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Morningstar | Initiating Coverage on Modestly Undervalued DCP Midstream; We Like Its DJ Basin Position

We are initiating coverage of DCP Midstream with a fair value estimate of $47 per unit and no-moat and stable trend ratings. Our fair value estimate implies a 2019 enterprise value/EBITDA ratio of 9 times and a 2019 distribution yield of 6.6% as the partnership reports it. If we include both limited partner and general partner distributions in the distribution payout, as peers do, our yield increases to close to 10%. Adjusting for the general-partner take rate, our 2019 EV/EBITDA ratio is 11.8 times, a similar valuation to peers that have eliminated incentive distribution rights.

DCP Midstream is well-positioned to benefit from the surge in U.S. natural gas liquids production and exports in the coming years. DCP, in our view, represents a leveraged bet on the growth prospects of U.S. NGLs, given its high financial leverage, volume-dependent asset base, and extensive marketing operations, where it benefits from NGL differentials.

The partnership's simplification transaction in 2017 created one of the largest gatherer and marketer of NGLs in the United States, with an asset base of gathering and processing assets across the Permian, Eagle Ford, SCOOP/STACK, and DJ Basin. In turn, DCP has leveraged its asset base to make growth investments in pipelines, including the important Sand Hills project, which will take advantage of quickly growing Permian NGL production and the Permian Gulf Coast Express, which should capture growth opportunities in Permian gas. Further, the partnership's DCP 2.0 investment in technology has improved asset optimization, reliability, and real-time decision-making. The example of increasing Sand Hill's capacity by 35 thousand barrels per day with no incremental capital investment (beyond those in technology) resonates.

Despite the partnership's position in the Permian, where we expect significant growth amid attractive well economics, we actually think its DJ Basin assets are more attractive. The entity's 45% market share in G&P by our estimates as part of a midstream duopoly means competition for new investment opportunities is minimal as competitors would need to build both G&P assets and pipelines due to the ability for DCP to block connections, lowering returns. This environment has allowed DCP to pursue incremental investments in several underutilized pipelines (Southern Hills, Front Range, Texas Express) to take advantage of expected NGL growth in the basin. The opportunity is not only in the expansions totaling 240 mb/d, which we expect to be contracted, but also in addressing the existing underutilization of the combined pipelines totaling around 230 mb/d, providing substantial additional potential earnings uplift. However, investors should keep in mind that DCP is more exposed to shifts in commodity prices than peers are, with about 20% of its 2018 gross margin unhedged and not fee-based.

For more on our NGL forecast, please see our July Energy Observer "The Natural Gas Liquids Rubik's Cube Solved."