Too Much Gas in This Stock's Price

Despite some of the enthusiasm we hear for  Pembina Pipeline (PBA)/(PPL) and its 3.8% yield--as measured by ever-increasing price targets from some of our peers--we continue to view the shares as overvalued.

Our $32 and CAD 36 fair value estimates are based on a 50/50 blend of a discounted cash flow model and expected dividend stream. The DCF values Pembina at $31 or CAD 34 per share, while the dividend stream values it at $33 or CAD 37 per share and assumes 4% annual growth to 2018 and 5% thereafter. In this Stock Strategist, we want to review first-quarter results and then provide additional commentary on Pembina's valuation and what we think it would take for the current share price to match a possible valuation scenario.

Our fair value estimate incorporates a 95% increase in Pembina's operating margin by 2018, in line with management guidance, with the inclusion of uncommitted capital. In addition, it includes recent project announcements (such as the RFS III) and a propane export terminal in 2020. We find the share price appreciation in response to the RFS III and HVP pipeline announcements as unwarranted and bordering on irrational, given the limited EBITDA uplift from HVP (CAD 2 million-3 million on 2015 EBITDA of CAD 1.2 billion) and widely telegraphed costs and timing for RFS III.

Pembina reported strong results for the first quarter and increased its monthly dividend 3.5%, slightly behind our estimate of 4%. The company reported a CAD 350 million operating margin, well ahead of our CAD 268 million estimate. Excluding the volatile midstream business, the quarter would have been in line with our estimates. We do not consider the quarter's results as indicative of long-term performance for this business unit, and as a result, we are maintaining our fair value estimates of $32 and CAD 36 per share and our narrow Morningstar Economic Moat Rating.

The margin for the midstream business unit was CAD 209 million, a 63% increase from the prior year and well ahead of our estimated 1.5% margin increase to CAD 130 million. Pembina does not disclose how much is tied to fee-for-service revenue versus exposure to commodity and frac spreads. However, we estimate that the margin associated with its fee-for-service businesses accounts for CAD 100 million-110 million, split between the largely fee-for-service crude oil and natural gas liquid units, with the NGL unit being responsible for majority of the commodity exposure. This implies that the estimate-beating results are due to commodity exposure, which is largely tied to propane prices.

According to Morningstar's commodity data group, propane prices reached a five-year high of $1.67 per gallon Feb. 10 before collapsing to $1.04 today; during the quarter, prices averaged $1.31. While the dual impact of cold weather and wet crops boosted propane prices in late 2013 and early 2014, we do not believe this is indicative of a trend.

As a result, we think it is responsible to err on the side of history and caution by maintaining our estimated 10.4% annual average operating margin (excluding the 13.5% margin for the first quarter of 2014) for Pembina's midstream business.

Even if we assumed the unusually strong midstream margin was maintained, our fair value estimate would only climb to $37 or CAD 41, with a further uplift of $2-3 or CAD 2-3 possible on account of a higher dividend that the increased margin could support. We do not view this as plausible and believe the midstream margin is already contracting.

The most likely scenario for a boost in our fair value estimate relates to stronger margins for Pembina's pipelines, storage, and unit train loading, in addition to new project developments. We believe many of the announced pipeline expansions (in particular the Phase III Expansion project) will pull higher-paying noncontracted spot volumes onto lower-paying long-term fee-for-service tolls. We need to be careful not to view near-term margin strength in the pipeline business units as indicative of long-term trends when new/expansion pipelines come on line.

As a result, we believe our bull-case scenario, which values Pembina at $39 or CAD 43 per share, is representative of the upside for the firm under a rather aggressive--but not implausible--growth scenario. This scenario includes additional growth projects such as further pipeline expansions and five new gas plants, which are not included in uncommitted capital. We caution that the success of these new projects is extremely reliant on exploration and production success in areas such as the Duvernay and Montney.