Western Midstream: Distribution Increases 52% As The Turnaround Continues (NYSE:WES)

Note: WES is a partnership that issues a Schedule K-1.

Western Midstream (NYSE:WES) announced a 52% distribution increase in the latest first quarter press release as the partnership achieved an investment grade rating. Not only is the distribution increasing, but so is the balance sheet improving.

The last article that I wrote with Rida Morwa focused more on the business itself and the advantages of being part of the Occidental Petroleum (OXY) organization. This one will report the first quarter results while spending a little more time on the undervaluation. Both of us like that distribution increase.

Probably the key idea is that most midstream companies (or partnerships), including this one, are far stronger financially than they were back during the boom times. This partnership, as noted in the press release, managed to pay the whole capital budget and the distribution while having some free cash flow left over.

It used to be acceptable to borrow and use capital raises to fund the capital budget while paying a distribution. That’s no longer the case and frankly shareholders are far better off because of that change.

But share repurchases also indicate that management believes the common units are cheap. The reasoning of management is shown above. Now with a debt ratio of 3.3 and a goal to hit 3.0 relatively promptly, management intends to see what else needs to be done to get the common unit price higher.

For common unit holders, this is that rare midstream company that offers appreciation potential combined with a well-covered distribution and investment grade debt. That combination reduces investment risk compared to other midstream companies considerably, while management is clearly going for a superior return.

In general, this means the midstream area as a whole is cheap and out of favor. Therefore, there’s some appreciation potential just waiting for the midstream companies to return to historical valuations. One of the things to keep in mind is that while midstream partnerships and companies grew faster during the boom times, that growth largely came with dilutive common unit offerings. Therefore, shareholders often saw only a fraction of that growth in the form of increasing distributions and appreciation.

Now, whatever growth is available is self-funded as demanded by the market. The result of that demand is likely to be more growth per common unit than was the case during the boom times. The management case concludes with better common unit growth prospects combined with lower common unit valuations. This is the argument that much of the industry is at bargain levels. It looks like a good argument. Future growth per unit will come from a combination of organic growth as well as common unit repurchases.

First Quarter Results

Western Midstream Partners LP (WES) reported its first quarter 2024 earnings on May 8, announcing record natural gas and produced-water throughput across its asset base. As a result, WES generated its highest quarterly net income ($559.5 million) and adjusted EBITDA ($608.4 million) in the partnership’s history. The company reported free cash flow of $225 million before dividends and $1.5 million after dividends.

“The first quarter was very successful for WES as we generated the highest quarterly net income and adjusted EBITDA in our partnership’s history. These records were primarily driven by increased throughput across all operated assets and across all products. We also set new gathering records for natural gas and produced-water throughput in the Delaware Basin, and we continued to experience natural gas and crude oil and NGLs throughput growth in the DJ Basin.” – Michael Ure, President and Chief Executive Officer

It needs to be noted that there were some declines in volumes processed due to the sales of generally lower margin joint ventures. The fireside chat after the conference call noted that these sales created a one-time margin boost for some measures due to the change of earnings mix.

Western Midstream is becoming more focused on the operations of Occidental Petroleum (OXY). The ability to coordinate capital projects with Occidental is likely to raise the return on capital in the future. Occidental itself is widely regarded as financially healthy, with decent debt ratings. Therefore, Western Midstream will likewise have high ratings due to its low debt levels and the fact that Occidental is well regarded. As an essentially captive midstream, the financial ratings are capped by the financial strength of the parent company. Fortunately, that cap is a very high one.

In the future, the pending Occidental acquisition could well provide still more growth opportunities for common unit holders. It’s very possible that Western Midstream could grow faster than Occidental as a result. One thing to watch is how any possible midstream holdings are sold or dropped down to Western Midstream as a result of these acquisitions.

Customer Base

Shown below is the makeup of the customer base in the major basins serviced:

Western Midstream largely provides transportation to either long-distance connections or a gathering service, after which a competitor transports the production to a customer or for export. Shown below are the major products that are gathered and transported.

When Occidental gained control of this midstream company, the center of operations was the DJ Basin. That’s the one that has been upgraded and rationalized the most. On the other hand, the Delaware Basin is much more favorably located for natural gas export that’s coming online over the next two years. The gas produced in the Delaware Basin could prove to be far more valuable in the future to Occidental Petroleum. As such, that basin is likely to be a focus area for more midstream growth.

There are services that midstream partnerships can provide. Investors can expect that the management will explore this opportunity to earn more in the future. Right now, much of the income comes from transportation. But large competitors like Kinder Morgan (KMI) and Enterprise Products Partners (EPD) have significant income from services that reasonably accompany that transportation. This is also a way to increase the overall profitability of the partnership.

Therefore, investors can likely expect to see an increasing amount of differentiation in future presentations as this particular long-term goal receives more coverage.

Shareholder Returns

This is a turnaround story in progress that I would consider holding until the story changes materially.

Clearly, the rest of the current fiscal year will be devoted to the current distribution. However, should things go as planned, there’s a chance for an enhanced distribution in 2025.

That goal of a 3.0 debt ratio is typical for captive midstream that have a major customer. But that level of debt also leaves a lot of options for an opportunistic acquisition, or some of the things noted in the slide above.

Occidental has an impressive history of making midstream operations very valuable and then selling those operations for darn good money (usually at or near a cyclical top).

Occidental owns roughly half of the outstanding common units while controlling the general partner according to the latest annual report. That means that common unit holders have no input to the above policy. On the other hand, management can think what’s best for the partnership long term while withstanding short-term market demands that may harm the long-term outlook.

Valuation

As was previously discussed, this part of the industry is out of favor. I would therefore probably wait for the whole sector to return to something that approaches historical valuations before considering a sale.

Right now, a future of lower interest rates, even if that future is delayed, bodes very well for a return to historical valuations.

As shown above, the potential average appreciation from a cyclical recovery is substantial. It would not take much growth combined with that recovery for these units to double over five years. The tax deferred distribution is “icing on the cake.” That’s a lot of icing, too, as it’s more than many investors report for long-term total returns on average.

The midstream industry is known as the utility part of the oil and gas industry because the take-or-pay provisions limit earnings downside. Additionally, this particular partnership has an investment grade debt rating that few midstream competitors attain to further add some safety.

Even though balance sheets are stronger, free cash flow is emphasized, and the industry is doing share buybacks, the whole industry, on average, is dirt cheap. This makes a potential combined return in the teens a reality.

Risks

Midstream companies tend to follow upstream company stock prices, even though midstream earnings are generally not cyclical. This can make for a bumpy ride, even though the long-term outlook is positive, as shown above. Even considering this, the midstream area is likely to provide a superior return long-term for those who can handle the volatility that goes with upstream stocks.

Western Midstream is largely dependent upon the fortunes of Occidental Petroleum for its future outlook. Right now, that outlook is pretty good. But there’s no assurance it will stay that way.

A loss of key personnel could have a material effect on the future of the company.