Like their E&P brethren, midstream companies want to attract greater investment from generalist and others.

After a big gain of about 12% in January, midstream equities slowed down with the Alerian MLP (AMZ) index now up nearly 16% year to date, analysts with Raymond James said in a report discussing the 2019 MLP and Energy Infrastructure Conference held in Las Vegas in mid-May.

A disconnect is discernible between public and private valuations of the AMZ group, within both asset and corporate level valuations, according to the Raymond James report, which also noted the conference’s tone was more optimistic than in recent years.

Highlighting the state of affairs is the recent $6.5 billion acquisition of Buckeye Pipeline Partners by a private-equity firm for a greater than 25% premium. This variance in public vs. private markets “suggest that private markets are paying as much as about two turns more than that of publics on asset deals,” the analysts said. “The data also suggests that asset level deals are getting a similar premium on corporate deals.”

RELATED: Buckeye Partners Sells At Premium To International Infrastructure Investor

The Raymond James team’s research indicates that public equities are trading at a discount and M&A will increase. Perhaps more important, however, the analysts think that for more funds to flow into the midstream space and bolster equities, “we need to see further evolution of the midstream financial model—including eliminating the ‘growth for growth’s sake’ mentality from the midstream group.”

Similar to E&Ps, midstream companies will have more luck wooing investors, particularly generalist ones, if they focus on capital allocation and near-term and sustainable free cash-flow generation.

The Raymond James team constructed a hypothetical midstream company to try to answer the question of what the appropriate amount of capex spending is for a midstream stock. Using these baseline metrics, the analysts came up with this answer: “…a fairly generic midstream entity should only spend about 40% of its distributable cash flow on growth capex on average over a five-year period.”

Raymond James also gauged its covered midstream stocks’ financial flexibility. “This was spurred on by the idea that midstream stocks may not only have to be free-cash-flow positive, but also generate free cash flow after paying out the existing dividend.”

After applying a variety of calculations to the group, the analysts came up with the estimated change in the average yield from 2019 through 2021. “With the 2019 to 2020 yield improving from about 1% to 4%, this analysis basically tells us that 2019-2020 is the transition period for most of our stocks,” the analysts said. “In short, midstream financial models are in the middle innings of their evolution.”

The upshot of the current investor focus, throughout the energy space, on capital discipline and free cash flow is that hurdle rates “need to be much higher,” according to the report. This year and next, the industry should largely catch up with takeaway constraints; then “we’d hope to see the midstream group transition to quicker-to-cash, higher return optimization and bolt-on growth—this concept would make integration more important than ever.”

As to how midstream companies can lure generalist investors, the answer again echoes that of E&Ps: It revolves around free cash flow and the ability to compete on that metric with the broader market.

Raymond James expects the sector to achieve this, not in 2019, but by 2020 and 2021. “We expect midstream to far outpace the historical S&P 500 average in 2021,” the analysts said. The team believes the midstream space will perform more strongly overall, but current top picks are Enterprise Products Partners LP, Energy Transfer LP as well as Plains All American Pipeline LP and Plains GP Holdings LP.

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