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This Dividend-Paying Energy Stock Thinks Its Shares Are Dirt Cheap

By Matthew DiLallo – Oct 6, 2020 at 8:17AM

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With market conditions improving, it's using its free cash flow to gobble up its beaten-down stock.

This year has been a bit of a whirlwind for Targa Resources (TRGP 0.75%). Like most energy companies, the midstream service provider made drastic changes as oil prices plunged earlier this year, slashing both its dividend and capital spending program to shore up its balance sheet. That put a lot of pressure on its stock price, which has plummetted nearly 65% this year.

However, the company thinks the sell-off is overdone, especially given the significant improvement in its financial profile and market conditions. That led it to authorize a $500 million stock repurchase program to gobble up a meaningful amount of its beaten-down shares. 

People making calculations with a stock chart in the foreground.

Image source: Getty Images.

Bouncing back faster than anticipated

Targa Resources recently provided investors with an update to its outlook for 2020. The midstream company noted that despite the impacts and uncertainties caused by COVID-19, its "overall business performance has been strong." That leads it to believe its 2020 adjusted EBITDA will be at or around the high-end of its revised outlook of $1.5 billion to $1.65 billion. That would also put it right around the low-end of its initial forecast range of $1.65 billion to $1.75 billion, which is a strong result considering all the turmoil in the energy market this year as volumes have improved faster than anticipated. 

Meanwhile, the company also noted that capital spending would be at the low-end of its revised budget range of $700 million to $800 million, which is even further below its initial forecast of $1.2 billion to $1.3 billion. With earnings at the high end and spending coming in toward the bottom, Targa Resources is on track to generate additional free cash flow this year. That's giving it the funds to pay down debt and the flexibility to launch the $500 million buyback program.

A bottom-of-the-barrel valuation

That buyback is an excellent use of cash, given the deep discount in the company's valuation. With shares tumbling 65% this year, Targa's current market capitalization is down to around $3.5 billion, while its enterprise value is about $14.6 billion. Thus, the company sells for less than nine times its enterprise value to EBITDA, which is a cheap level since midstream companies have historically traded at a mid-teens EBITDA multiple.

Because Targa sells at such a low valuation these days, its $500 million buyback could retire more than 14% of its outstanding shares at the current price. That disconnect "provides us with an attractive opportunity to return value to our shareholders," according to comments by CEO Matt Meloy in the press release announcing the repurchase program.

The buyback will also put the company's reset dividend -- which still yields an above-average 2.8% -- on a firmer foundation. That's because it will pay that dividend across fewer shares as it retires them.

Meanwhile, the repurchase program won't affect Targa's continued focus on improving its financial flexibility by reducing its leverage. It currently has lots of cushion given that its leverage ratio stood at 4.1 times debt-to-EBITDA at the end of the second quarter, well below its 5.5 times covenant with lenders. Meanwhile, it has $2.1 billion of liquidity and minimal debt maturing until 2023. Because of those factors, it has plenty of time and flexibility to use some of its additional free cash flow to buy back a chunk of its beaten-down stock.

A high upside energy stock

Investors have all but abandoned the midstream sector this year following another devastating crude price crash. However, the industry has weathered this storm much better than investors initially feared, which is evident by Targa Resource's operations update. That's giving it the confidence to use some of its extra free cash to repurchase its deeply discounted stock. This program could fuel a meaningful boost in its share price in the coming months, enhancing its total return potential when adding its still-attractive dividend. That makes it a potentially high-rewarding opportunity for investors willing to take on the risk.

Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool recommends Targa Resources. The Motley Fool has a disclosure policy.

Stocks Mentioned

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Targa Resources
$74.95 (0.75%) $0.56

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