Shares of the Williams Companies (WMB) are down over 22% over the past year. While not an enjoyable performance, this is better than the performance of many other pipeline companies like Energy Transfer (ET), Enterprise Products (EPD), and Kinder Morgan (KMI), which have shed over 30% of their value. The company’s second quarter results were very impressive, showing the stability of its franchise. WMB’s business model justifies a premium valuation, and WMB is an excellent income stock with capital appreciation potential.
(Source: Seeking Alpha)
Q2 Results Were Resilient
In the company’s second quarter (financials available here), Williams earned $0.25, a penny ahead of consensus, as revenue fell 12.7% to $1.78 billion. As a pipeline company, investors focus primarily on distributable cash flow (DCF), which was actually up 2% to $797 million on a tax-adjusted basis. DCF provided 1.64x coverage of its distribution.
Indeed, adjusted EBITDA was flat at $1.24 billion, and cash flow from operations was up 7% to $1.143 thanks to strong working capital management. To hold the line on cash flow and EBITDA even as revenue was softer spoke to very strong cost control. Indeed, operating and maintenance expenses were down 17.3% to $320 million. SG&A was down 16.5% to $127 million. With these cost cuts, WMB was able to maintain margins even as revenue fell due primarily to the deferral of projects and temporary shut-ins.
Williams operates in three segments. Transmission & Deepwater, its largest at 53% of the business, reported adjusted EBITDA down 2% to $617 million. This decline was driven by temporary shut-ins in the Gulf of Mexico region. In its gathering and processing (G&P) units, 38% is gas oriented G&P and 7% is oil-oriented G&P.
Regionally, Northeast G&P was actually up 13% to $363 million as gross volumes were up 7% thanks to expansion products that came online. The West region was down 12% to $287 million. The primary headwind here was the expiration of minimum volume commitments out of the Barnett. During the quarter, WMB saw a 3.6% increase in gas volumes flowing through its pipes even as overall US production was down 0.3%, thanks to investment in more competitive shale plays in the Northeast.
Aside from lowering operating expenses, Williams brought cap-ex down 48% to $363 million as it pushes back some projects. Its balance sheet is also in a healthy place. In fact, debt to EBITDA was brought down to 4.3x from 4.4x a year ago.
Thanks to the company’s fee-based revenue stream and focus on natural gas, its cash flow was largely intact despite the carnage that spread through the energy sector. Fortunately, Q2 was not an aberration but rather a validation of management’s strategy to de-risk its business. As such, I expect strong results to continue for the rest of the year.
Williams Is Well-Positioned To Grow Cash Flow
In addition to solid Q2 results, Williams also released encouraging guidance for the year. Management expects $0.95-$1.00 of EPS on $5 billion of EBITDA. This should lead to DCF of $2.50-$2.83, which would provide a 1.7x coverage ratio for its dividend. The company should generate over $1.2 billion of excess cash flow, which will largely cover its cap-ex budget. Management trimmed its growth cap-ex to $1-$1.2 billion, a $100 million reduction with major Gulf of Mexico projects not coming online until the 2022-2024 time frame.
Many investors have worried about WMB’s client mix, and its exposure to the Barnett will be a headwind to Western G&P. However, its exposure to Chesapeake and other high-yield producers is not what it was. Indeed, 90% of transmission revenue comes from investment grade customers. Additionally, utilities, who need natural gas to power their plants, account for 68% of the transmission segment’s firmly contracted capacity.
It is also important to realize that natural gas demand was not nearly as disrupted as crude oil was by lockdowns. Crude oil is primarily used as a transportation fuel, so less driving and flying caused a severe shock to demand there. Natural gas is primarily used to generate power; electricity usage is far less elastic. After all, you still need to use lights whether home or in the office. As a consequence, natural gas demand was up 2% from a year ago. This resilience is why WMB saw steady fee income and growing volumes out of the Northeast. WMB’s natural gas-oriented business makes it much less exposed to COVID-19.
While transmission & deepwater is 53% of the business, it is worth noting that Transco alone is 34% of the business. This pipeline is the bedrock of the company, providing a baseline of cash flow that has seen the company through multiple cycles and stress periods like the 2014-2016 crash.
Transco carries 15% of natural gas in the country, covering 10,000 miles from South Texas to feed major economic centers like New York City. A FERC-regulated pipeline, Transco provides a steady take-or-pay revenue base with rates that move up gradually over time in keeping with inflation and incremental investment. Perversely, the difficult regulatory environment for pipelines from the cancellation of the Atlantic Coast Pipeline to issues over the Dakota Access Pipeline enhances the value of Transco. It is increasingly difficult to build pipelines, particularly in populated areas, making it harder to build potential competitors to incumbents like Transco. New York City needs power, and Transco is one of the only ways to get fuel there.
Transco is a unique asset, critical to daily life for millions of Americans, that can’t be replicated. With $1.7 billion in highly predictable EBITDA, it would potentially fetch $20 billion (a 12x multiple) if it were ever to be sold given its unique size and high-quality cash flow. WMB would never part with the asset; I just highlight this as WMB has a $46 billion enterprise value. Transco is nearly half of the business, providing the bulk of the cash flow with which the company pays dividends and invests in growth projects.
Valuation Is Compelling
While the gathering and processing units may see some deterioration as associated gas production falls, resilient demand for gas should keep results steady. At the same time, Transco will continue to churn out free cash flow quarter after quarter. WMB currently pays a $1.60 dividend, which gives it an 8.36% yield. While this yield is lower than some other pipeline firms, WMB’s focus on natural gas and supplying utilities with fuel for power gives it extremely resilient cash flows.
Resilient cash flows, combined with a 1.7x coverage ratio, is a recipe for steady dividend growth over time, and Williams is mostly side-stepping the problems facing operators more dependent on crude oil. As growth projects underway come online in 2022-2024, that could further support dividend growth.
Over the next five years, WMB has the capacity to grow its dividend by about 5% per annum while the stable baseline of cash flows from Transco should alleviate any concern about the current dividend level. An 8% starting yield with 5% dividend growth is the recipe for a double-digit medium-term return profile.
Given the strength of its cash flow, WMB should trade closer to 10x DCF or $25 per share, which would still give shares a 6.4% yield. With a secure and growing dividend, WMB offers appeal to income investors while the potential 25% upside in shares should make it attractive for capital gains-focused investors.
Disclosure: I am/we are long EPD. 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.