ETRN and the Mountain Valley Pipeline

#57: What the pipeline's completion means for Equitrans Midstream...

Last Saturday, as Biden signed The Fiscal Responsibility Act - the legislation extending the debt ceiling - the loudest cheers may have come from Canonsburg, Pennsylvania.

Southwest of Pittsburgh and a stone’s throw from the West Virginia border, Canonsburg hosts the headquarters of Equitrans Midstream Corporation (NYSE:ETRN) a major owner and operator of natural gas infrastructure. ETRN has a brief and complicated history as a standalone company. Originally carved out of the nation’s largest gas producer EQT Corporation (NYSE:EQT) in 2018, Equitrans has undergone a series of corporate reorganizations, material contract renegotiations, and name changes.

But ETRN is most well known as the operator and largest investor in the Mountain Valley Pipeline (“Mountain Valley” or “MVP”)¹. Mountain Valley is a 303-mile pipeline currently under construction, meant to take natural gas from the heart of the Appalachian Basin - home of the Marcellus and Utica shale formations - to the Transco pipeline, the nation’s most important natural gas artery spanning from the Texas Gulf Coast to New York City.

Despite construction being over 90% complete, the project has languished in legal limbo for years. Well-funded activist groups intent on obstructing any new fossil fuel infrastructure have pried at every legal opening - permits, environmental reviews, even jurisdictional arguments about the divisions of the Department of the Interior - in order to forestall completion.

With a sympathetic ear in the Fourth Circuit Court of Appeals, advocacy groups succeeded in preventing the completion of the project for years, resulting in ballooning capex budgets, extensive legal costs, and additional environmental liability by preventing remediation of stalled construction zones.

For ETRN, Mountain Valley long ago transformed from a marquee project to a $3.4 billion albatross. As the project cost and timeline doubled, the company accrued billions in debt, slashed its dividend and saw its share price fall by over 80% at the lows. After years of setbacks, the market had mostly written off the value of the project.

But ETRN’s fortunes reversed dramatically in the past week as MVP was one of several bargaining chips that made it into the debt-ceiling pact due to the efforts of West Virginia Senator and key swing voter Joe Manchin (D). Drafts of the legislation released last week showed that Mountain Valley would receive expedited approvals as a matter of national interest and any further judicial challenges would be moved out of the antagonistic Fourth Circuit, essentially clearing the way for the project’s completion.

The news sent ETRN soaring - up 55% since the draft of the bill hit the wire last week and up nearly 100% since the recent lows back in April. Yet for the such a transformational announcement, the stock has yet to break out of the historical trading range from the past several years.

ETRN share price performance since inception.

This week, we take a deeper look at ETRN, and decide whether it still has room to run.

Mountain Valley Upside

By statute, ETRN must be granted all outstanding permits by June 24, 2023, and the company now expects to complete the pipeline by the end of the year.

For the ETRN, it couldn’t come sooner.

Capex to Cash Flow: Having already spent $2.8 billion on the project, MVP capex has been an enormous cash drain for the company over the past decade without a dime of revenue to show for it. With roughly $600 million in capex left to complete the project, the company is finally close to unlocking $315 million in net annual EBITDA between Mountain Valley and two smaller expansion projects that will be placed in service upon MVP’s completion.

This two-way swing, from capex to cash flow comes just in the nick of time, as it will serve to offset declines elsewhere in the business.

Back in early 2020, ETRN renegotiated its commercial contracts with EQT - its largest customer and former parent - which gradually reduces the fee ETRN charges to EQT for transporting its gas volumes from over $0.62/mcf in 2020 to just $0.12/mcf by 2032². While ETRN gained higher minimum volume commitments (MVCs) and extended the length of the contracts as part of the deal, ETRN’s cash revenue will begin to fall materially over the coming years³.

The completion of MVP will trigger several other contract provisions with EQT, but assuming no growth in the base business (which has plateaued in recent years), the incremental EBITDA provided by MVP will merely maintain the company’s cash earnings over the next five years.

(Note: A full reconciliation of the projections is provided in the appendix.)

Absent MVP, ETRN’s shrinking revenues pose an immense challenge to the company already overburdened with leverage.

Leverage and Covenants: Completion of MVP is also critical for maintaining the financial covenants of ETRN’s Revolving Credit Facility, which includes a 5.50x Consolidated Leverage Ratio⁴. The calculation of this ratio is on a cash basis (including the effect of Deferred Revenue) and only pertains to consolidated company debt.

Upon completion of the project, ETRN and its partners intend to place project-level financing on the MVP JV that would result in a paydown of $800 - $1,000 million of consolidated debt at ETRN. With the pipe fully contracted under 20-year agreements with high quality off-takers, $800 million of JV debt (under 4.0x project-level leverage) should be achievable at a reasonable interest rate.

This maneuver has little economic consequence to the common shareholders, but greatly improves covenant headroom by adding roughly $180 million of JV distributions (MVP EBITDA less project interest) to the calculation of EBITDA, while also reducing ETRN’s consolidated debt by $800 million for the purposes of the leverage test.

Without MVP’s completion or other changes to the dividend or capital structure, the company will likely blow through its financial covenants within the next two years. Realistically, this means that the company will need to slash its dividend in the coming year if MVP does not come into service.

Again, we see that MVP is critical in maintaining good standing under its credit facility, ensuring ample access to liquidity for to fund growth projects or unbudgeted expenses.

Dividend Security: Maintaining the dividend is crucial for a company that trades primarily as a yield vehicle.

While ETRN will be cashflow negative in 2023 after funding the remaining MVP capex and before receiving revenues, the company should be able to finance the current dividend with internally generated cash flow thereafter, even without organic growth and against the headwind of declining EQT revenues.

When the company traded below $5 per share in April, the company’s $0.60 annual dividend represented a yield of over 12% - implicitly suggesting that a dividend cut was likely. But with the recent uptick in share price, the dividend now represents a 6.4% dividend yield, relatively in line with comparable publicly traded peers.

So, what is ETRN worth?