Published on March 28th, 2017 by Nicholas McCullum
Joel Greenblatt is the co-Chief Investment Officer and portfolio manager of Gotham Asset Management, a hedge fund with ~$15 billion of assets.
Greenblatt has achieved fame among the investing community. This is partially due to his investing success, but also because of his critically acclaimed books You Can Be A Stock Market Genius, The Little Book That Beats The Market, and others.
Investors can benefit from Greenblatt’s investment expertise by investigating his 13F filings with the U.S. Securities & Exchange Commission, where Greenblatt’s fund must disclose its holdings on a quarterly basis.
Targa Resources Corporation (TRGP) is one of Greenblatt’s more interesting investments. The company has a current dividend yield of 6.4%, making it Greenblatt’s second highest yielding position.
Greenblatt’s fund controls 471,070 shares of Targa Resources Corporation with a total market value of $26 million.
This post will analyze Targa Resources Corporation in detail.
Targa Resources Corporation is one of the largest independent midstream energy corporations in North America with a market capitalization of $11.1 billion.
When Targa completed its IPO in 2010, the company was solely focused on the gathering and processing (G&P) subsector of the energy industry. Since then, it has grown into a fully diversified midstream services provider.
Targa’s corporate structure is as follows:
- Targa’s shareholders own Targa Resources Corporation
- Targa Resources Corporation owns Targa Resources Partners LP, an MLP
- The MLP owns assets in the midstream energy industry, dividend into two segments
This corporate structure is visualized below.
Source: Targa’s Presentation at the Wells Fargo Energy Symposium, slide 3
Targa Resources Corporation and Targa Resources Partners were independently-owned entities in the past. However, they executed a merger in February of 2016 and Targa Resources Corporation was the surviving entity.
The current entity reports earnings in two segments: Downstream and G&P. 70% of the company’s operating margin is fee-based in nature, which limits the exposure of this company to fluctuations in commodity prices.
Source: Targa’s Presentation at the Wells Fargo Energy Symposium, slide 6
Current Events: Acquisition of Delaware and Midland Basin Assets
Targa recently (3/1/2017) closed on the acquisition of the following group of midstream assets:
- Outrigger Delaware Operating LLC
- Outrigger Southern Delaware Operating LLC
- Outrigger Midland Operating LLC
Together, these entities will hereafter be called ‘Outrigger’.
For this transaction, Targa will pay $475 million in cash upfront as well as another $90 million within 90 days of closing. This represents a total initial cash consideration of $565 million, which is a 9x multiple of the 2017 expected EBITDA generated from the Outrigger assets.
Source: Targa-Outrigger Transaction Presentation, slide 3
The strategic imperative behind this acquisition is to complement Targa’s existing footprint in these regions.
Targa will benefit from the addition of 250,000+ acres of oil basin territory, as well as new contracts with high-quality customers that have a weighted average contract life exceeding 13 years.
Source: Targa-Outrigger Transaction Presentation, slide 4
Targa paid for this acquisition with capital markets financing and borrowing from a credit facility. Targa issued 9.2 million common shares at a price of $57.65 to help fund the transaction. For context, the company’s stock is currently trading ~1.4% below the issuing price.
The structure of the transaction appears beneficial for Targa’s shareholders. It is tiered in nature, with Targa delivering a portion of the payment up-front and the remainder based on the amount of realized gross margin from existing contracts during 1-year and 2-year periods after the transaction closes.
Source: Targa-Outrigger Transaction Presentation, slide 5
While Targa already had a presence in the geography where the Outrigger assets are located, there is minimal direct overlap. This improve Targa’s geographic diversification.
In the following diagram, Targa’s assets are in green and the Outrigger assets are in red.
Source: Targa-Outrigger Transaction Presentation, slide 6
The acquisition is expected to be immediately accretive to Targa’s distributable cash flow, and improves the company’s near-term growth prospects considerably.
Targa’s growth prospects come from continued internal reinvestment and industry consolidation.
As one of the larger players in the independent midstream energy sector, Targa is well-poised to acquire smaller companies experiencing financial distress due to low energy prices. One obvious example of this strategy is the Outrigger asset acquisition.
The company also earmarks a substantial amount of cash for capital expenditures. In fiscal 2017, Targa expects to spend at least $700 million on growth capex, which will be largely devoted to four major growth projects.
Details about Targa’s 2017 capex plans can be seen below.
Source: Targa Fourth Quarter Earnings Presentation, slide 11
Targa reported a net loss in fiscal 2016, but I expect growth to resume in fiscal 2017 and beyond.
Competitive Advantage & Recession Performance
Targa’s competitive advantage comes from its high-quality asset base which it continues to build through strategic acquisitions.
Targa was not a publicly-traded company during the Great Recession of 2008-2009, so there is no data available on the company’s performance during broad economic downturns.
However, Targa appears well-positioned from a financial perspective. This will help in case of an upcoming recession.
At the end of the first quarter, Targa reported a leverage ratio of 3.8x. Financial covenants allow Targa’s leverage ratio to increase to a maximum of 5.5x, which gives the company some room to breathe if a recession hits.
Further, Targa has current available liquidity of $1.9 billion. This is equal to ~17% of the company’s current market capitalization. No material amount of this liquidity will be eaten up by debt maturities in the near-term, as Targa has no senior note maturities in 2017 and only $251 million in 2018.
More information about Targa’s current financial positioning can be seen below.
Source: Targa Fourth Quarter Earnings Presentation, slide 9
Targa has a current dividend yield north of 6%. It is reasonable to be suspicious of the company’s ability to sustain this high payout.
In 2016, Targa’s dividend was covered by distributable cash flow by a factor of 1.1x. Targa also expects that the company’s dividend coverage ratio will exceed 1.0x for fiscal 2017. Targa’s dividend appear well-covered for now, but investors should keep an eye on the company’s coverage ratio.
Targa’s adequate dividend coverage and sound financial position mean that the company is well-prepared to endure the next economic downturn.
Valuation & Expected Returns
Total returns for Targa’s shareholders will come from dividend yield, valuation expansion, and earnings-per-share growth.
Targa’s current valuation cannot be meaningfully analyzed using the trailing price-to-earnings ratio because the company reported a $187 million loss for fiscal 2017. However, Targa’s valuation can be assessed by comparing its current dividend yield to its historical dividend yield.
The following diagram compares Targa’s current dividend yield to its historical dividend yield.
Source: Value Line
Targa’s dividend yield has come down a bit from its highs in 2016, but right now presents a historically attractive opportunity to buy this stock.
This also makes sense in light of Greenblatt’s investment in the stock. Gotham Asset Management first initiated its position in Targa Resources during the first quarter of 2016, when oil prices (and Targa’s stock price) were at rock-bottom levels. Back then, Targa could be purchase for $16. It trades for $57 today.
Looking ahead, there is a lot of uncertainty around Targa’s growth prospects. On the one way, oil prices appear to be rebounding due to a supply-demand rebalancing and discretionary efforts taken by OPEC. However, Targa continued to operate through the oil downturn and is increasing its asset base over time.
To gain context, it can be helpful to consider Targa’s historical growth rate.
The company grew adjusted earnings-per-share by more than 40% per year between 2011 and 2014 (an oil boom). Earnings then fell into the red when oil prices dropped.
I believe that investors can conservatively expect earnings-per-share growth in the range of 4%-6% for Targa Resources over full economic cycles.
This means total returns will be composed of:
- 6.4% dividend yield
- 4%-6% earnings-per-share growth
For total expected returns of 10.4%-12.4% in the long run. Returns may be higher than this (since Targa appears attractively valued) but may also be lower if oil prices fail to rebound as expected.
Targa Resources Corporation has been hammered by the decline in oil prices and reported an operating loss in fiscal 2016.
However, the company maintains sound financial positioning and still has access to a considerable amount of liquidity. Targa also closed on the acquisition of the Outrigger assets, which bolsters the company’s growth prospects.
Targa’s dividend coverage ratio is barely above 1.0x. The company may be at risk of a dividend cut if its economic conditions deteriorate further.
With all this in mind, Targa may offer outsized total returns for investors comfortable with the inherent risk of this company.
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