Editor’s Note: The following article first appeared in our premium investing service, Dividends & Income Select. It was originally published on September 13, 2024. Thanks to a recent pullback, we now have an even better buying opportunity than we did a couple months ago: In short, the stock featured is now yielding 9.1% and trading at a potential 25% discount to its estimated fair value price. Read on…
It’s so important to be honest with ourselves as investors.
We should be perfectly clear about what we want out of our investments.
And the fact is, many investors want something simple: financial freedom.
If that’s the goal, we can reverse engineer our way there.
When you do that, you see how it really comes down to passive income exceeding expenses.
Once passive income covers all expenses, that’s the promised land.
This is why I’m such a fanatic for dividends.
Dividends are the most passive form of income in the world.
A dividend is a distribution of a company’s earnings to its shareholders, totally bypassing the vagaries of the stock market, creating a smooth source of pure passive income.
No matter what’s happening with stock prices or the market, dividends tend to reliably come in at the same rate (or better) – especially when dealing with great businesses.
Stock prices fluctuate, but dividends usually do not.
That’s a great thing, as our real-life bills also don’t usually fluctuate too much (other than, unfortunately, steadily heading higher over time).
Being paid dividends involves nothing more than sitting back and collecting the checks from the businesses you own a slice of.
It can’t get any more passive than that.
Creating enough of this passive income to cover bills?
That just makes life so much easier!
The best part of all might be the fact that these dividends allow the shareholder to keep their shares and wealth intact.
Collecting “golden eggs” from “golden geese” without ever slaughtering them is a nice way to ensure that there will always be some livelihood there.
It’s all about protecting the wealth you worked so hard to build, in turn protecting what ultimately underpins that financial freedom.
If we slowly sell off assets and drain our wealth, we risk running out of money and freedom.
Of course, reaching the promised land within a reasonable amount of time requires one to pump out as much passive income as sustainably possible from their investments.
That’s where the honesty comes in.
If the goal is generating enough passive income to cover bills so as to achieve financial freedom and alleviate a lot of life’s problems, we must choose our investments wisely.
Buying stocks that pay little to no dividends won’t help much.
But buying stocks with high yields can act as a bit of a “time machine”, fast-forwarding our way to the promised land.
Moreover, in addition to their passive nature, dividends can be a tax-advantaged source of income.
Boy, collecting enough totally passive, tax-advantaged income to cover the bills is kind of a dream come true.
And it gets even better.
Many businesses that pay dividends also regularly increase the size of those dividends.
This is incredibly helpful in a reality in which inflation is slowly causing the price of almost everything to rise over time (which hits our bills and our wallets hard).
If that tax-advantaged passive income can rise to the occasion and offset inflation’s nasty effects, you’ve really got yourself a home run.
With all of that in mind, I want to cover a high-yield dividend growth stock that can help you to cover your bills and make your life a lot easier…
Western Midstream Partners, LP (WES) is a master limited partnership formed to acquire, own, develop, and operate midstream assets.
Founded in 2012, Western Midstream Partners now has a market cap of nearly $15 billion.
This MLP owns and operates over 14,000 miles of pipeline, 69 processing and treating facilities, seven natural gas pipelines, and 12 Crude Oil/NGL pipelines.
Assets are strategically located in some of the most active basins in the US, including the Delaware and DJ Basins.
Western Midstream controls vast swaths of critical North American energy infrastructure.
This is infrastructure our modern-day society cannot function without.
If we want to continue manufacturing, using electricity, and doing almost everything we’re accustomed to, we need the hydrocarbon energy products Western Midstream’s infrastructure is involved in gathering, processing, and transporting.
The necessity of these products creates a necessity for Western Midstream’s very business model, building in a certain level of safety and predictability.
Adding to that predictability is the fact that Western Midstream has almost no direct exposure to the underlying pricing of various commodities.
It has 95% fee-based gas contracts, and 100% fee-based liquids contracts.
It’s essentially a “tool booth” operator, collecting its fees – no matter what’s going on with energy pricing.
What’s especially interesting about Western Midstream, relative to a lot of other players in the midstream space, is that none other than Warren Buffett is a key backer.
Indeed, his conglomerate, Berkshire Hathaway Inc. (BRK.B), owns a large stake in Occidental Petroleum Corp. (OXY).
That’s material.
See, Occidental Petroleum is Western Midstream’s general partner, and it owns 49.9% of the MLP.
As such, investing in Western Midstream gives one the opportunity to be exposed alongside Warren Buffett himself to one of North America’s premier collection of critical energy infrastructure assets.
Moreover, it’s not just energy products that Western Midstream is busy pipelining.
It’s also pipelining cash flow.
Western Midstream is expected to generate more than $1 billion in free cash flow this year.
Best of all?
It then pipelines substantially all of that cash flow straight into investors’ brokerage accounts via very large cash dividend payments.
Dividend Yield And Growth
How large are we talking?
The stock offers up a massive 9.1% yield.
(Now, I want to quickly point out that WES technically pays “distributions”, not dividends, as this is a master limited partnership with a different tax and payout structure. There are K-1 forms involved, so please be aware of the tax implications).
There are not many ways in which you can go out and get 9%+ yield on your money – even in high-yield areas of the market (such as REITs and telecoms).
It’s quite incredible.
For perspective on just how outsized this yield is, it’s seven times higher than the broader market’s yield.
Again, being able to get this kind of yield from an investment is like having a time machine, as it significantly reduces the amount of capital (and time required to acquire that capital) needed to produce copious amounts of income.
It can be a life-changing experience.
This 9.1% yield is also 110 basis points higher than its own five-year average, so this is unusually high – even for Western Midstream.
If this high yield was all there was, it’d be pretty compelling.
But there’s actually more.
Western Midstream regularly increases its distributions to unitholders.
And not just a little, either.
In fact, Western Midstream increased its quarterly distribution by 52.2% in April!
Now, to be fair, the MLP is making up for lost ground, as it did have to temporarily cut the distribution during the pandemic.
But the current distribution is now well beyond where it was before the pandemic hit, and it’s 141% higher than it was a decade ago – good for a 10.2% compound annual growth rate.
Just think about that.
A 9%+ yield and a 10%+ distribution growth rate?!
Super unusual.
Super compelling.
And the distribution appears to be extremely sustainable (or else it wouldn’t have just been increased so much).
I say that because Western Midstream is guiding for $2.2 billion to $2.4 billion in adjusted EBITDA for FY 2024, covering the ~$900 million in annual cash distributions more than twice over.
At the midpoint of that guidance, the payout ratio is roughly 40%.
That indicates a rather safe distribution, which actually is not all that common when dealing with such high yields.
Western Midstream offers an unusually nice combination of yield, growth, and safety.
For income-oriented investors who enjoy being showered with cash flow, Western Midstream is making it rain.
Revenue and Earnings Growth
Of course, Western Midstream is able to pay out such large cash distributions to unitholders because the underlying pipeline assets are raking in the fees and generating lots of growing cash flow.
Western Midstream has grown its revenue from $1.5 billion in FY 2014 to $3.1 billion in FY 2023.
That’s a compound annual growth rate of 8.4%.
Strong.
However, top-line growth is not necessarily indicative of the true growth profile of an MLP, as MLPs use debt and equity to fund growth.
Thus, it’s imperative to look at growth on a per unit basis – factoring in the dilution.
Now, usually, I’d be looking at FCF/unit growth for an MLP.
However, I’m substituting net income per unit (EPU, akin to EPS) in this case, as Western Midstream’s high level of CapEx was creating negative FCF a decade ago (making a comparison N/A).
Western Midstream’s EPU has increased from $1.02 to $2.60 over this 10-year period, which is a CAGR of 11%.
Quite impressive, in my view.
Based on FY 2024 midpoint guidance adjusted EBIDTA, YOY growth would come in at ~11% – continuing this trajectory of low-double-digit growth.
But the dilution shouldn’t be ignored.
Western Midstream’s weighted-average common units have exploded from 218.9 million in FY 2014 to 384.4 million.
That’s a CAGR of 6.5%.
So the growth of the business and its cash flow has to overcome that consistent dilution over time, and that can be a challenge.
That said, even without any growth at all, the stock’s 9%+ yield is almost good enough – all by itself.
Growth icing on the income cake is pure bonus.
The fact that Western Midstream is growing, and the fact that FCF is so far into the positive (not easy for a capital-intensive business model), should be reassuring to unitholders.
Financial Position
Western Midstream’s financial position is relatively solid.
The long-term debt/equity ratio is 2.4, while the interest coverage ratio is slightly over 5.
A common metric for measuring leverage when dealing with a pass-through vehicle like this is the debt/EBITDA ratio.
Generally speaking, I see this ratio range between 3 and 7 (lower is better).
Western Midstream has a net debt/adjusted EBITDA ratio of 3.
That’s on the lower end of this industry’s common range, although it’s elevated in comparison to most other businesses I follow.
The company’s debt does have (albeit barely) investment-grade credit ratings: BBB-, Fitch; BBB-, Standard and Poor’s; Baa3, Moody’s.
Notably, Western Midstream noted in its Q2 FY 2024 report that it has paid down $763 million in long-term debt (with proceeds from asset sales) since the end of 2023, allowing it to hit its targeted net debt/adjusted EBITDA ratio of 3 earlier than expected – an encouraging development.
In absolute terms, this is a leveraged balance sheet that may, at first glance, be somewhat concerning.
However, for this specific business model, relative to what you commonly see in this industry, Western Midstream is not overly leveraged.
This a capital-intensive business model, making heavy usage of leverage understandable and even necessary.
Profitability
Profitability is challenging to measure and gauge for this type of business, as an MLP like Western Midstream relies on a variety of non-GAAP numbers to translate profit.
But return on equity has averaged 31.3% over the last five years, which is actually very strong (although accomplished with the leveraged balance sheet).
Overall, Western Midstream offers investors an opportunity to own a share of strategic and critical energy assets while collecting a very generous distribution along the way.
And with economies of scale, entrenched infrastructure at strategic locations, and fee-based cash flow, the company does benefit from durable competitive advantages.
Risks
But there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Western Midstream is heavily leveraged, and this leverage exposes the MLP to interest rate sensitivity and a drain on cash flow.
Through its fee-based structure, Western Midstream is mostly protected against volatile commodity pricing, but a severe downturn in pricing (which would likely be due to economic problems and reduced demand for energy) would impact flows and demand for the MLP’s infrastructure.
Western Midstream may start to become a victim of its own success, as bringing new major energy projects to market involves lots of difficulties (such as regulatory headaches and legal battles) – making it increasingly difficult to scale infrastructure and grow the business.
The MLP has some exposure to the broader economy, as demand for energy products is correlated to economic health/activity.
Because of the way an MLP is structured (almost all cash flow gets returned to unitholders via those generous distributions), Western Midstream will be forced to continuously issue more equity and debt in order to fund growth (thus diluting unitholders and constantly pressuring the balance sheet).
I definitely see some risks to consider here, but all equity investments have risk.
And the low valuation appears to price in lots of risk anyway.
Valuation
The P/CF ratio is 7.6.
I view a multiple of cash flow as the best lens through which to quickly assess an MLP’s valuation.
Western Midstream is guiding for $2.3 billion (at the midpoint) in adjusted EBITDA for this year, and the market cap is just 6.4 times that number.
To be fair, a pass-through vehicle like Western Midstream never gets assigned high multiples from the market.
With slow growth, high debt, and ongoing dilution, low multiples are justified.
For more perspective on this point, Western Midstream’s own five-year average P/CF ratio is 4.9.
While we’re higher than that now, this five-year average is unfairly skewed lower by the pandemic.
A 7.6 multiple is not high at all in absolute terms.
Before the pandemic, the cash flow multiple was actually often over 7.
Furthermore, the current yield is significantly higher than its own recent historical average, giving us some indication of the valuation being relatively appealing.
In order to estimate the intrinsic value of the business, I used a dividend discount model analysis.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I factored in a 10% discount rate and a long-term dividend growth rate of 2.5%.
This is obviously a very low growth rate expectation, but I’ve found it appropriate to be cautious around MLPs.
The space can be deceptively volatile, despite fixed infrastructure and fee-based contracts, and dividend/distribution cuts are not at all unheard of or even all that uncommon.
Western Midstream itself cut its distribution by about 50% in 2020.
The MLP has clearly shown an ability to grow the business at a nice clip over a long stretch of time, even though bumps along the way are inevitable, and the distribution is currently more than twice as high as it was a decade ago.
But the high yield is basically good enough all by itself, even without much growth.
And so erring on the side of caution and assuming inflation-like growth (to protect one’s purchasing power) makes a lot of sense when dealing with a pass-through income vehicle like this.
The DDM analysis gives me a fair value of $47.83, which would indicate the stock is 19%undervalued.
Bottom Line
Western Midstream Partners, LP (WES) is pipelining energy products for customers and then pipelining cash flow to unitholders. Its built-out infrastructure network would be almost impossible to build from scratch today, protecting the business from competitors. In spite of newer/cleaner forms of renewable energy catching on, the world still mostly runs on hydrocarbons. Plus, global energy needs are only growing. For income-oriented investors, this stock’s massive 9%+ yield can help to offset bills and make a difficult life easier – without needing to sell off units and risk running out of wealth and money. And with the potential that the stock is 19% undervalued, this name gives value hunters an easy-to-swallow deal.
-Jason Fieber
Editor’s Note: What you just read was originally published on Dividends & Income Select, our premium investing service. To learn more about this exclusive service, and how to get instant access to our real-money portfolios, trade alerts and more, click here.
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