Strong Upside Potential for This MLP

Chesapeake Midstream Partners will head to market later next week, and will attempt to raise $425 million from its scheduled IPO. Morningstar analyst Avi Feinberg believes the firm has some competitive advantages stemming from its assets and long-term contracts, and he thinks the high end of its proposed offer range (at $21 per share) is the floor for his fair value estimate. He estimates the fair value of the firm at $21-$25 per share, and gives his full take on Chesapeake below:

"Chesapeake Midstream (CHKM) follows in the footsteps of  Quicksilver Gas Services  and  Western Gas  as a midstream master limited partnership with fee-based contracts spun off from an independent producer. We like CHKM's stable cash-flow profile and think it fits well with the MLP model, thanks to the relatively mature production profile in its gathering areas and its 20-year fixed-fee contracts with  Chesapeake  and  Total (TOT).

"CHKM also benefits from a 2.0%-2.5% annual fee escalation built into its contracts, which promote slight growth even if volumes are flat. While we don't expect rapid volume growth in the near term from Chesapeake's Barnett and Mid-Continent assets, where CHKM operates, we think CHKM's long-term growth prospects remain bright. Chesapeake continues to plow capital into midstream infrastructure to support its Haynesville, Marcellus, and Fayetteville shale drilling programs with the intent to eventually drop the midstream assets down to the partnership. This strategy makes a lot of sense to us; by maintaining greenfield development at the parent level, Chesapeake takes on the more capital-intensive stages of midstream development, dropping down the assets only after their cash flows have ramped up enough to support a stable distribution.

"CHKM's risk profile also closely mirrors those of KGS and Western Gas. The biggest risk is CHKM's concentrated dependence on Chesapeake, which provided 95% of CHKM's volumes in 2009. Financial distress at Chesapeake would almost certainly filter down in the form of weaker volumes. CHKM also faces indirect commodity exposure, as persistently low gas prices would likely slow Chesapeake's pace of drilling. While CHKM does have minimum volume guarantees, these cover less than a third of 2009 throughput. Another risk, common to all MLPs, is CHKM's dependence on the capital markets to finance growth projects. Finally, CHKM will face the typical midstream operating risks of leaks, fires, explosions, or other environmental impacts.

"We think CHKM deserves a narrow moat rating based on its assets, long-term contracts, acreage dedications, and sponsorship from a strong producer with a growing trove of potential drop-downs. Chesapeake cannot direct its production in dedicated areas of the Barnett and Mid-Continent to any other gatherer, but equally important, Chesapeake wouldn't want to as the general partner and holder of the incentive distribution rights of CHKM. We note that with production of 1.5 billion cubic feet per day in 2009, CHKM is among the largest pure-play gas gatherers in the industry, and Chesapeake may be the largest gatherer including its other midstream assets. We think this scale could help CHKM attract third-party volumes in its gathering areas, but CHKM's lack of processing capabilities limits the benefits of this scale.

"In terms of valuation, we'd estimate that CHKM units are worth roughly $21-$25 each based on similar multiples and yield to those implied by our fair value estimates for KGS and Western Gas. We think the comparison to Western Gas is especially relevant, as CHKM and Western Gas have similarly low debt levels and bright growth prospects thanks to visible drop-down opportunities. We thus assume CHKM's enterprise value is worth about 9.5-11.5 times the company's estimated $300 million of EBITDA for the 12 months ending June 30, 2011. To arrive at our equity value, we subtract 10% of this enterprise value to account for the general partner's claim on future cash flows, similar to our GP valuation for both KGS and Western Gas.

"Our valuation range would imply an annualized yield between 5.4% and 6.6% based on CHKM's minimum quarterly distribution of $0.3375 per unit. It makes sense to us that the yield is a bit lower than the yields for KGS and WES at our respective fair value estimates, as CHKM has no debt, and thus the greatest ability to speed up distribution growth through accretive debt-funded projects. We expect that over time CHKM will migrate its capital structure toward the midstream MLP industry standard of 50/50 debt/equity."

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