(Note: This article originally appeared in the August 3, 2022 newsletter.)
Antero Midstream Corporation (NYSE:AM) is a company that usually gets a lot of criticism for its low dividend coverage. The conversation lacks the various calculations that arise when a non-GAAP measure is used. An adjustment of such a measure is a necessary requirement before a reasonable comparison can be made between the companies. Otherwise, “apples and oranges” are compared to the point that an investor may come to the wrong conclusion.
Antero Midstream uses a very conservative definition of free cash flow, as shown below:
This management subtracts the total investment budget from the net cash provided by operating activities. That’s about as conservative as it gets in the industry. Many other companies simply subtract maintenance capital because they intend to borrow at least some of the money to fund the expansion capital budget.
This management aims to reduce an already conservative debt ratio (for intermediate companies). Therefore, all expenses that may increase debt are included in free cash flow after calculating dividends. This leadership has demonstrated in the past that the dividend will not be increased if the debt cannot be managed according to the stated conservative objectives.
That’s very different from a lot of companies that don’t cut dividends or distributions until there’s trouble ahead. Given that the debt-to-equity ratio is comfortably below 4, there are unlikely to be any financial problems, as it is one of the lowest ratios in the midstream industry.
Free Cash Flow Advice
The dividend should be maintained as free cash flow should increase significantly. It also implies that there will be dividend growth in the future.
Management is currently holding the dividend steady as they want to reduce debt from currently fairly conservative levels. The capital budget should decrease while the volumes handled should continue to increase slowly over time.
This intermediate company does not serve all the production of the parent company. As long as this is the case, capital requirements and interim growth may differ from the parent company’s overall growth forecast.
Similarly, once the basic midstream structure is in place, capacity expansion as needed is often accomplished with small capital projects that tend to pay for themselves quickly. This means that the graph above is plausible.
Henceforth, an acquisition of intermediate capacity or a major expansion in certain production areas which were not covered before are not taken into account in the above orientations. But the overall goal is to serve the parent company, Antero Resources Corporation (AR), while maintaining considerable financial flexibility that is rarely seen in other midstream companies.
Self-financing of investment projects has been the rule here since the company’s IPO. This means that a relatively high percentage of cash flow has been reinvested in the business. As a result, earnings growth should accrue a little faster than with many competitors.
Calculation of distributable cash flow from energy transfer
Energy Transfer LP (ET) has a fairly typical distributable cash flow calculation that nevertheless illustrates the pitfall of blindly comparing distributable cash flow:
Since free cash flow and distributable cash flow are non-GAAP numbers, management is free to include or exclude whatever they want in the presentation of these numbers. Even though there are general agreements about what should be in the numbers, reasoned management can literally differ at will as long as there is a note somewhere revealing how the number was calculated. For this reason, comparing figures without a GAAP definition can be a real challenge.
The difference between the calculation for Antero Midstream and the energy transfer is clearly indicated in both calculations. Antero Midstream put the entire budget into the free cash flow calculation (and essentially uses it as distributable cash flow as well), while Energy Transfer clearly only uses maintenance capital.
Therefore, energy transfer will have strong coverage as maintenance capital is usually a fairly small part of the investment budget. In order to compare the distribution (or dividend) coverage of the two companies, either they both use maintenance capital or they both use the entire capital budget. For individual investors, this makes comparing non-GAAP numbers a real challenge if you want to compare multiple companies.
Similarly, if there is an acquisition, Energy Transfer is not as likely to enter acquisition spend (excluding P&L items) as a conservative competitor like Enterprise Products Partners (EPD) is more likely to consider this in a distributable cash flow calculation.
In addition to the various calculations, there is also the structure of the balance sheet. These two companies have very different financial structures.
Antero Midstream has a leverage ratio of less than 4. However one looks at the ratio, the fact is that the company can borrow to maintain the dividend for a period of time. Management aims to reduce this debt ratio to 3. This debt ratio would be among the lowest of the intermediate debt ratios of the companies that I follow.
On the other hand, Energy Transfer has a calculated leverage ratio with $48 billion in long-term debt combined with $6 billion in senior loans. Even with a guided EBITDA of at least $12 billion, the senior debt to common unit ratio is on track to reach 5 (albeit below 5), which is well above the debt ratio. from Antero Midstream.
A higher debt ratio is accompanied by a higher implicit service obligation. Even if energy transfer debt has an investment grade rating, there may well be higher or sooner debt repayment obligations than a lower leverage ratio would allow for 100% refinancing at maturity. . Indeed, this may be the reason why Energy Transfer reduced the distribution payment some time ago.
Free Cash Flow and Distributable Cash Flow (as well as EBITDA or EBITDAX) do not have a standard definition that managements are held accountable for. As a result, comparisons of these numbers between companies can be a real challenge, as investors may not be able to tell enough of a difference from public information to get comparable numbers (easily).
Therefore, a very strong balance sheet is essential to be able to use non-GAAP figures as many investors wish to use them. Weaker balance sheets mean unpleasant surprises despite good payout coverage ratios, because weaker balance sheets may have items that override anything in the non-GAAP calculation (such as debt repayments).
Antero Midstream has a much simpler and easier to understand future. The risk is lower due to the solid finances of the midstream sector and its main client, Antero Resources (AR). Any reduction in distribution here just makes finances more conservative. There really is no financial problem to speak of.
Energy Transfer really needs to reduce debt ratios and redeem preferred stock. This company has demonstrated that a quality rating will not prevent a reduction in distribution. But the need to reduce debt levels and eliminate preferred stock as well as potential future challenges make these common units much riskier than is the case with Antero Midstream. Note that distributing or hedging dividends does not factor as much into the risk in the overall picture.