Altus Midstream (OTC:ALTM) announced earnings and had their conference call after hours Nov. 4. As we highlighted in Cash Flow Kingdom chat that night, the big news was that they planned “to recommend to the board of directors a quarterly dividend of $1.50 per quarter per share beginning in March 2021.” That $1.50 / qtr 2021 guidance represented a 33.6% dividend yield on the $17.85 price we were able to buy at after hours with 1.8x coverage (60% DCF yield). Hopefully some readers were able to do the same, because I don’t think it’s going to be just a $6 dividend, but rather a $6 and growing dividend.
To be fair, while we were well aware of Altus’ strong underlying cash flow, I too was initially surprised they made such a bold dividend statement. Going from $0 to $6 per year, instead of focusing on paying off the high cost preferred and buying back common shares, was not expected. However, because we had previously researched the firm, we were already primed and ready to act when they did. We were able to act quickly and decisively specifically because we already were well aware of the market, the firm, its management, its cash flows, and risks. Thus, management’s big announcement and the conference call made a number of things clear.
Prior to this, there has been a lot of speculation on what management motivations and thought process were and what that implies for the shares and dividend sustainability, so I’ll spend some time giving my take. Before doing so however there’s a few things we knew then, that readers should be aware of now (if they aren’t already).
- Altus Midstream is a pure play Permian to Gulf Coast midstream firm that is 77% owned by their parent, the major E&P firm Apache (APA). So nothing is going to happen at ALTM without APA giving their OK. Side note: ALTM is a C-corp with no IDRs or K-1 to deal with.
- Altus preferred has a 1.3x minimum profit clause which means paying it off earlier than 2022 doesn’t make any sense.
- Altus has a lot of midstream assets in the Alpine High region which are underperforming because Apache has not been drilling a lot in this “gassy” play. However, the combination of greater offtake capacity, higher natural gas prices supported by increased export demand, and potential Biden fees and regulations on flaring could bring Alpine High back into play.
- Regardless, A lot of the firm’s existing cash flow is coming out of high demand long-haul Permian to the Gulf Coast pipelines with predictable cash flows (one crude, one NGL, one natural gas). These cash flows will increase considerably when their second natural gas pipeline, a 27% interest in Permian Highway (“PHP”), comes online in early 2021 (>90% complete already).
- The spice (natural gas) must flow. The US is going to keep heating its buildings, cooking its food, turning on the lights (a.k.a. demanding electricity), and probably even doing things like making plastic and fertilizer (industrial demand). Foreign countries are doing the same. Thus natural gas demand isn’t going anywhere.
Solar and wind are often touted by environmentalists, and there’s little doubt their subsidy and usage will continue to grow in the US once Biden becomes president. However, the simple fact that’s often ignored is combined they only account for less than 10% of electricity production, and worse that production is intermittent (you can’t count on it being there when you need it). Thus, dirty coal-based electricity generation is being replaced by wind and solar to some extent, but it’s really natural gas that has been the main benefactor of the switch from coal. Additionally, electricity production is just one of many uses for natural gas, and it’s not until 2045 that the Energy Information Administration estimates alternative energy will even catch up to natural gas for just the one use of electricity production.
In other words, the most likely replacement for any natural gas not coming out of one region (e.g. federal lands) is not going to be wind and solar. It’s going to be natural gas coming out of some other region (e.g. not federal lands). Thus, banning new drilling permits on federal lands is really just a politically-motivated shell game, albeit one that produces winners and losers.
Intermediate term, Altus is likely one of those winners. A Biden Presidency with the Senate staying Republican might result in no new drilling permits on federal lands, and some sort of increased regulation or fees associated with flaring, but overall natural gas processing and transportation demand will still grow. Any more hampering of production than that would never get through the Senate and would be completely impractical. Do you really think even Biden-Harris would let the Democratic support bases in the Pacific Northwest and Atlantic Northeast freeze each winter?
Alpine High is near Big Basin National Park, but it’s not on federal lands. Likewise most of the Permian which the Altus pipelines service are not on federal lands (an exception is part of the upper Delaware basin in New Mexico but its a relatively small portion of the Permian total). Thus, less natural gas coming out of federal lands over the intermediate or long term, likely just means more energy coming from the Marcellus and Permian.
Additionally if natural gas prices continue to increase, Alpine High will become more economically viable for Apache. Again demand for natural gas isn’t going anywhere. So low oil prices that result in less cheap ancillary or associated gas just gets replaced elsewhere. That elsewhere is likely more gassy regions like the Marcellus (and possibly Alpine High) as the continued demand but less associated gas production results in increased natural gas prices. This could be a very good thing for the Altus gathering and processing assets in the Alpine High region. Increases in Alpine High development and/or Permian transport however are not required for Altus to pay out the $6 in dividends next year.
Management indicates the existing gathering and processing business plus their ownership in Permian pipelines, will produce enough cash flow to cover the new $6 dividend by 1.8x once the Permian Highway pipeline ‘PHP’ starts up in early 2021 ($10.80 DCF).
Source: ALTM Presentation
This is why they are waiting to enact their new dividend until PHP is up and running. Once it’s running they expect to be totally self funding with an additional $43 million in retained cash flow on top.
Source: Company Presentation
Side Note: I expect significant FCF increase announcements to become the norm as natural gas midstream firms start to give specific 2021 guidance.
Overall in addition to paying out this high dividend and covering all costs, ALTM forecasts they will also be able to improve leverage to 3x Net Debt / EBITDA by year end 2021. This is in part to paydowns but really more dependent on the EBITDA increase expected from PHP coming online.
So, in doing initial 2021 budgets Altus and Apache management realized Altus was going to have a lot of predictable cash flow coming in starting early in 2021. The further realized there was even more potential revenue upside should Permian or Alpine High production increase (for example Apache announced earlier today that they would be completing three additional DUCs in Alpine High). They also realized they had successfully cut operating costs 30% and capex needs were going to decline 90% from $345 million to $35 million.
Source: Company Presentation
So there was going to be a sea change in free cash flowing to the bottom line.
At the same time, ALTM was trading very cheaply compared to forecasted DCF. In fact the expected 2021 DCF was roughly equivalent to ALTM’s total current market cap at the time. Thus, one’s first inclination might have been for the firm or its parent to buy more ALTM shares.
Apache however already owned 77% of ALTM, and apparently a decision was made that they would rather not do a complete takeunder (wrapping it back up into Apache). I’m guessing a key factor in that decision was that Apache already benefits from roughly 77% of the cash flow Altus produces or dividend it issues. So a full takeunder really only gained them the additional 23%. Thus, Apache still gets to use 77% of the new high dividend to fund its operations.
Another factor probably taken into consideration was that a midstream child helps Apache grow and develop more land over the long term by providing a source of additional financing to fund that growth (the drop-down strategy). Had Apache done a takeunder, the resulting investor chagrin would likely have prevented a new midstream spin-off for at least few years. It also could have affected investor opinion about the parent, and of course might have put Altus management itself out of work.
Was getting the last 23% of benefit you weren’t already going to get anyway really worth the negatives? Apparently management decided it was not as they made the strategic decision to increase the dividend instead of rolling Altus back into Apache. To be clear, the conference call and dividend guidance didn’t just highlight the huge underlying cash flow, and signal a whopping $6 dividend, it also significantly reduced any risk of a takeunder. This was previously a significant risk for shareholders that held many in the know from investing too much in the name.
Altus could have chosen to pay down the preferred instead of increasing the dividend. However, that preferred has a 1.3x minimum return clause which won’t be fulfilled naturally until early 2022. Thus paying it off early doesn’t save any interest until after that date is reached. Management likely figures either the additional cash flow from the forecasted 1.8x coverage, and/or potential growth in Alpine High, and/or issuance of stock at a much higher price will be more than sufficient to take care of the preferred in 2022 (or later).
ALTM could also have chosen to buy back its own shares. This sounds economically sound on the surface. However, they already are thinly traded with only 3.75 million shares outstanding. Thus further buying in of more shares would be counterproductive to Apache’s long-term goal of using Altus to help fund growth. Additionally, just how many shares would Altus realistically be able to buy without significantly affecting price when there’s only 3.75 million shares outstanding?
Last Altus could have used the excess funds generated in 2021 to eventually pursue some M&A or future growth need. However, building or investing in new assets is heavily out of favor with investors and the industry right now.
So the decision was made to reward shareholders by increasing the dividend. Apache made a choice to spin-off a midstream firm in order to help it fund long-term growth via drop-downs. With the announcement above it appears they have decided to double-down with that original strategy.
It’s already having researched ALTM and listening to the conference call, which allowed us to quickly come to these conclusions and buy before the next day’s open.
That Altus guided to an admittedly shockingly big jump in the dividend to $1.50 per quarter is something they correctly judged would make an impression. They clearly wanted to make that impression with shareholders, but not an impression of recklessness. This is why in the conference call they were very prepared and eager to explain why the dividend would be covered a sound 1.8 times over even without counting on any new growth other than PHP coming online. They also were eager to explain that most of the cash flow came from existing crude, natural gas and NGL pipelines that connected the most productive basin in the US, the Permian, to existing growing demand from coastal entities like refineries, ethylene plants, and export terminals.
Yet management also was able to point to potential sources of cash flow growth over and above the expected 1.8x coverage. For example they pointed out that the Shin Oak (NGLs) and Epic (crude) pipelines still have capacity available. Thus any increase in Permian transport demand could produce more revenue from them without also incurring significant additional cost. Though they did not emphasize it, I also noted earlier that higher natural gas prices could lead to more development in Alpine High region which would benefit their excess gathering and processing capacity that region.
Source: Natural Gas Intelligence
That being said, Altus does still have significant risks.
- They are a small, thinly traded firm concentrated in one basin.
- They have a lot of debt and high cost preferred.
- They are counting on PHP coming online in early 2021 to achieve the stated guidance.
- They are counting on the Permian remaining a highly productive basin.
However, Altus management also was careful to give themselves some wiggle room in case PHP is delayed. Again they were clear that an increase in the dividend is not going to be submitted to the board until after PHP is finished. That PHP is more than 90% completed now, and is wholly located within energy-friendly Texas, and was good enough for me to accept those risks. I think there’s a pretty good chance the dividend actually comes through as stated, but there is of course always the potential for something significant to change between here and there.
If things go as planned, it’s not unreasonable to surmise that ALTM could one day trade for $60, or a 10% yield on a $6 and growing dividend.
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Disclosure: I am/we are long ALTM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article discusses a thinly traded, volatile, small cap stock. We do not know your goals, risk tolerance, or particular situation; therefore, we cannot recommend any specific investment to you. Please do your own additional due diligence.