Free Cash Flow: A Tailwind for Midstream/MLPs in 2021?

09/15/20 | Stacey Morris

Summary //

  • The combination of resilient cash flows and lower spending directly supports excess cash flow generation for midstream, as demonstrated by the top constituents of the Alerian Midstream Energy Index (AMNA).
  • Of these companies, many are expected to generate free cash flow in 2020 and 2021, with a few forecasted to have positive free cash flow after dividends in 2020 and even more expected to join that number in 2021.
  • With a few notable exceptions, the complexion of growth in midstream is changing. Dividend growth going forward will still be supported to some extent by growth projects, but it will also be supported by increasing free cash flow as spending moderates from elevated levels in recent years, and companies reap the cash flows of past projects.

Free cash flow has been a common topic of Alerian’s research and a focus area across energy, including midstream. While we’ve historically looked at free cash flow yields at the index level, examining expected free cash flow for individual companies may be more tangible for investors. To that end, today’s note pairs consensus estimates and company guidance for the top ten constituents of the Alerian Midstream Energy Index (AMNA) to better frame the outlook for free cash flow generation in midstream as well as discussing the exceptions to this trend. Together, these companies represented 70.6% of the midstream universe by market cap as of August 31 and are a diverse grouping of MLPs, US C-Corps, and Canadian C-Corps. (Note: Alerian is not endorsing or recommending these companies but rather using them as examples.) The free cash flow potential of these companies, particularly as the calendar turns to 2021, helps frame the broader trend underway in midstream.

Setting the stage.
Free cash flow is simply operating cash flow less capital expenditures. By definition, free cash flow can increase as a result of higher operating cash flow or lower spending. Within midstream, companies have significantly reduced growth capital spending plans in response to the current market environment (read more). Meanwhile, the fee-based nature of midstream has led to stability in forecasted EBITDA (read more), which can be a proxy for operating cash flow. In short, the combination of resilient cash flows and lower spending directly supports excess cash flow generation for midstream.

Framing midstream’s free cash flow potential.
A key component of increasing free cash flow generation for midstream is moderating capital spending, which was underway prior to COVID-19 (read more). Companies are reaping the cash flows from years of hefty investments and are now spending less. Macro headwinds resulted in further cuts to capital budgets as companies prioritized financial flexibility and recalibrated budgets to a changing production outlook. The table below shows growth capital budgets for eight of the top ten constituents of the AMNA Index that provide guidance and reflects Enterprise Products Partners’ (EPD) recent cancellation of the Midland-to-ECHO 4 crude pipeline. As shown, spending plans for 2020 have been significantly reduced, and those with guidance beyond 2020 are anticipating further declines. Growth spending and the growth rate for midstream may be moderating overall, but this creates the opportunity for excess cash flow, which can be used to reduce debt or return cash to shareholders.

To better appreciate the financial flexibility of free cash flow, it is helpful to evaluate on an after-dividend basis. For midstream, free cash flow after dividends is particularly useful given the generous income provided by these companies. The money left over after dividends is what can be used to reduce debt or even repurchase shares. To illustrate the free cash flow potential of midstream, the table below shows estimated 2020 and 2021 free cash flow for the top constituents of AMNA based on Bloomberg estimates and company guidance for capital spending where available. Keep in mind that none of these companies cut their dividends this year. Cheniere Energy (LNG) does not pay a dividend but does have a share repurchase program.

Of these companies, many are expected to generate free cash flow in 2020 and 2021, with a few forecasted to have positive free cash flow after dividends in 2020 and even more expected to join that number in 2021. Considering EPD and Energy Transfer (ET) are expecting significant reductions to growth capital spending in 2021, both are forecasted to generate meaningful free cash flow after dividends next year. Setting aside TC Energy (TRP) and Enbridge (ENB), which are discussed below, midstream names appear well positioned to generate significant free cash flow next year, with some forecasted to have plenty of cash left over after paying dividends based on these estimates. Importantly, the estimates do not assume any dividend cuts, which would lower the after-dividend hurdle. While this analysis focused on the top constituents of AMNA, these companies exemplify a broader trend across midstream, with many other companies discussing free cash flow generation this year or next (read more).

Relative to the others, TRP and ENB stand out for significant and growing capital spending expectations, which support a differentiated growth profile but impair free cash flow generation. While the company does not provide capex guidance, TRP has a capital program exceeding $37 billion (CAD) with $11 billion in projects currently underway. Similarly, ENB has an $11 billion (CAD) capital program through 2022. TRP and ENB remain in growth mode with new projects supporting growing dividends. TRP has guided to dividend growth of 8-10% in 2021 and 5-7% beyond 2021, while ENB grew its dividend by 9.8% in 2020 and discussed 5-7% growth at its December 2019 analyst day with a view to a 65% long-term payout target.

So what?
With a few notable exceptions, the complexion of growth in midstream is changing. Historically, dividend growth was supported by increasing cash flows from investing in new projects (or acquisitions) as is still the case with TRP and ENB. More broadly, dividend growth going forward will still be supported to some extent by growth projects, but it will also be supported by increasing free cash flow as growth spending moderates from the very high levels required to facilitate the shale revolution over the last several years, and companies reap the cash flows of past projects.

Free cash flow is a good thing. It can be used to reduce debt for those with elevated leverage. If balance sheets are well positioned, it can be used for shareholder-friendly actions like buybacks and dividend increases. Given current uncertainty, excess cash flow is likely to be used to enhance the balance sheet, but in a more stable macro environment, buybacks and dividend increases could see greater traction. In addition to Cheniere, EPD, Kinder Morgan (KMI), and Magellan Midstream Partners (MMP) currently have buyback authorizations in place. In terms of dividend hikes, KMI has noted a commitment to increase its dividend to $1.25 per share annualized (from $1.05 now), but its board will weigh many factors when it meets early next year. More broadly, as the space looks ahead to 2021, perhaps increasing free cash flow generation (and potentially more buybacks) will be coupled with an improved macro energy backdrop to the benefit of midstream investors, replacing 2020 headwinds with tailwinds.