Description

Bottom line
Rice Midstream is a recent, poorly-timed IPO that trades at a significant discount to peers despite owning an attractive portfolio of current and prospective assets that are not directly exposed to commodity price fluctuations. I believe a long position in RMP provides excellent current yield, exposure to upcoming volume growth from the two most economic shale gas plays in the US, and a significant margin of safety. My base-case valuation shows 30% upside after distributions, with bearish assumptions yielding 7% downside while returns can approach 100% given a constructive outlook.

Overview
Rice Midstream (RMP) IPO’ed in December 2014 holding midstream assets of Rice Energy (RICE), a gassy E&P operating in the Marcellus and Utica shales. Its main business is to gather natural gas produced at wells and bring them to larger trunklines, which then transport the gas to end markets for better price realizations.

Current assets include gas gathering pipelines in Pennsylvania supporting mostly RICE’s current Marcellus operations in the Washington and Greene counties, plus some third-party volumes; right-of-first-offer (ROFO) assets include RICE’s Utica gathering system in Ohio, addition pipelines to be constructed in both plays, and potentially water treatment systems which must await an IRS ruling to be considered “MLP-able”.

Discount valuation versus Appalachian MLP peers
RMP priced at $16.50 when it IPO’ed on December 19, significantly below the $19-$21 initial range, and is currently trading even lower at $14.26. At its current $0.75 annualized distribution, RMP trades at a yield of 5.26%, compared with Marcellus midstream peers Antero Midstream (AM) at 2.78%, EQT Midstream (EQM) at 2.64%, and Cone Midstream (CNNX) at 3.71%.


In the broad MLP universe, RMP is priced at a very high yield especially considering it does not have any direct commodity price exposure (like refining and fractionation MLPs). For reference, the Alerian MLP ETF (AMLP) is currently yielding 6.85% but with the index dominated by constituents with significant, direct exposure to commodity pricing.

Poor performance since IPO reflects low gas prices, depressed basis, and greater perceived sponsor risk
Natural gas prices have steadily declined in recent months, with Henry Hub font-month currently trading below $3/MMBtu, the lowest since 2012. This is especially stunning considering we are trading winter-month gas, when there is typically a seasonal premium. The main driver for low gas prices has been relentless production growth in the US as drillers improve efficiencies and benefit from technological improvements, along with the rapid volume growth seen from the Marcellus play in the past few years. That said, calendar 2018 gas forward swaps are trading at a stronger $3.75 level due to expected demand gains from LNG exports, greater industrial demand, and retirement of coal-fired power plants.

In addition to depressed Henry Hub pries, Northeast gas basis remains depressed due to a lack of takeaway capacity, creating sharply divergent gas values between producing basins and stranded demand centers. For example, Dominion South, which makes up 18% of RICE’s 2014 gas realizations, is currently trading below $2.25 for a discount of more than 50c to Henry Hub. Due to low NE gas prices, investors are uncertain whether Rice Midstream will continue to drill at the current pace which puts into doubt whether RMP can deliver the volume growth profile it promised ahead of the IPO.

RMP has a shorter trading and operating history than peers like AM and CNNX, and Rice is a smaller E&P than sponsors such as Antero and Consol. This likely resulted in the current valuation discount amid general turmoil in the broader North American and global energy industry.

Upcoming infrastructure projects to improve Northeast basis pricing and support RMP's growth projections
Independent of the macro outlook for natural gas prices, I believe the Marcellus and Utica will be the "last plays standing" in North America. Breakeven prices for the Utica and Marcellus dry gas windows where RICE operates are estimated at $2.30 and $3.20 by RBC, which compare very favorable against alternatives such as the Haynesville ($3.75), Eagle Ford gas window ($4.00), and Barnett ($4.75).

The discount discussed earlier for Northeast gas basis is set to narrow in coming years. A large backlog of takeaway projects including Texas Eastern (late 2015), Access South (late 2017), ET Rover (mid-2017), and Constitution (late 2015) will allow more gas production to leave the region and serve higher-priced end markets, especially in New England where winter prices can reach $20+ levels. These markets will be better served by cheap gas production only a few hundred miles away, while Marcellus producers will benefit at the expense of higher-cost basins that will no longer be shielded by transportation bottlenecks in the Northeast.

Within the Marcellus, RMP’s sponsor, RICE, is a strong operator which has among the lowest F&D costs in the Marcellus (#2 out of 8 according to Citi).

Together, this means that as long as Rice is able to maintain a cost structure and return profile in the top quartile of regional peers (which it has accomplished thus far), RMP will have adequate volumes to support its dropdown schedule and deliver ongoing cash returns to investors.

Strong hedging positions and balance sheet will carry RMP through near-term pricing pressures
To move through what admittedly could be a price-challenged year for gas 2015, Rice has established strong hedging positions. It has 84% of 2015 volumes hedged at year-end 2014 via both Henry Hub and Appalachian basis, and 245 BBtu/d of volumes hedged in 2016 at similar levels; more hedges were likely added opportunistically YTD during winter weather-driven rallies off lows.

RMP was structured with an ultra-clean balance sheet, with leverage likely to stay below 3x and a $450MM revolver. It will unlikely need to issue equity to fund future dropdowns, the first of which will probably be in early 2016 (after the Ohio gathering system comes online by year-end 2015).

Initial distributions intact and 20% CAGR 3-5 years out looks safe

Management affirmed in a recent capital expenditures guidance it will distribute $0.75 in 2015 while investing in projects that set the company up for solid distribution growth in 2016 and beyond. In other words, the recent sell-off in natural gas has not changed initial plans before the IPO and this is an opportunity to get long RMP during a period of depressed commodity prices and general fear of investing in the energy sector (which is much more oil-driven than gas-driven).

Given the strong outlook for RICE's production volumes and the healthy, visible backlog of ROFO assets that will be gradually dropped down from RICE, I believe a 20% annualized distribution growth rate starting in 2016 for 3-5 years is very achievable while preserving a healthy coverage ratio.

Additional upside optionality
RICE has water treatment facilities which could be potential dropdown candidates, but are currently pending an IRS review to determine their MLP-able eligibility. Sell-side analyst valuations do not currently assign any value to these assets and a favorable ruling could provide additional SOTP upside to RMP as the ROFO inventory would meaningfully increase.

There is also growing evidence that the Utica shale in OH extends into southwest PA, meaning there could be additional gas resources RICE has not yet booked in its inventory. This would provide additional incentive to ramp up RMP’s gathering volumes in the long term.

Aligned incentives
RICE, as the sponsor and GP holder, owns 50% of RMP units (subordinated) and has incentive distribution rights (IDRs) in place to boost distributions to increase the GP take. The current quarterly distribution is $0.1875, with the IDRs kicking in at $0.2156 (15% IDR), $0.2344 (25%), and $0.2813+ (50%).

In addition, the Rice family owns $1.2 billion in RICE stock, and family members run the C-suite and board of the company. Hence there is great personal incentives for managing RICE’s production growth and valuation by the owner-operators, and one of the best ways to do so is to highlight value in RMP.

Valuation scenarios
I believe RMP can trade at similar yields its Northeast gathering peers AM, CNNX, and EQM, which currently trade at an average of 3.04% and is arguably too cheap as a group given the still-strong volume outlook for the Marcellus and Utica on a 5-year horizon. Valuing RMP at a conservative 4.0% yield (1.14% discount to peers) on distributions of $0.75 per annum arrives at a $18.75 price target, or $4.49 upside from current prices; adding in 75c of current distributions yields a 30% return to extremely conservative valuations that do not give RMP credit for its fairly high-confidence growth profile.

My bear-case valuation assumes no distribution growth as RICE fails to deliver throughput volume growth and assumes RMP trades wider to a very depressed 6% yield 12 months out, for valuation of $12.50, or 12% downside after distributions.

My bull-case valuation assumes RMP can trade to peer group average of 3% and deliver on its growth targets, reaching distributions of $0.2156 in a year; this yields a price target of $28.75, for nearly 100% upside from current levels including distributions.

Sell-side analysts from Citi, RBC, Barclays, and others have a consensus $22 price target on RMP, which I believe is achievable but perhaps slightly too optimistic during 2015 amid a low gas price environment.

Current distribution yields
RMP - 5.00%
AM - 2.72%
CNNX - 3.53%
EQM - 2.32%
Peer average - 2.86%

RMP initial annualized distributions = $0.75 (20% annualized 3-5 year growth likely starting in 2016)

RMP base-case price target = $0.75/(4.00%) = $18.75
Total return = ($18.75 + $0.75)/$14.26 = 30%

RMP bear-case price target = $0.75/(6.00%) = $12.50
Total return = ($12.50 + $0.75)/$14.26 = -12%

RMP bull-case price target = $0.8624/(3.00%) = $28.75
Total return = ($28.75 + $0.75)/$14.26 = 97%

Key risks
-MLPs are interest-rate sensitive, and a structural rise in treasury rates could hurt RMP's valuation. I believe rates will rise slower than already tame expectations due to the sluggish global economy and currency wars along with risks of deflation in the next 3-5 years.
-RMP has no Minimum Volume Commitments (MVCs) that guarantee fees if RICE or other E&Ps do not ship enough volumes on its lines due to poor drilling economics, exposing it to decreases in throughput levels. It depends on RICE to deliver adequate drilling and volume growth to support its distribution target.
-Pipeline projects could be delayed by regulatory and environmental hurdles.        

Catalyst

Various pipeline projects to increase offtake capacity from the Marcellus and Utica plays; production results from Utica wells; asset dropdown announcements from parent RICE; IRS ruling on water treatment assets.