Western Midstream Partners: Guidance Doesn’t Reflect Long-Term Opportunity (NYSE:WES)

Too Much Of A Good Thing

Western Midstream Partners (NYSE:WES) followed up last month’s pleasant surprise of a 12.5% distribution increase with the negative surprise of a $100 million, or 5% downward guidance to EBITDA in their 2Q earnings release. Paradoxically, the change was attributed to new wells coming on line and performing better than expected, as discussed on the earnings call.

Several new wells that came online during the second quarter outperformed relative to initial expectations and this outperformance led to challenges across the production chain, specifically with producer-based wells. Based on discussions with our producers and after analyzing their revised forecasts, we expect these issues to be temporary in nature, but will continue into the second half of 2023.

As such, we expect total average year-over-year throughput growth to increase at a slower pace than initially expected. These revised throughput expectations for the remainder of the year will result in WES coming in below the low end of our previously disclosed 2023 adjusted EBITDA guidance range.

Source: CEO Michael Ure, WES 2Q 2023 Earnings Call

Throughput growth forecast for the year was also revised down, from mid-single digits to low single digits for natural gas and from mid-twenties to upper teens for produced water.

This prompted a rating downgrade from overweight to neutral at JPMorgan (JPM). The market reaction was a slight (2.5%) decline in unit price. It appears any breakout from the $23-$29 range in which the partnership has traded since the start of 2022 remains on hold.

It was the JPM analyst who articulated better than anyone else on the call how strong performance of the new wells could result in lower throughput for the system:

Jeremy Tonet

I just wondered if you might be able to expand a bit more on the operational issues that were experienced during the quarter. It seems like the stronger well performance that kind of choked back the legacy wells as far as the flow is concerned.

Management’s answer was basically to confirm the analyst’s interpretation. While a little more operational detail would have been nice, the explanation sounds reasonable. With thousands of miles of gathering lines in West Texas’s Delaware Basin, it can be a challenge to balance the flows and pressures when new wells come on producing more than expected.

The good news is that this issue does not appear to reduce the longer-term growth plan. It only defers it a bit into 2024. Based on prepared remarks, the performance of the new wells could even be an upside to throughput in future years.

…we remain confident in our producer’s ability to deliver on their volume expectations over the long run and these recent well results further support our belief that our assets service some of the best rock in the Delaware Basin.

In fact, based on the outperformance of these recent wells, we expect higher base production in future periods coupled with a lower overall decline rate.

CEO Michael Ure, WES 2Q 2023 Earnings Call

The recent distribution increase is a better indicator of future performance than the downward guidance that is limited to 2023 results. The partnership has added 950 million cubic feet per day of firm volume commitments in the past year. This is supported by capex on a third train at the Mentone gas processing plant starting up in 1Q 2024 and the North Loving plant, online a year after that. This higher base distribution would probably cause a bigger negative market reaction if cut than a missed special distribution. It is unlikely the board would have agreed to it without confidence in the underlying throughput growth.

Distribution Outlook

WES was able to pay a special distribution in 2023 because it had excess cash and met the debt/EBITDA leverage target of 3.4 at the end of 2022. I noted last quarter that WES had issued new debt putting this year’s lower leverage target of 3.2 possibly out of reach. Since then, the partnership paid off its revolving credit facility, eliminating a variable interest loan in a rising rate environment. The partnership also continues to nibble away at some of its senior note issues, buying them back below par in the open market. As a result, I now expect WES to reduce total debt in 2023 but unfortunately the lower EBITDA guidance now puts a 2024 special distribution at risk.

If WES catches back up to my expectations for higher throughput in 2024 and beyond, there is a good chance the partnership can hit the leverage target of 3.0 and pay a special distribution in 2025. It also appears that WES will have the capability to increase the base distribution by $0.25/year each year, hitting $3.00, or $0.75 quarterly by the second half of 2026. This would be a record high, surpassing the payouts prior to early 2020. I have updated my earnings model based on the latest guidance.

Earnings Model Update

I revised down the EBITDA forecast for 2023 by $68 million to $2 billion to match the midpoint of guidance. The partnership has not provided guidance for later years. For 2024, I am assuming 1.5% higher EBITDA than in last quarter’s model despite the lower 2023 starting point, due to the higher production from new wells. EBITDA then grows 5% per year in 2025 and 2026. I also increased capex for 2023 to $750 million from $675 million and left future years unchanged.

I now assume no unit buybacks in 2023 due to the temporary operating headwinds. I assume the $1.25 billion of buybacks authorized in 2022 has its end date extended one year to the end of 2025. WES has no debt due in 2024. Of the $1073 million due in 2025, I assume WES pays off $397 million and refinances the rest. This would take leverage down below 2.6 at the end of 2025. I also assume WES pays off all its debt due in 2026. This is conservative, as it takes debt/EBITDA leverage to 2.3, well below what is needed to maintain a BBB rating. If the partnership refinances in 2026 instead, it would free up cash for growth capex, M&A, or further distribution increases.

At $28, WES yields 8.9% based on 2023 distributions, including the special. I expect the yield to exceed 10% in 2025 and 2026 based on the current price.

Bond Update

Since last quarter, WES bond yields have increased by around 30 basis points. This is less than the corresponding 60-80 basis point increase in similar maturity Treasuries. This narrowing spread represents increased confidence in the partnership from the credit markets.

The increased base distribution along with the potential for growth in future years, even without a special in 2024, makes the equity a better deal than the bonds for income investors.

Conclusion

Western Midstream’s expected slow growth in 2023 slowed even more with operating issues bringing production from new wells into the system. Once these issues are resolved, the new wells provide a stronger base for throughput growth in 2024 and beyond. Any negative reaction based on this year’s guidance seems short sighted. While the lower 2023 guidance reduces the chance of a special distribution in 2024, the recent increase to the base distribution demonstrates management’s confidence in future growth. It now appears the base distribution can grow by about $0.25 per year especially as further deleveraging becomes unnecessary.

Unit prices have been steady in the $23-$29 range since the start of 2022. I don’t expect any breakout above the top of this range in the near term thanks to the recent guidance cut. I still think WES is a Buy however, due to the higher base distribution and potential for further growth.