4D Infrastructure on the road: Key insights from our latest research trip

The share price performance of all US infrastructure sub-sectors, excluding midstream oil/gas, was disappointing over the course of 2023. This was possibly spurred by weaker earnings expectations through the year for some companies. But for many names, the negative share price reaction was despite the underlying companies delivering consistent earnings growth.

No doubt increasing US treasury bond yields increased the valuation discount rate expectations through the course of the year. Higher discount rates deflated valuations of many listed infrastructure companies, more so than the rest of the market. Some of the most affected areas were capital-intensive sectors such as regulated utilities and tower communication companies, which were among the most penalised by investors.

Looking into 2024, management teams seem less concerned about the negative impacts of cost inflation and rising interest rates on earnings expectations. They were buoyed by the prospect for rates to decline in 2024, and the potential for strong load growth from manufacturing, data centres and the tech sector generally.

Following are some of the insights about companies in these sectors, on the back of our recent research trip to New York, Houston, Tulsa, and Arizona.

Sub-sector insights: Towers communication

Concerns regarding the capacity of MNO customers to invest in the continued roll-out of 5G raised questions regarding the domestic leasing growth potential for tower companies in 2023. Some MNOs are now looking more financially healthy, which reduces this risk in 2024. However, the impact of contractual churn from the T-mobile/Sprint merger will continue to dampen earnings. The potential for long-term growth from small cells needs to be proven out over time.

Crown Castle (NASDAQ: CCI)

During the trip, we met with the Houston-based management team of the listed communications tower company, Crown Castle. The firm’s domestic focus is a key differentiator versus its two main competitors. CCI delivers non-organic growth through the rollout of small cell and fibre technology. This is intended to facilitate higher data demand levels through high-frequency bandwidth, predominantly in urbanised areas.

In the year to November 2023, the three listed communications tower companies had experienced a long period of poor share price performance, which began between 18-24 months earlier. Their poor performance was driven by a number of factors, including

• the companies’ initial high valuations;
• rising interest rates affecting their cost of debt and discount rates;
• reduced investment activity from the mobile network operators (MNO)) after 5G roll-outs; and
• contractual churn as a result of the merger between MNOs, Sprint and T-mobile.

Crown Castle has differentiated its investment proposition by investing extensively in the roll-out of fibre and small cells, committing approximately US$19.1 billion to this space since 2015.

Management acknowledges that cash yield to date (between 6-7%) has been lower than that achieved in the tower business, largely because small cells are averaging less than one tenant (one-two small cell nodes per mile of fibre). Capital investment to date has focused on laying fibre for anchor tenants in new markets, which is the most capital-intensive component of the small cells business. But it does provide a barrier to new entrants to the market where fibre already exists.

Management outlined that the remaining contracted small cell pipeline of 50,000 nodes, planned coming three to four years, will require less fibre to be laid. Demand for these small cells is being driven by higher customer demands for data and by rising uptake of artificial intelligence (AI), cloud computing, the Internet of Things (IoT), virtual reality and increasing usage of mobile video.

Sub-sector insights: Midstream oil and gas

Companies are optimistic going into 2024 based on the continued demand for oil, gas and NGLs in light of strong domestic demand for energy, and overseas supply concerns associated with geopolitical tensions. The sector is well positioned, with companies largely within their debt gearing targets, and with expectation of strong cashflow generation to be maintained.

During several days in Houston, Texas and Tulsa, Oklahoma I met with key oil/gas midstream companies. The share price performance for companies in this space were strong in 2023, with only a few outliers. Topics we discussed with management teams explored the potential of stretched valuations, the likely drivers of cash flow growth, and how companies will be allocating capital in the year ahead.

Key oil and gas basins supporting their optimism about demand growth in 2024 include:

• Permian,
• Bakken,
• Haynseville, and
• Marcellus/Utica.

North American midstream companies generally now have strong balance sheets and are producing free cashflows, often after consideration of discretionary capital investment. This provides flexibility for companies to withstand operational challenges and finance capital investment opportunities.

How are companies spending free cash flow?

The unanimous preferred option was to invest in growth projects associated with their existing business strategy to maximise future earnings growth. Making organic investments in existing networks, which enhance capacity for low capital cost, provides companies with attractive returns on invested capital (ROIC). This is also a low-risk investment, as companies are investing in enhancements where they have strong visibility of demand dynamics, and lower permitting requirements than greenfield projects.

Plenty of M&A

A number of M&A transactions have been announced by midstream companies in the past 12 months. Most of these transactions were to complement the companies’ existing asset footprints, with the potential for significant cost and revenue synergies to be extracted.

We believe management teams are selectively executing these transactions as a means to utilise excess cashflow, while acquiring complementary asset portfolios at attractive/reasonable valuations.

Oneok (NYSE: OKE) and Magellan Midstream (NYSE: MMP)

The most prominent midstream transaction in the past 12 months was Oneok’s acquisition of Magellan Midstream for stock and cash, valuing the business at US$18.8 billion.

Oneok management outlined they had to initially educate analysts as to the justification for the deal, but it seems well understood now. Their focus post-closing the deal has been to amalgamate teams and systems, which has resulted in the execution of cost synergies earlier than anticipated. They are very optimistic on the potential of the combined business.

Williams Co (NYSE: WMB) acquisition of Cureton Front Range LLC and 50% of Rocky Mountain Midstream holdings

On its Q3 earnings call, Williams Co announced the company had agreed to acquire Cureton Front Range and the remaining 50% of Rocky Mountain Midstream for a combined EV of $1.3 billion. With an implied EV/EBITDA of approximately 7x, this includes the potential to reduce the multiple over time through deal synergies.

The transaction was partially financed with proceeds from the sale of legacy ethane pipelines for $300 million, and $533 million in net legal litigation proceeds from a failed past merger attempt by Energy Transfer.

Kinder Morgan’s (NYSE: KMI) acquisition of South Texas assets

In early November, Kinder Morgan announced the acquisition of NextEra Energy Partner’s (NEP) South Texas assets, STX Midstream, for $1.82 billion. The STX Midstream system consists of seven pipelines that can transport 4.9 Bcf/d. NextEra's Texas pipeline portfolio provides natural gas to Mexico as well as to power producers and municipalities in South Texas.

The STX Midstream system includes 90% ownership of the NET Mexico pipeline and a 50% share in Dos Caminos LLC. The portfolio of assets is highly contracted, with an average contract length of over eight years. Approximately 75% of the business is supported by take-or-pay contracts.

NEP’s multiple is based on 2023 EBITDA, where Kinder Morgan has used 2024 EBITDA with a few very obvious synergies included. Alongside the full year run rate effect of an expansion project undertaken this year, we are suspicious of the longer-term earnings potential of STX Midstream’s assets and the post-maturity of existing contractual protections, due to their interconnection with a historically less favourable basin in the Eagle Ford.

Sub-sector insights: Utilities

Plateauing and potentially falling interest rates in 2024 should be supportive of valuations, which are currently at the lowest point since the start of Covid. This, combined with moderating regulatory concerns and strong earnings drivers, should provide a strong year for shareholder returns. At current valuations, a number of US infrastructure companies offer attractive implied shareholder returns. We prefer companies that offer quality asset exposures, predictable and steady earnings growth, and are valued below their estimated intrinsic value.

Electric and gas utilities

Most engagement with electric and gas utility companies occurred during the Edison Electric Institute (EEI) Conference, which was held over three days just outside Phoenix, Arizona. We had 16 meetings over the three-day period with companies based across the US.

The messaging from companies at this year’s EEI conference was a lot more optimistic than 12 months earlier. Energy demand in the US is expected to be strong over the medium term, driven by growing commercial and industrial (C&I) demand associated with onshoring of certain industries, and the buildout of data centres. This should support investment growth and provide a tailwind to earnings for some companies in 2024. It also diminishes the concerns of regulatory bodies around customer affordability – by sharing the network’s fixed cost base with new, high-load demand customers.

Specific examples of C&I and retail load growth includes:

• American Electric Power (NYSE: AEP) - increased 2023 normalised retail sales growth from 0.8% to 2.3%, largely driven by increased commercial growth from 0.8% to 7.3%. The company also doubled 2024 and 2025 retail sales growth to 1.7% and 3.3% respectively.
• Sempra (NYSE: SRE) - Texas power market, ERCOT, set 10 peak demand records in summer 2023, with a new all-time peak of 85 GW, representing 16% growth since 2018. Significant C&I growth in Oncor service territory evidenced by around 34% year-over-year increase in active transmission point of interconnection requests.
• WEC Energy (NYSE: WEC) - communicated strong manufacturing developments within its jurisdiction including Microsoft, Foxconn, and Amazon. Long-term retail power sales growth of 4.5% - 5.0% pa expected.
• Pinnacle West Capital (NYSE: PNW) – have communicated long-term demand growth expectations of 4.5% - 6.5%, driven by customer premises growth and manufacturing developments by companies such as a Taiwan Semiconductor company, Proctor & Gamble, Air Products & Chemicals, and KORE Power.

Almost unanimously, companies communicated significantly increased capital investment programs. The drivers of the increased investment programs include

• the aforementioned increased load growth;
• strong decarbonisation efforts supported by legislation;
• resiliency investment in light of storms and wildfires; and
• the impact of high inflation on regular replacement investment.

This increased capital investment is expected to support rate base growth at high single digits over the next five years or so.

Affordability concerns subsiding

Cost of living concerns have been front of mind for legislators and regulators in the US throughout 2023. Utility companies have had to manage these concerns through managing their operating costs, but were supported through reducing energy and commodity costs post the easing of the European energy crisis, providing a tailwind to prices. This aside, the inflationary environment did result in more scrutiny on business plans from regulatory bodies throughout the year.

Coming into EEI, companies were a lot more optimistic of their ability to manage affordability in 2024, and were hopeful this would support improved regulatory outcomes.

Water utilities

American Water Works (NYSE: AWK) attended the EEI Conference, which seemed a wise decision considering it was one of only two water companies to attend, so received significant investor attention. The messaging from management was:

1. increasing water/wastewater regulation was increasing pressure on small municipal water networks to amalgamate with larger players;
2. continued asset replacement investment was required; and
3. there was a legislative focus on reducing the intensity of ‘forever chemicals’ in water, which would require upfront investment and ongoing management costs.

Continued strong investment drivers

AWK outlined confidence in the continued investment needs of its various networks, and the capacity to grow rate base and earnings. It updated its five and 10-year capital plans, which increased $2 billion and $4 billion respectively since the last guidance provided by the company. The 10-year capital plan of $34 - $38 billion (excluding regulated acquisitions of municipal networks) to 2033 is expected to be the key driver of rate base growth of between 8-9%. This rate base growth incorporates an allocation to municipal network acquisitions but still represents one of the stronger growth rates of any utility.

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4D Infrastructure is a Bennelong Funds Management boutique that invests in listed infrastructure companies across all four corners of the globe. For more insights on global infrastructure, visit 4D’s website.

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