Alma Recurrent Energy Infrastructure Income Fund

Market Review and Outlook

Since 2018, Wall Street has modelled Midstream as a low-growth / no-growth industry – but growth has persisted
As Midstream experienced a painful multi-year downturn from 2014 through 2020, many analysts’ cash flow growth forecasts began to reflect the painful downturn in stock prices. During and even after COVID, Wall Street forecasts for Midstream EBITDA growth have been anemic – reflecting concerns about lower Shale productivity and the impact of the Energy Transition on oil and gas demand. This “lack of growth” has been reflected in valuation multiples which remain well below pre-COVID levels. Interestingly, actual financial results have dramatically exceeded expectations in the past 5 years, reflecting an industry that has achieved meaningful operating leverage and margin expansion from assets which only became recently operational.

On a cumulative basis, Midstream industry EBITDA has expanded by $31bn, or nearly 50% – approximating $100bn on an annual basis today. If we were to look at the cumulative expectations for year-over-year EBITDA growth published by Wall Street analysts over that time, we would see $9bn of cumulative EBITDA growth. In other words, actual cumulative EBITDA growth has more than tripled analyst expectations over the past 5 years.

A skeptical reader might ask, “Aren’t Wall Street estimates made to be beaten?” – but there’s more to the story
We appreciate the skepticism that comes with midstream and energy investing, especially as the sector remains largely out of favor among investors. A possible reply might be, “They beat analyst estimates – so what?” And that question is fair in anticipating the fact that growth isn’t noteworthy simply because it exceeded Wall Street’s forecast – it’s only noteworthy if the growth is generated in a capital-efficient way. And here again, we see that Midstream is outperforming expectations – while EBITDA is sometimes subject to “sandbagging,” management teams generally do not sandbag capital expenditures. And we see again that Midstream is beating Wall Street capex estimates even while growing cash flow.

Midstream was exceeding capex forecasts – effectively running over budget on growth projects – by billions of dollars annually during 2018-2020. The result was a free cash flow outlook that consistently disappointed. Since 2021, Midstream industry capex has met or fallen below forecasts, with over $2bn in excess free cash flow coming from YTD 2023 capital discipline alone.

Even with large-cap Canadian midstream names outspending, most growth is being supported by near-maintenance capex
We noted two months ago that Canadian large cap midstream companies had maintained high capex business models, and their stock performance has suffered considerably as a result. But even with significant Canadian capex burdens, the Midstream sector broadly remains highly disciplined. Below, we take Wall Street forecasts out of the equation and compare the companies to themselves. As recently as 2018, Midstream capex was 2.7x greater than book depreciation. As spending has dropped by >$20bn in the last 5 years, capex today approximates 125-135% of book depreciation, despite meaningful economy-wide cost inflation in the last 3 years.

In our recent white paper, we noted that midstream earnings yields were double-digit, and meaningfully above REIT or utility earnings yields. Importantly, with midstream capex approximating book depreciation levels, this means that Midstream free cash flow yields are also likely to be double-digit – compared to a sector-wide dividend payout that remains approximately 6% to 7% today. With double-digit free cash yields and persistent EBITDA growth (even in a lower capex environment), Midstream continues to defy forecasts of obsolescence and decline even despite valuations that reflect a thus-far illusory terminal value risk.

Fund

In July 2023, our white paper, “More than just Dividend Yield,” explained that dividend yield analysis was no longer sufficient for valuing midstream stocks. While comparing dividend yields to bond yields has historically been a prominent valuation methodology, we argued it was increasingly outmoded given midstream’s historically low dividend payout ratios, and unprecedented levels of retained cash flow. Today’s low payouts have depressed volatility, reduced correlation to oil price, and they imply significant future dividend growth potential, a thesis we have already seen start to play out YTD. Looking at midstream earnings and cash flow yields, we see a sector that continues to offer almost 400 bps more yield than investment grade fixed income.

Please reach out for our new midstream white paper, which explores midstream’s excess (and growing) yield vs. fixed income and white paper on the long-term relationship between inflation and capex.

Performance review

During the month of May 2024, the Alma Recurrent Energy Infrastructure Fund generated net returns of +3.27%. Since the strategy’s July 2017 inception, Recurrent’s MLP &
Infrastructure Strategy has outperformed the Alerian MLP Index’s (AMZ) by +35.49% (+3.14% annualized), net of fees. On a gross basis, the Strategy has outperformed by +54.20% and +4.61% respectively.

Investment discussion

Midstream stocks have performed well since our July 2023 white paper, but remain historically dislocated
Our 2023 white paper explained that a simplistic dividend yield vs. fixed income yield (also known as “yield spread analysis”) was no longer sufficient for analyzing midstream stocks, as record-low payout ratios meant that a significant portion of the midstream value proposition was not captured by stated dividend yields.

Twelve and even six months ago, investors were expecting significant interest rate cuts by the Federal Reserve in 2024. With the prospects of 2024 rate cuts having faded, investment grade (BBB) bond yields have crept into the high-5% range, leading investors to again ask, “why bother with midstream and MLPs when they offer a comparable yield to BBB bonds?”

We would argue, that this comparison is misguided. Dividend yields, which have been structurally reduced, remain attractive vs. bond yields, although not historically so. However, earnings and cash flow yields, which more accurately depict the midstream value proposition, sit hundreds of basis points higher than they did during the 2000-2015 period, when IG bond yields were comparable to current levels. All three metrics – dividends, earnings, and cash flow – continue to grow at a healthy clip, as they have for the last 5 years.

While some investors say yields have normalized (they haven’t); others say they “missed the downturn”
Some investors believe that midstream yields have returned to “normal.” If 2000-2014 was “normal,” we can see that midstream is nowhere close to the yield valuations of that timeframe. Other investors have trouble bringing themselves to invest after the recovery has already taken place. But is the recovery over?

Many midstream investors believe that 2015-2020 was a unique dip-buying opportunity. Accordingly, many investors who didn’t invest during that timeframe believe they’ve “missed the move.” As is often the case, investors became fixated on “getting back to pre-COVID price levels,” while ignoring the fact that earnings have grown roughly 60% over this time. The reality is that midstream stocks have meaningfully underperformed earnings and cash flow growth during the last decade.

We’ve spent much of the last 7+ years debating midstream “bogeymen” with investors: ESG, the rapid obsolescence of fossil fuels globally, potential for hockey stick-style growth in renewables, the potential for hyper-fast EV adoption, COVID work-from-home patterns as a stimulant for rapid growth in renewables and Cleantech, potential government drilling bans, export bans, to name a few. We feel like many of these talking points have been exposed as more hype than reality, and there have been almost no signs that these oft-cited variables have impacted midstream fundamentals – cash flows and earnings – at all.

But the valuation metrics tell another story. The steep rise in midstream yields – at a time when bonds, utilities, REITs and other “real assets” yields have fallen – indicates that many of the (dispelled) risks which gained prominence during COVID still impact the way the market values midstream stocks. And that, we believe, is an opportunity.