Friday, July 10, 2015

I added to my stake in Oneok (OKE)

As I was discussing recentlywhen revealing that I added to my position in Apple Inc. (AAPL), June has been a really crazy and abnormal month in regards to capital deployment.
However, as mentioned, that AAPL purchase was fully funded by the cash that was part of the acquisition of Lorillard Inc. by Reynolds American, Inc. (RAI).
I decided to spread that capital out across a few different plays because, frankly, I see various and diversified opportunities in both the market and my portfolio across a number of different industries and companies. The AAPL position was small, and I felt it was appropriate to double that.
The stock I’ll be discussing below is a bit different. I actually wasn’t all that displeased with the size of the position nor was I particularly anxious to buy more shares. In addition, I’m overexposed to the sector it’s in. However, sometimes Mr. Market becomes particularly depressed about a certain company’s future prospects and wants to sell for a ridiculously low price. And, well, I’m generally a buyer more often than not when that happens.
I purchased 20 shares of ONEOK, Inc. (OKE) on 6/15/15 for $39.46 per share.

Overview

ONEOK, Inc. is a diversified energy company. It is the sole general partner and, as of March 31, 2015, 37.6 percent owner of ONEOK Partners L.P. (OKS). OKS is a leader in the gathering, processing, transportation, and storage of natural gas. It also owns and operates a large natural gas liquids system, connecting NGL supply in the Mid-Continent and Rocky Mountain regions with key market centers.
OKS is a midstream master limited partnership. OKE, on the other hand, operates as normal corporation. Its a pure-play general partner, whose purpose is to own the GP and limited partner units in OKS. Its growth is highly tied to OKS’s growth.
The MLP owns and operates more than 18,000 miles of natural gas gathering pipelines and 6,600 miles of transmission pipeline. They also own and operate 19 active processing plants. For NGLs, they own and operate more than 7,000 miles of NGL gathering pipelines, more than 4,000 miles of distribution pipeline, seven fractionators, and eight NGL product terminals.

Reduced Dividend Growth Guidance

last picked up shares in OKE back in December 2014, at $44.56 per share. At the time, the company was guiding for dividend growth of 14% in 2015 and 12% to 15% dividend growth looking out over the foreseeable future. Obviously, this is incredible growth when you factor in what’s already a very high and attractive starting yield.
Well, that guidance has since been reduced:
2015 revised guidance now includes a projected 4 percent to 8 percent increase in ONEOK’s dividends declared compared with 2014, subject to ONEOK board approval, compared with its previous guidance of a 14 percent increase.
Due to lower commodity prices, reduced producer drilling and the anticipated impact to natural gas volume growth, ONEOK Partners is suspending capital expenditures for the following announced capital-growth projects:
  • The Demicks Lake natural gas processing plant and related infrastructure in the Williston Basin in North Dakota;
  • The Knox natural gas processing plant and related infrastructure in the Mid-Continent region in Oklahoma; and
  • The Bronco natural gas processing plant and related infrastructure in the Powder River Basin in Wyoming.
“ONEOK Partners expects to resume suspended capital-growth projects and update associated completion dates as soon as market conditions improve,” said Spencer. “The planning and development the partnership has already completed puts it in a position to quickly resume these projects when the environment improves and its customers require these services.”
It’s important, however, to keep perspective here.
First, we’re still looking at 4% dividend growth on the low end, if guidance holds true. So far, that guidance looks good with the recent reaffirmation when OKE released Q1 2015 results. If every stock in my portfolio could produce the 6.13% yield that OKE does and stilldeliver 4% dividend growth, I’d be elated. The company’s dividend for Q1 2015 was 2.5% higher than the payout for Q4 2014 and 51.3% higher than Q1 2014. So a lot of dividend growth has really already been front-loaded here.
Second, the stock is down almost 20% YTD and about 41% over the last year. Is that warranted? Is OKE worth more than $2 billion less in June than it was in January? Is the company worth some $6 billion less YOY?
I happen to think not. Cash flow available for dividends was $152.1 million in Q1 2015, compared to $211.4 million in Q1 2014. That’s a drop of 28% on the face of it, but Q1 2014’s results included $82.8 million in cash flow from the former energy services segment. So we have a drop in YOY cash flow for dividends that isn’t even close to the slide in the stock’s price over the last year, while one also has to really question whether or not the current commodity pricing situation is set to last forever.

Risks

There are a number of risks to consider here with OKE, and I consider it a rather aggressive investment from a standpoint of risk and reward.
Primarily, the MLP structure could come under pressure if there are any material changes at the federal government level insofar as taxation. Though highly unlikely, it’s a risk that, if it were to occur, could have a substantial effect on the business (and others like it).
Rising interest rates is also a risk due to the amount of debt that OKE and OKS carry.
Although OKE is somewhat insulated from major swings in commodity prices, they are exposed through their processing business. In addition, lower natural gas prices can reduce demand for transportation and new growth projects.
One other potential risk is a dividend cut as, like a lot of other MLPs, the dividend coverage is pretty tight. As of Q1 2015, cash flow for dividends covered the dividend 1.2 times over. That’s in line with OKE’s long-term target of 1.0 to 1.1.
Finally, I view black swan events as a risk, such as a fire or other disaster at one of their pipelines or plants.

Valuation

Net income isn’t an accurate picture of cash flow for a MLP or its GP, so the P/E ratio isn’t a viable valuation metric.
I valued shares using a dividend discount model analysis with an 8% discount rate and a 4% long-term dividend growth rate. That growth rate is lower than the 6% I used last time, to account for reduced guidance. I happen to think that’s an incredibly conservative growth rate when looking out over the long term. However, I also used a lower discount rate to account for the time value of money. The DDM analysis gives me a fair value of$62.92.
Overall, I think the stock is very attractively valued here, relative to both its current potential and long-term potential. The more than 36,000 miles of pipelines the firm controls are incredible assets and almost impossible to replicate for a new competitor. When/if commodity prices bounce back and the company’s growth projects are back online, its cash flow could increase rather significantly, meaning the margin of safety right now is rather sizable. Even if commodity pricing stays low for a sustained period of time, the dividend is covered and the low end of guidance still provides for very attractive total income prospects and dividend growth potential, as well as a severely undervalued stock.

Conclusion

This is the lowest price I’ve been able to land OKE at. And I’m very excited about that. I thought the stock was cheap in the mid-$40s, so I think it’s an incredible opportunity here below $40.
I’ve long been too heavily allocated to energy, so I wasn’t in a rush to buy OKE. But I think the valuation, yield, and quality all combine to offer a rather compelling investment thesis right now. As I discussed before, the fundamentals are solid, the company enjoys massive competitive advantages, and their track record is excellent.
One potential possibility is that OKE follows in the footsteps of some peers and consolidates with OKS. That could provide for additional clarity, less complexity, a pop in the stock’s price, as well as an immediate boost to the dividend.
But this is one of those rare stocks where you can land a yield that’s about three times that of the broader market along with dividend growth well over the rate of inflation.
I used a free trade in my Scottrade account for this purchase. While it was a smaller transaction than normal, I paid no commission fee.
This purchase adds $48.40 to my annual dividend income, based on the current $0.6050 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates OKE as a 4/5 star valuation, with a fair value estimate of $52.00.
S&P Capital IQ rates OKE as a 3/5 star “hold”, with a fair value calculation of $31.60.
I’ll update my Freedom Fund in early July to reflect this recent purchase.
Full Disclosure: Long AAPL, RAI, and OKE.
What do you think of OKE here? Like the valuation after the drop? Think it’s a good opportunity? 
Thanks for reading.

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