Today, we are updating our model on EQT Midstream (EQM). We are very bullish on EQM again in 2014 after having liked the stock in 2013. Despite increasing 90% over the past year, we still see more upside. The Marcellus Shale continues to become one of the most important natural gas producers in the USA, and we believe a combination of recent acquisitions as well as a better market for natural gas in 2014 will continue to drive upside in shares.
In today's article, we will update our model, talk about two important catalysts for the company's growth, and discuss how we get to a 2014 $95 price tag for the stock.
Current Oxen Thesis
Business Overview
The midstream partner of EQT Corp. (EQT), a natural gas producer in the Marcellus Shale and Appalachian Basin, EQM operates as an MLP and does midstream operations - gathering, piping, and storage. The company, additionally, has been able to produce excess capacity for their facilities that they have been able to sell to third parties. The company operates a 700-mile interstate pipeline as well as 2100 miles of gathering lines.
Industry Trends
In the industry trends section, we will discuss current happenings in the Marcellus Shale basin as well as natural gas.
Statistics about Marcellus Shale and natural gas:
- From 2005 to 2012, annual dry gas production rose 33%, according to the EIA.
- The Marcellus Shale site saw 14% growth year/year.
- Barclays believes that shale production can grow 30% in 2014 (maybe even more)
- As of October 2013, Marcellus production was at 12BBtu/per day - 6x 2009 production
Yet, one of the most interesting things about Marcellus Shale is that many wells are backlogged because there are not enough pipelines and midstream companies operating in the space. Barclays believes that if these backups can be undone, the area's production will grow faster in the coming year than it did even in 2013. Utica shale in Ohio is expected to grow significantly in 2014 - 2015, which will continue to increase overall 
Most estimates put the amount of Marcellus shale potential around 300TBtu - 350TBtu. With 12BBtu being produced per day, there is still 40-50 years of production, and the basin is going to provide resources for a significant period it appears.
As far as natural gas prices, these are expected to rise in 2014 and again in 2015. The reason is that a combination of underlying demand increases are expected as well as better economic environments. Foreign markets are also starting to demand LNG and CNG more. According to the EIA, natural gas consumption will actually drop in 2014 due to less heating days, but it will rebound in 2015 with the closing of some coal power plants that will have to shutter due to the Mercury and Air Toxic Standards legislation. Those plants are expected to be replaced with natural gas facilities. The EIA also predicts imports to fall as domestic supply continues to rise. The EIA believes the USA will be the leading exporter of natural gas by 2018.
Main Catalyst
The obvious main catalyst for EQM is what is happening in the Marcellus shale arena, but the success here has been widely documented. We will discuss more about how much revenue accretion is potentially there for EQM in this area in our price target analysis section. One catalyst that we believe is being undervalued is the company's potential outside of Marcellus on top of the strength of this area. A lot of people in the industry do believe that Marcellus will top out in growth in 2015 and start to taper off to a more reasonable level. The Marcellus is expected to reach 14BBtu/day this year, a level that was not thought to be hit until 2020 by pipeline company Dominion Resources (D):
(click to enlarge)
Therefore, growth may start to slow in 2015 (EQT expects potentially 30% more volume in 2015 as well) and be more flattish from there as the established companies continue to grind away, but growth of contracts will slow for a midstream company, meaning their revenue/earnings will become more predictable. Yet, as we can see from Dominion, the future after Marcellus Shale is Upper Devonian shale and Utica in Ohio. That 30% number, though, also includes the Upper Devonian and Utica shale plays, two areas that are the next phase of growth for EQT. EQT has been slow to move into Utica, but Upper Devonian looks intriguing. First off, the Upper Devonian shale sits above the Marcellus zone, so it is already in areas where EQT is drilling, and thus sits in areas where EQM can gather, pipe, and store. EQT owns 170K acres of Upper Devonian acreage, so a lot of potential is there as well. Devonian is not as strong in production efficiency as Marcellus, but with the shale sitting just above Marcellus it makes sense to take it as well. According to the industry, Devonian is mostly dry gas, but it is still economically feasible especially with pads already in place for Marcellus. Here is the Upper Devonian in comparison to Marcellus:
(click to enlarge)
What we like about this for EQM is that it means that volumes will stay elevated for some time. Upper is riskier, but most experts suggest that there could be 55Tcf in the Upper Devonian region, and early results for EQT are promising:
After great results from early test wells - an average estimated ultimate recovery of 1.2 billion cubic feet per 1,000 feet drilled - the E&P firm has made the Upper Devonian a major contributor to its future drilling and production plans. Like RRC, EQT is planning on drilling both the Marcellus and Devonian from a single well pad and has recently doubled the number of wells its plans to drill in the region to 22. Yet there is still plenty of room for EQT to grow in the Devonian as well as the Marcellus. Across the Appalachian Basin, the firm has drilling rights on nearly 3.5 million acres. That's a huge amount of land for prospecting. More importantly, EQT estimates that its proven and probable reserves for its Upper Devonian holdings sit at an impressive 2.4 trillion cubic feet.
What this means for EQM is that their services are going to continue to be in high demand for several years at least. That is not to mention that Devonian could end up developing into the same type of bountiful product, as Marcellus and their midstream operations will be licensed out by more users. Given another 30% growth in volumes in 2015 are expected, we can anticipate that at least 10-20% growth in 2016 can be expected. From there, visibility is a bit more limited.
The company has a smaller play in Utica, which is also very rich in natural gas. They have been less quick to buy up there because acreage is expensive, and their midstream play with EQM is questionable at that distance. If they do start pushing into that area, though, the company will definitely benefit from higher volumes at parent EQT.
EQM is not even close to tapped out in their potential resources as well. As we will discuss in our secondary catalyst, the company is adding more, but we see that they now have nearly 3Tcf potential per day. EQT is expected to use about 1.6Tcf/day in 2014, but that means the company has more potential to add more to Upper Devonian, and it can also continue to add more third parties as well. Overall, we believe the Devonian development has large implications for the company, and it can help EQT continue to see volumes up 25-30% through 2015 with double-digit growth continuing into 2016. As we will show in the price target section, this growth is not priced in at this point.
There is definitely risk with Devonian. It is smaller in size than Marcellus, and it requires more effort (fracking) to get into it. The initial results are positive, but it is not as for sure as Marcellus. We still see that even if its remotely successful, it is not priced in at this point.
The company, though, feels strongly about Devonian first and Utica second, and they like the economics of Marcellus and Devonian. Here is a response to a question about pushing into Utica from Senior VP Steven Schlotterbeck:
Yes, I really don't have much to add. I agree. It's on our radar, but not at the top of our list. I think it's deeper. It's more expensive. It's dry gas. We're going to be focused on the more profitable Marcellus opportunity in that area for now. And we'll see what develops with the dry gas Utica, certainly there's some potential there, but not a high priority right now for us.
The company is set on Upper Devonian, and they see it as the most viable option right now. Utica will come in time as well.
Secondary Catalyst
On top of the Devonian potential, we are excited by the company's continued expansion of its capacity for production. The company added the Sunrise Pipeline in late mid-2013, which added 400B Btu/day. The company added another 200B to that, and it is all under contract right now. The company, additionally, is working on a project to add another 550B Btu/day to their Jefferson compressor that is expected to be completed in Q3 of 2014. The company added another 150B with completion of the low pressure East project in Q4 of 2013.
In 2014, expansion of capacity will continue. The company should add another 650 BBtu/day in the year, bringing total capacity to 2.9TBtu per day. The company will add another 100BBtu through potential expansion or acquisition.
What does this mean for the company?
The company is seeing revenues of about 185M with 2.25TBtu capacity. They add about 29% capacity in 2014; we should expect to see about the same increase in revenue. Most contracts are long-term (ten years), and the company can only make more money if they build out and fill up that capacity. Demand is strong as we shown in the prior section, and capacity is being met. It is obviously a case of the company has incredible demand, and they will add as they can. Yet, the company does not have to see incredible CapEx to see great growth. This coming year, they are only expected to see about $80-$85M in expenditures, allowing for a lot of solid cash flow that will mean a solid dividend to holders as well as good cash on hand to acquire or add pieces in other areas.
What's great also is that as they increase capacity, they start to outpace EQT and can have high fees for third parties that help margins grow. For example, with Sunrise, the company was about 62:38 in ratio of EQT to third parties. Yet, they are getting ahead of EQT and using extra capacity for long-term deals with third parties. With the 550M add on to the Jefferson compressor, the deals are 50:50 EQT to third party. The wells that are coming on are now able to have a midstream company, and the backlog plays out well for EQM as they continue to expand.
Pricing/Valuation
In our pricing model, we came up with a $95 price target for the next twelve months. We believe that EQM has tremendous untapped potential as a company and as share value is concerned. Currently, EQT predicts about 30% growth in 2014 and 2015 as far as volumes. EQM will continue to add to their capacity to help meet this demand, and they want to stay ahead of the curve. From there, we can expect some slowdown in growth to 8-10% before potentially being flat around 2018.
Revenue - We took our best-case scenario and worst-case scenario and combined it. In the best-case, we will see 30% growth in 2014 and 2015 with around 15-20% tapering down to around 5-8% as growth dwindles in Marcellus/Devonian, and the company does not have another major find by then. In our worst-case, we see 25-30% over the next two years with a major shift down to around 5-10% in the following two years and a decline in 2018.
Gross/operating margins - Margins should likely stay flat to potentially improve for EQM. As the company continues to build out, their costs of doing business become less and less over time. The company has maintenance costs that will stay pretty flat, and the added costs of adding new business will start to decline as a percent of sales over time. We see operating income rising to about $195M by 2018.
Taxes - We used a 5% tax rate for the company, as they have minimal taxes due to their MLP status.
CapEx/Depreciation - The company will have to continue to add pieces and see rising maintenance costs. We forecasted CapEx growing to back into the 100-105M range by 2017, as the company will continue to have to add to maintain capacity. Further, we see larger costs arising during that period as the company will likely start to shift to new regions like Utica and increase at Devonian.
We used a fairly aggressive cap rate of 2% because we believe that growth is high here, and the company is attractive as an MLP. Not only is this company growing, but they are also a significant dividend payer with high distributable cash flow. That dividend will grow as that cash flow rises, and they should continue to attract a valuation at a premium to the rest of the market.
Risk/Variance
There are some definite risks here with EQM. The company has obvious risks in that they are tied very exclusively to Marcellus shale, and it is never a great business to be all-in on one product. Further, while we have high expectations for expansion into other regions, the company has not proven itself in these areas. Further, the risk of natural gas price fluctuation plays a major role. One thing that gives us excitement, though, is that when we price zero growth beyond 2014 into the model and keep nearly everything else the same, we get a price target of $45. So in the absolute most detrimental case (which will never happen) where Marcellus comes to a standstill in growth, the stock has limited downside.
Conclusion
In conclusion, we believe opportunity is ripe for EQT Midstream. The company has fascinating and strong growth prospects, and we believe their business is ripe for growth. Marcellus continues to impress, and it is not slowing down. Further, the company has tremendous prospects with EQT pushing into new shale formations that could produce tremendous results for EQM. Getting paid a 3% dividend in a high-growth name with high economic moats…yes please!
Disclosure
The analysts contributing to this report do not hold shares of this stock. The EPS and revenue forecasts are estimate opinions and are not factually accurate. They are based off of what we believe to be reliable information. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analyst's personal views as to the subject securities and issuers. The Oxen Group certifies that no part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. The article is an opinion and should be used for informational purposes. Seek financial advice from a registered advisor before taking on any investments.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.
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