a partnership with KKR. Pembina will serve as the manager and operator of Newco, and the company expects the transaction to close in Q2/22 or Q3/22.
By vending in assets, Pembina expects to receive roughly $700 million in cash to both pay down holdco debt and incrementally fund share buybacks. As part of the transaction, Pembina expects to receive approximately $700 million in cash. The company has signaled its intention to repay $550 million of holding company debt while directing about $150 million to its share buyback program (bringing its buyback program up to roughly $350 million in 2022).
Attractive financial attributes. On top of the strategic benefits of the transaction, we highlight that the combination also results in attractive financial attributes including: (1) AFFO/share accretion, which we estimate to be in the 4–5% range in the first full year; (2) a 3.6% increase in the dividend underpinned by the AFFO/share accretion; (3) the receipt of $700 million of cash that Pembina expects to use to repay debt and increase its 2022 share buyback program; and (4) delivering all of these financial benefits without materially changing leverage.
Ability to pursue gathering and processing facility growth on a capital[1]efficient basis with KKR. As part of Newco, Pembina and KKR have increased their alignment via the inclusion of area of mutual interest (AMI) provisions whereby the two parties have agreed to pursue field[1]based natural gas gathering and processing assets in western Canada within Newco.
Raising estimates and price target. Based on our analysis of the transaction, we increase our 2022 and 2023 AFFO/share estimates to $4.59 and $5.00 (from $4.51 and $4.79), respectively. From a valuation point of view, we estimate that the transaction adds roughly $1/share to value, with upside depending on revenue and cost synergies; accordingly, we raise our price target to $49.00 (from $48.00).
Ticking all the boxes
Attractive financial attributes
· Immediate AFFO/share accretion. Based on our preliminary analysis, we estimate that the transaction could be roughly 4–5% accretive to AFFO/share in the first full year depending on the proceeds from the monetization of KAPS, the level of synergies, and the distribution policy from Newco. Of that range, we believe that approximately half of the accretion is from the incremental EBITDA (net of financing and the buyback) and the remaining accretion from cash tax synergies. Over time, Pembina expects accretion in the mid- to high-single-digit range, partly due to the ramp-up of revenue and cost synergies.
· Receiving $700 million to pay down debt and buy back stock. As part of the transaction, Pembina will receive $700 million, of which it expects to direct $550 million to repaying debt. For the remaining $150 million, Pembina now targets a $350 million share buyback program for 2022 (increased from up to $200 million).
· Bumping up the dividend to reflect the AFFO/share accretion. Following the close of the transaction, Pembina intends to increase its common share dividend by 3.6% to a new annualized rate of $2.61/share (from the current rate of $2.52/share). Pembina noted that the targeted increase reflects the immediate cash flow accretion from the Newco joint venture.
· Delivering all of this without materially changing net debt/EBITDA. As shown in Exhibit 1, we expect the transaction to be roughly neutral to Pembina’s net debt/EBITDA on the assumption that Newco’s 50% interest in KAPS will be sold at a price equivalent to the construction work-in-progress.
Strategic fit by growing and diversifying the footprint
· Growing and diversifying the Western Canada Sedimentary Basin gas processing footprint. As part of the transaction, Pembina will grow its gathering and processing footprint to include a 60% interest in 25 facilities with a combined net processing capacity of 3 Bcf/d (up from 15 plants and a 45% interest in five processing facilities held by Veresen Midstream with a combined net processing capacity of roughly 2.8 Bcf/d). With respect to the combined assets, Pembina noted the following: o physical capacity utilization of approximately 65%, offering a strong base cash flow stream and incremental low-cost processing capacity that can meet customers’ requirements; o contract tenures range from five to nearly 25 years, with an average of 14 years; o approximately 94% of the operating expenses across the asset portfolio are flow[1]through; and o approximately 80% of counterparty credit exposure is with investment grade or secured entities.
· Ability to pursue gathering and processing facility growth on a capital-efficient basis with KKR. As part of Newco, Pembina and KKR have increased their alignment via the inclusion of area of mutual interest (AMI) provisions whereby the two parties have agreed to pursue field-based natural gas gathering and processing assets in western Canada within Newco. The shareholder agreement also includes right of first offer (ROFO), right of first refusal (ROFR), and tag-along provisions.
· Effectively increasing its ownership in Veresen Midstream. The Veresen Midstream assets, largely in the B.C. Montney, are well positioned to benefit from the completion of the third-party LNG Canada export facility. As part of Newco, Pembina will effectively have a 60% interest in the Veresen Midstream facilities (versus its prior 45% ownership of the entity).
Raising estimates to reflect forecast accretion from the transaction
Based on our analysis of the transaction, we increase our 2022 and 2023 AFFO/share estimates to $4.59 and $5.00 (from $4.51 and $4.79), respectively, as shown in Exhibit 4. Key changes of note impacting our AFFO estimates include:
· EBITDA. We have increased our EBITDA forecast to reflect the net impact of the transaction in line with Pembina’s reporting of EBITDA (i.e., proportionate consolidation).
· Interest expense. We have reduced our interest expense estimates to reflect the receipt of $700 million in cash from the transaction of which Pembina expects to reduce its debt by $550 million. Pembina Pipeline Corporation 633852_701baaaa-7c5c-43b1-b002-8ffa07a9afb9.pdf March 2, 2022 Robert Kwan, CFA (604) 257-7611; robert.kwan@rbccm.com 4
· Cash tax benefit. The transaction and the structuring of Newco should allow Pembina to take advantage of the entity’s tax pools (versus Veresen Midstream being structured as a partnership), and we have assumed a $75 million benefit in 2023, with a partial benefit in 2022.
· Equity distributions. As Pembina expects to account for Newco as an equity investment, we have included our forecast for equity distributions from the investment in our AFFO forecast. We assume that Newco distributes substantially all of its operating cash flow throughout our forecast period.
Valuation
Our $49.00/share price target is based on an EV/EBITDA multiple of 11.5x and includes $1/share from the pending gathering and processing transaction with KKR. For much of the last 15 years, Pembina’s shares have traded within a range of roughly 10–13x EBITDA. We believe a valuation at the midpoint of the range is appropriate given the improving market fundamentals, particularly in Western Canada. We believe that the relative risk-adjusted expected total return to our price target supports our Outperform rating on the shares.
Upside scenario
Our $57.00 per share upside scenario is based on a 1x premium to our base valuation (resulting in EV/EBITDA being toward the high of the 15-year range), roughly $1.00/share for deferred projects that have been mothballed in the current environment but could move forward in the future and $2.00/ share from the pending transaction with KKR, which assumes 10% EBITDA upside from synergies. The EV/EBITDA valuation is modestly higher than the group average, reflecting the high proportion of cash flow derived from the NGL pipeline and terminal infrastructure, primarily under take-or-pay contracts.
Downside scenario
Our downside scenario of $31.00 is based on applying the pre[1]COVID trough valuation for the stock (i.e., 9x EBITDA) to our forward EBITDA. Our downside scenario does not include any value for the pending transaction with KKR.
Investment summary
We expect Pembina’s shares to outperform its peers for the following key reasons: • Attractive transaction to grow the G&P footprint with forecast AFFO/share accretion, a dividend increase, and the receipt of proceeds to repay holding company debt and fund share buybacks. We positively view Pembina’s ability to structure a transaction that enhances and diversifies its gathering and processing footprint while financially delivering immediate AFFO/share accretion (underpinning a 3.6% dividend increase), providing incremental proceeds to fund share buybacks and roughly maintaining proportionate debt/EBITDA (i.e., no material change in leverage).
• Growing WCSB volumes should drive higher EBITDA. Whether it be uncontracted capacity or within its contract structures that blend minimum take-or-pay levels with fee[1]for-service upside as volumes grow, we expect Pembina to benefit from growing gas and liquids volumes in the Western Canada Sedimentary Basin (WCSB), particularly with its assets levered to the Montney, Duvernay, and Deep Basin. Further, growing volumes could result in contracted infrastructure opportunities, evidenced by the re-activation of the Phase IX expansion. New projects could include previously mothballed initiatives including the Phase VIII pipeline expansion or the Prince Rupert Terminal expansion.
• Solid base of business with a commodity kicker. Although the hedge book was prudent risk management for 2021, it has resulted in a substantial reduction from margins based on spot commodity prices. However, hedge disclosures lead us to believe that hedging losses booked in 2021 should largely reverse in 2022 assuming constant commodity prices/spreads.
• Potential catalysts. Closing of the G&P transaction with KKR; improved investor sentiment toward energy and midstream stocks; additional volumes for the conventional pipeline system; government programs that strengthen oil and gas producing customers; increased Montney producer activity on the back of the sanctioning of the third-party LNG Canada project.
Risks to rating and price target
Risks to our price target and rating include: (1) the impact of COVID-19 and a weak market for energy including lower-than[1]expected throughput on the pipeline systems; (2) regulatory intervention; (3) the ability to complete new projects on time and on budget; (4) operational issues; (5) reduced margins in the midstream and marketing segment; and (6) acquisitions, investments and/or projects that fail to gain the confidence of investors.