From an energy perspective, things are pretty good right now for the handful of countries that call North America home. That's because the continent is on the fast track to energy independence, which will arrive sometime in the 2020s. But why stop there? The continent will become a net energy exporter, too, thanks to a flood of cargoes leaving the United States.
That's all great news for a wide range of domestic energy companies ranging from oil and gas producers to pipeline operators to refiners. Investors looking to piggyback on the sweeping trend, while maximizing income, may be inclined to consider master limited partnerships (MLPs), which distribute nearly all cash flow to unitholders, especially those with stable and reputable "parent" companies.
Both Holly Energy Partners, L.P. (NYSE: HEP) and Phillips 66 Partners LP (NYSE: PSXP) fit the bill with 8.6% and 5.3% yields, respectively. They also are majority-owned by refiners HollyFrontier and Phillips 66, respectively. How do they compare, and which stock is the better buy?
Both MLPs were created to own and operate various midstream assets. These mostly are pipelines, but also include product terminals and even downstream assets such as specialized process units at refineries. The fee-based businesses often support the operations of their majority owners -- not technically parents, but basically parents -- all while using their status as MLPs to turn most revenue into profits and then distribute it to unitholders. Put another way, they may trade separately from HollyFrontier and Phillips 66, but essentially represent the midstream business strategy of each larger company.
Holly Energy Partners operates pipelines for refined products, crude oil, and intermediate products, in addition to terminals, storage tanks, loading racks, and refinery-processing units. The company's refined-products business remains the strongest, thanks to the broader trend in American exports of refined petroleum products.
The MLP has an impressive history of increasing its distribution every quarter since it went public in 2004. The business has steadily grown both revenue and earnings in that span, too. Operating income grew from $145 million in 2014 to $247 million in 2017, while operating margin swelled from 44% to 54% in the same period.
However, that trend may not prove sustainable indefinitely. Holly Energy Partners paid out 100% of its operating cash flow in 2017 compared to just 83% in 2014. For the distribution to continue rising, growth projects absolutely need to deliver higher earnings -- and soon -- or the MLP will be forced to continue taking on debt (close to $500 million in new net debt in the last two years alone). That risks inflating the leverage ratio to levels that make creditors uncomfortable, and could result in a downgrade.
Phillips 66 Partners shares many similarities with Holly Energy Partners. It owns similar operations (pipelines and special processing units at refineries), has increased its distribution per share every quarter dating back to its IPO in July 2013, and recently took on a boatload of new debt to fund growth projects.
However, Phillips 66 Partners paid out just 89% of operating cash flow in 2017, making it more sustainable than its peer in this matchup. It also has a better track record of growing its operating cash flow, which jumped 144% from 2014 to 2017, and distributable cash flow, which increased 60% in the last two years alone. By comparison, Holly Energy Partners reported a 29% increase in operating cash flow from 2014 to 2017.
In terms of distribution sustainability, Phillips 66 Partners is the clear winner. While it offers a lower yield, income investors can't really complain with 5.3% -- well ahead of the S&P 500. The company also boasts more favorable valuation and growth metrics than its smaller peer.
Phillips 66 Partners is expected to grow faster in the next five years than Holly Energy Partners and trades at a lower premium to expected earnings in the next 12 months. While the larger company is more expensive on an EV/EBITDA basis, that's mostly explained by its lower operating margin in 2017.
Which stock is the better buy?
It generally is the case that investments offering higher yields come with a higher degree of risk. While both of these MLPs offer relatively stable fee-based businesses, Holly Energy Partners is paying out all of its cash flow to unitholders. The worrisome part is that the coverage ratio has steadily slid toward one times cash flow, which hints that distribution increases could stop in the near future.
Given that Phillips 66 Partners has demonstrated its ability to quickly grow cash flows, along with its advantage on several growth and valuation metrics, I think it's the better buy in this matchup. Management's firm belief in the ability of growth projects to deliver higher earnings has led it to publicly declare that its intention is to grow the distribution at a rate that leads the peer group.
That said, it's also worth considering that neither stock has managed to beat the total returns of the S&P 500 in the last three years. Then again, investors interested in owning MLPs are likely making yield a priority. For everyone else, it may make more sense to simply own the index for the long haul.
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