Oil crashes as severe as the one we are currently going through can make it difficult for many income investors to maintain a long-term perspective. Yet even as energy prices fall to their lowest levels since the financial crisis, there are still excellent long-term dividend growth opportunities out there, such as Phillips 66 Partners (NYSE: PSXP), whose management is guiding for 30% compound annual payout growth through 2018. Let's take a closer look at this midstream MLP and its specific plans for achieving this breathtaking dividend growth.
The first thing to understand about Phillips 66 Partners' plans is how its business model works. Its distribution -- a kind of tax-deferred dividend -- is paid out of distributable cash flow, or DCF, which is derived from long-term fixed-fee, inflation adjusted contracts with minimum volume commitments from its sponsor and general partner Phillips 66 (NYSE: PSX).
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Source: Phillips 66 Partners investor presentation.
Phillips 66 Partners' primary growth driver at this stage in its life cycle is from the dropdown acquisitions it makes from Phillips 66, such as its recent $1.1 billion acquisition of the respective 33.3%, 33.3%, and 19.5% interest in the Sand Hills NGL, Southern Hills NGL, and Explorer refined products pipelines it made in the first quarter of 2015.
Source: Phillips 66 Partners investor presentation.
Phillips 66's incentive for such dropdowns is twofold. First, it owns 69% of the MLP's limited units, so any increase in the distribution means a direct financial benefit to itself. However, since it also owns 100% of the incentive distribution rights, or IDRs, then Phillips 66 will receive 50% of all distributions paid out by Phillips 66 Partners above $0.244 per unit per quarter, giving it further incentive to grow its MLP's payout as quickly as possible.
Just how big of a potential growth runway are future dropdowns? According to Tim Taylor, Phillips 66 Partners' president, Phillips 66 has an organic growth project backlog of over $20 billion, and according to Bob Herman, senior vice president of operations, about $8 billion to $9 billion of that figure is in midstream projects to be completed through 2018-2019 that would generate $1.3 billion to $1.4 billion in additional annual EBITDA and bring Phillips 66's total midstream annual EBITDA to around $2.3 billion.
In other words, if Phillips 66 were to drop down all of its upcoming midstream projects over the next three to four years to Phillips 66 Partners, it would increase its MLP's annual EBITDA 1,164%.
Or put another way, the 30% distribution growth that management is guiding for through 2018 should be an easy target to hit. However, Phillips 66 Partners may be able to sustain some of the best long-term distribution growth in its industry far longer due to its second growth strategy.
Organic growth projects and a low cost of debt capitalOnce Phillips 66 Partners buys a midstream asset from Phillips 66, it can then invest in expanding it. In fact, it currently has plans to invest $275 million through the end of 2016 and $604 million in total liquidity -- $104 million in cash and $500 million in an untapped credit revolver-- with which to accomplish it.What's more, management believes it may be able to expand its credit revolver by 50% to $750 million; the better to grow the MLP in the future.
Another important aspect of its future growth is its cost of debt capital. The average midstream MLP has a debt-to-EBITDA ratio of 5.7, but Phillips 66 Partners' management is more conservative, preferring to target a long-term debt-to-EBITDA ratio of 3.5 to protect its investment-grade credit rating.
That has helped it to achieve an average borrowing cost of just 3.64%, and since MLPs must fund expansion with a combination of both debt and equity, it helps lower its weighted average cost of capital; thus raising its overall profitability and allowing for faster long-term distribution growth.
Finally, lest investors worry that falling unit prices mean that Phillips 66 Partners will have to sell more an outrageous amount of equity to fund its growth capital -- which would excessively dilute existing investors and threaten to slow future distribution growth -- you can take heart from the fact that Phillips 66 Partners has held up remarkably well during the oil crash.
Takeaway: Phillips 66 Partners' business model and growth runway mean its distribution's hypergrowth is probably safeWith a 2.7% yield, Phillips 66 Partners is among themost expensiveof midstream MLPs you can buy today. However, given its top-notch sponsor and one of the best long-term distribution growth prospects in it's industry, it's well worth considering as an addition to any diversified income portfolio.
The article 2 Ways Phillips 66 Partners Plans to Keep Growing Its Dividend originally appeared on Fool.com.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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