Description

I believe HESM, a recent IPO, is an attractive long – I expect it to outperform the MLP universe by ~20-25% over the next year, for a ~30% total return, or a ~$33 price target.

The idea here is pretty simple. Basically, “captive” midstream MLPs like HESM have a tendency to dramatically outperform the broader MLP universe (proxied by the Alerian) for the first year of their public life, for a variety of technical reasons. Furthermore, I believe HESM’s structure is inherently pretty attractive – its initial dividend of 4.7% is essentially locked in through the unique contracts it has with HES, its parent, and its goal of increasing its annual distributions by 15% is extremely achievable for many years given very high visibility on dropdown-able assets equal to 4x their current EBITDA.

What is a “captive” midstream MLP?

I have defined “captive” midstream MLPs as MLPs with the following characteristics:

• Sponsored by a parent/GP that is a refiner or an E&P firm

• Has the vast majority of revenue coming from long-term contracts with that GP

• Has a guaranteed growth pipeline of additional dropdown-able assets from their parent

In recent years there has been a variety of these “captive” MLPs taken public by refiners and E&P firms. The idea is that these firms have had to build midstream infrastructure to serve their core business (E&P firms need gathering systems to get oil/gas from the wellhead to larger pipelines, as well as gas plants and other processing assets; refiners need to build pipelines to get oil into the refinery and move refined products out, and need to utilize storage), but the public markets typically have not rewarded them for the value of this infrastructure. To remedy this, it is often attractive to IPO these assets in a tax-efficient structure like an MLP, and then to sign long-term contracts with the MLP to ensure use of that infrastructure over a long period of time. The sponsor also typically retains LP units and a GP/IDR interest, helping to align interests between the sponsor/MLP and to give them the ability to benefit from future growth in the MLP.

So what? Why should I care?

Simply put, you should care because captive MLPs tend to dramatically outperform the broader MLP index over their first year of trading. Below is a list of all post-2009 MLP IPOs (n = 44) and their performance over the first year of their trading life. On the whole, recently-IPOed MLPs tended to generate healthy outperformance, with 16% outperformance vs. other MLPs:

However, note what happens when we separate out captive MLPs (n = 16) from all other MLPs. While non-captive MLPs still generate some outperformance (7%), the captive MLPs really shine, with an average outperformance of 31% over their first year.

For reference, here are the captive MLPs I am using in my dataset (note: NBLX hasn’t been public for a full year so I am using outperformance  to-date)

I believe this outperformance is driven by a very common event path over the first year:

• Generally not “hot” IPOs – initial investors are MLP specialists, don’t get hyped or a 1st day “pop”

• Sell-side picks up coverage shortly after and is almost always very bullish, driven by a desire to get in mgmt’s good graces for future debt/equity raises (almost a certainty for MLPs)

• Payment of first full dividend causes the MLP to finally “screen” for a  dividend yield

• Index inclusions – Alerian MLP ETF owns 7% of the free float of its components – getting included here is like hitting the jackpot

• Strong GP alignment through IDRs + dropdown portfolio allows for significant year-1 increases in the dividend, causing the MLP to screen even better (higher div yield, faster growth in div)

• Opening of float through dropdowns makes MLPs investible for larger investors, and increases ownership from ETFs (which generally own a % of float)

Okay, you’ve convinced me of the trading dynamics – but what do I actually own here? Is the dividend safe?

In addition to the trading dynamics of captive MLPs, I believe HESM’s fundamentals are pretty attractive as well. HESM’s initial dividend of $0.30/sh (4.7% yield) is essentially locked-in due to the presence of two fairly unique components of the contract with HES – minimum volume commitments (“MVC”), and a fee recalculation mechanism.

But first, to step back a bit – what is HESM?

HESM basically consists of a 20% ownership of all of HES’s midstream operations in the Bakken. The remaining 80% is owned by Hess Infrastructure Partners (“HIP”) which is a JV between HES and Global Infrastructure Partners (“GIP”), a PE firm. GIP purchased a 50% JV stake in HES’s midstream assets in June 2015 for $2.7B. This JV creates a pretty unique incentive structure where the GP parties (both HES and GIP) are both incented to increase the value of the IDR, but the presence of GIP at the GP helps ensure that HES doesn’t take undue advantage of HESM in their operating agreements – HES does not control the board (HES has 3 seats; 2 to GIP, 3 to independents). Essentially you get alignment on the positive incentives (increase distributions) without some of the conflicts of interest inherent in the normal GP/LP relationship (screw the MLP to benefit the GP).

The assets include all of the gathering, processing, storage, and terminaling/export facilities necessary to get HES’s Bakken production to market. Currently HES generates 105MBOE/d, or 33% of its global production from the Bakken play, and believes that can go to 175MBOE/d over time. Estimated recoveries from the HES’s Bakken acreage is 1.6BBOE, or 42 years of production at current rates.

HES has signed a series of LT contracts with HIP/HESM with the following characteristics:

• 10 year initial term, with 10 year option to renew following that (note: contract start date was 2014 so there are 7 years left in the initial term)

• Minimum volume commitment equal to 80% of HES’s development plan on a 3-yr forward basis

• The way this works is that every year, HES lays out its updated long-term Bakken development plans for the next 10-20 years – the minimum volumes guaranteed to HESM are then equal to the greater of the prior agreed-upon minimum volume and 80% of the new plan

• In other words, HESM knows exactly what minimum volumes will be over the next 3 years – these commitments cannot be decreased but can go up if production estimates under subsequent years increases

• Because HES’s drilling plan got cut back post-2014, production volumes are currently slightly below minimum volumes – therefore, results for the next year are essentially locked in @ the minimum volumes with no downside

• CPI inflation adjustment – escalator each year equal to the change in CPI, with a +3% growth ceiling and a floor equal to current price levels

• Fee recalculation mechanism – this mechanism effectively insulates HESM from longer-term variances against HES’s expected volumes

• Essentially, the rates that HESM gets paid per boe/mcfe get adjusted to reflect longer-term, structural changes in HES’s expected volumes

• The end effect is that HESM’s cash flows are effectively utility-like, with a guaranteed return on capital over the life of its contract

• Potential upside to these utility-like returns is still available to HESM from a few sources:

• Incremental capital invested

• Incremental 3rd party volumes (HESM already processes meaningful non-HES volumes under its contract with HES)

• Some upside sharing if nominated volumes increase meaningfully

• Overdeliveries on nominated volumes

The stability of this structure allows management to have very high confidence in their initial dividend. In the IPO prospectus, they include NTM projections with dividend coverage increasing from 1.05x in the Q2 2017 to 1.23x in Q1 2018. Notably, 96% of the revenues under these projections are backed by the MVC with HES.

Okay, I understand that their contracts get you to a safe 4.7% yield – but what gives you confidence they can increase the dividend at 15% per annum?

Management has guided to a 15% per annum increase in their dividend rate. The reason they can be so comfortable in this guidance is because of the fairly unique structure that HESM has – essentially they only own a 20% economic interest in their operating assets. The remaining 80% is still owned by HIP, which is a JV between HES and GIP. The ownership structure is below.

That’s a slightly scary chart, but the important thing to take away is that HESM has a meaningful dropdown opportunity of the remaining 80% interest in the assets they already control – in fact, they have a ROFO on this interest. The nature of dropdowns like this is that they are inherently very accretive to distributable cash flow, made even more so because HESM currently runs debt-free – I model out four separate drops of 20% each, increasing EBITDA from $84M (Q1 2018 PF) to $429M, and increasing the dividend 72% from $0.30/sh @ 1.2x coverage to $0.52/sh @ 1.2x coverage. I can walk through my assumptions in more detail in the Q&A but suffice to say I do not think I am being particularly aggressive.

So with 72% accretion available just from dropping down the remaining 80% interest in their existing assets, HESM has high visibility into 15% distribution growth for at least 4 years.

Captive E&P-sponsored midstream MLP comps currently trade at yields between 3.5 – 5.2% (excluding PTXP which now is stranded), and Alerian components with moderate dividend growth expected (0-10% over the next year) trade at a 5.8 – 9.2% yield (and most have exposure to commodity prices/volumes so should trade at a higher yield). Pro forma for the dropdown of the remaining 80% interest in its assets, HESM would be trading at an 8.2% yield, which seems very attractive given the stability of its cash flows and supports a ~30% total return over the next year.

Catalyst

Sell-side initiations; declaration of first dividends; initial dropdowns, index inclusions; opening up of float