Markets & Finance

ONEOK: Burning Bright


Standard & Poor's likes the gas utility's valuation and dividend yield—and rates the shares strong buy

From Standard & Poor's Equity ResearchWe think that ONEOK's (OKE; recent price, $45) compelling valuation compared to its natural gas utility peers, combined with its good balance sheet and higher-than-peers dividend yield, make the stock attractive for purchase.

We expect the average price for natural gas utility stocks in our coverage to appreciate 18% over the next 12 months, assuming no changes to the fundamentals of the companies. As a result, we believe that ONEOK's stock has the potential for an 18% gain built into it. In addition, we think the company's fundamentals, quickly growing unregulated operations, discount valuation, and higher-than-peers dividend yield of 3.5% will attract investors to the stock and help drive the shares higher. We believe that ONEOK's fundamentals are solid and that the company's balance sheet provides the company with adequate financial flexibility.

By our analysis, ONEOK's business model provides the company with the ability to achieve EPS growth higher than the peer average. The company's three reporting segments provide both a stable base at the utility business, as well as a growth platform at the Energy Services segment and its mostly unregulated ONEOK Partners (OKS) subsidiary, which operates as a master limited partnership. ONEOK's regulated businesses have grown relatively slowly over the past 10 years, even though it purchased Texas' third largest distribution system in 2003, and Kansas' largest distribution system in 1997. However, growth in its unregulated businesses has been extremely strong, in our view, helped by both internal growth as well as acquisitions. As a result, the regulated businesses, which contributed 44% of revenues and 80% of operating income in 1996, made up only 19% of revenues and 32% of operating income in 2006. The company's unregulated businesses are now its main growth drivers.

The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

Company Strategy

ONEOK's two financial objectives of generating consistent and sustainable earnings growth and managing its balance sheet to ensure financial flexibility are driven by four key strategies. First, the company plans to develop and execute internally generated growth projects at ONEOK Partners. Second, ONEOK expects to focus efforts on improving profits at its distribution companies through continued rate case management and disciplined capital investment and expense control. Third, the company plans to continue its focus on physical activities at ONEOK's Energy Services segment. Finally, ONEOK aims to make strategic acquisitions and divestitures that provide long-term value to its shareholders.

ONEOK's gas utilities in Kansas and Oklahoma are the largest in each state, and its Texas utility is the third largest. The utilities operate in constructive regulatory environments where the most recent rate cases have been settled with rate increases enacted. ONEOK's utilities aim to improve return on equity to the allowed amount by disciplined capital investment, rate adjustment filings, and expense control and recovery.

ONEOK Partners has a large number of new or expansion projects under way. We believe these projects will lead to substantial growth in the partnership's earnings before interest, taxes, and depreciation and amortization (EBITDA). ONEOK Partners' cash flows are predominantly fee-based and the subsidiary expects 61% of its 2008 gross margin guidance of $886 million to come from fee-based business. The subsidiary expects commodity-based cash flows to be 33% of 2008 gross margin and spread-based margins to make up the rest.

We believe ONEOK Partners will try to keep this mix or make it even more fee-based through the addition of new or expansion projects. ONEOK Partners plans to spend $1.6 billion on projects from late 2007 through 2009, with a large majority of the spending occurring in 2007 and 2008. ONEOK Partners expects that the incremental EBITDA benefit from these projects will increase quickly to more than $300 million by 2010.

ONEOK's Energy Services segment delivers physical and risk management products and services through its network of contracted gas supply, transportation, and storage assets. The segment attempts to optimize storage and transportation capacity through the daily application of market knowledge and effective risk management.

We like ONEOK's strategy of building its unregulated businesses to drive earnings growth while maintaining and improving a solid earnings base in the regulated utility unit. We believe that ONEOK Partners is a well-run master limited partnership with continuing opportunities for growth. The retail-services business has a firm storage and transportation presence in the central states, in our opinion. We think the unregulated businesses are poised to drive EPS growth over the next three years.

Company Profile

ONEOK's operating income is almost evenly split between its three principal businesses. ONEOK Partners, which contributed 37% of 2006's operating income, will likely become the predominant business for ONEOK as we believe it will have the fastest growth in the future. ONEOK's regulated gas distribution segment contributed 32% of the company's 2006 operating earnings and its energy-services segment contributed 31%. Other corporate activities contributed less than 1%. Over the past 10 years, ONEOK has achieved an annual cumulative average growth rate (CAGR) of 20% in operating earnings through both internal growth and several substantial acquisitions.

Distribution

The regulated natural gas distribution utilities are comprised of Oklahoma Natural Gas (ONG), Kansas Gas Service (KGS), and Texas Gas Service (TGS). ONG and KGS are the largest gas utilities in their respective states, and TGS is the third largest gas utility in Texas. Together, these utilities serve more than 2 million customers.

ONG serves 800,000 customers with its 1,275 employees and 16,978 miles of pipelines. Its service territory encompasses one-half of Oklahoma. The utility recently implemented the first base rate increase for its customers in a decade through the July, 2005, $58 million rate hike. The new rates were the result of a settlement with customer groups. The utility also has a request for recovery of capital spending costs pending and an initial hearing is expected in January.

KGS, which was acquired in 1997, serves 642,000 customers with its 1,000 employees and 19,073 miles of pipelines. Its service territory encompasses two-thirds of Kansas. The utility implemented a $52 million rate increase in November, 2006, the result of a settlement agreement with customer groups. The increase was the first since 2003.

TGS, which was acquired in 2003, serves 550,000 customers with its 700 employees and 13,114 miles of pipelines. It is regulated mostly by the local jurisdictions in which it operates. In 2006, the utility received several regulatory approvals to implement rate increases totaling $5.5 million in 11 cities between Abilene and Fort Worth, in Port Arthur and surrounding areas, and other jurisdictions. Also in August, 2007, TGS filed for a $5.5 million rate adjustment with the city of El Paso and the municipalities of Anthony, Clint, Horizon City, Socorro, and Vinton.

In 2006, residential customers accounted for 62% of total gas volumes sold, commercial customers for 20%, industrial and public authority customers for 2%, and wholesale customers for 16%. Total volumes sold made up 47% of total volumes delivered and transportation customers made up the other 53%.

ONEOK Partners

ONEOK owns approximately 37.0 million common and Class B limited partner units, and the entire 2% general partner interest, which represents a 45.7% total interest in ONEOK Partners. ONEOK started consolidating OKS results on Jan. 1, 2006. ONEOK Partners gathers and processes natural gas and fractionates natural gas liquids (NGLs), primarily in the Mid-Continent and Rocky Mountain regions covering Oklahoma, Kansas, Montana, North Dakota, and Wyoming. ONEOK Partners owns pipeline and storage assets that gather and transport natural gas through regulated intrastate natural gas transmission pipelines and NGLs through regulated intrastate natural gas liquids gathering and FERC-regulated natural gas liquids gathering and distribution pipelines. The partnership also owns and operates interstate natural gas pipelines that primarily transport natural gas from the Western Canada Sedimentary Basin to the Midwestern U.S. through Midwestern Gas Transmission, Viking Gas Transmission, Guardian Pipeline and its 50% ownership in Northern Border Pipeline.

Recent transactions have helped ONEOK to transfer several operations to ONEOK Partners. In July, 2005, ONEOK completed its purchase of several NGL businesses in Oklahoma, Kansas, and Texas for about $1.35 billion. In September, ONEOK finalized the sale of its oil and gas production assets for $645 million. In December, 2005, ONEOK completed the divestiture of its Texas-based natural gas gathering and processing assets for $528 million.

In April, 2006, ONEOK finished acquiring the remaining 17.5% of the general partner interests in ONEOK Partners while transferring its gas gathering and processing, pipeline and storage and natural gas liquids operations to OKS. ONEOK received about $1.33 billion in cash and approximately 36.5 million limited partner units as a result of the transfer and paid $40 million for the increased general partner interest. We think this transaction generates cash for ONEOK to reduce debt acquired during its purchase of the natural gas liquids assets in 2005.

We see these transactions (taken collectively) as furthering ONEOK's strategy of focused growth in geographically integrated NGLs and gas gathering and processing operations. We also view these businesses as well positioned to offer steadier and lower risk long-term growth opportunities than E&P operations. Additionally, the company should be able to increase its midstream operations through ONEOK Partners and its limited partnership structure, which, in our view, provides a strong platform for expansion and growth of these businesses.

As the general partner, ONEOK is set to receive incentive payments of 15% of quarterly amounts distributed in excess of $0.605 per unit, 25% of amounts in excess of $0.715 per unit, and 50% of amounts in excess of 93.5 cents per unit. On Jan. 15, OKS increased its quarterly distribution to $1.025 per unit, providing ONEOK with a healthy incentive distribution.

Energy Services

The Energy Services segment historically focused on natural gas trading, maintaining gas storage capacity, but it has diversified in recent periods into power, crude oil and NGLs trading. The segment has 96 billion cubic feet (Bcf) of leased storage capacity with 2.4Bcf per day (Bcf/d) of withdrawal and 1.6 Bcf/d of injection capacity rights. In addition, the segment has 1.7 Bcf/d of leased transportation capacity. The company uses these assets directly to meet customers' baseload, swing and peaking requirements.

Valuation

After reaching an all-time closing high of $55.27 on July 20, 2007, the stock has traded down 18% compared with a 16% decline in the S&P 500 Gas Utilities Index and a 13% decrease in the S&P 500, as of Jan. 25, 2008. We believe the sell-off has provided an attractive buying opportunity for investors.

We expect ONEOK's EPS to achieve three-year cumulative average growth of about 12%, substantially higher than the company's peers. Our 2007 and 2008 EPS estimates are $2.76 and $3.11. In addition, we think the company has a strong balance sheet and cash flows, which gives it financial flexibility. In our opinion, this flexibility should allow ONEOK to continue raising its dividend every half-year. Additionally, the company recently repurchased 15.2 million shares for a total of $671.5 million, or an average of about $44 per share. With its strong cash flows and long-term debt to total capitalization currently near 61%, we believe ONEOK is in a good position to continue periodic share repurchases, should it desire.

Recently, ONEOK's stock traded at 14.5X our 2008 EPS estimate, or at a small discount to the company's gas utility peers. Given our view of the company's financial flexibility and above-peer-average earnings growth expectations, we believe the stock should trade at a premium multiple to peers. Our 12-month target price of $57 reflects a P/E multiple of 18.3X our 2008 EPS estimate, a slight premium to our 12-month peer target P/E of about 17.4X 2008 EPS expectations. Our peer target multiple reflects our expectations for normal multiple expansion over a one-year period.

Corporate Governance

Overall, our view of ONEOK's corporate governance is positive. Some of the practices we view favorably are that the board is controlled by a supermajority of independent directors; the performance of the board is reviewed regularly; the audit and compensation committees are entirely comprised of independent outside directors; and officers and directors have a vested interest in ONEOK, owning a combined 1.3% of the outstanding stock.

However, an area of concern for us is that the chairman of the board and CEO roles can be filled by the same person, which we believe presents a potential conflict of interest. Although the board is composed mostly of independent directors, we have some reservations that it is classified into different classes, which we think tips the balance of power to incumbent management since it makes it more difficult to change control.

Investment Risks

Risks to our recommendation and target price include weak natural gas trading results, mild winter weather, a prolonged decline in natural gas prices leading to lower levels of well development, low gas-fired power margins, and a sharp rise in interest rates.


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