Why This Newly Minted Stock Could Be a Gold Mine for Income Investors

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Last fall, big oil giant BP (NYSE: BP) provided income-seeking investors with a new option to consider by completing an initial public offering (IPO) of a vehicle to operate and acquire its U.S. midstream assets. The company, aptly named BP Midstream Partners (NYSE: BPMP), is a master limited partnership (MLP) that currently owns stakes in several of BP's pipeline assets.

This brand-new income stock offers investors a golden income opportunity. The MLP recently declared its initial distribution, implying a yield of 6.1%. However, it sees that payout rising by a mid-teens annual rate through 2020, with ample growth potential beyond that time frame, which positions it to create meaningful value for investors in the coming years.

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A built upon a rock-solid foundation

BP seeded its MLP with stakes in several pipelines that provide it with stable cash flow. The most important is BP2, which is an onshore pipeline that moves oil to one of BP's refineries. While only 12 miles long, the line should supply BP Midstream with 41.8% of its cash flow this year. It's one of three onshore pipelines the company owns that also moves refined products and diluent, which helps dilute heavy oil produced from Canada's oil sands. BP Midstream also owns stakes in several pipelines that transport oil and natural gas from offshore facilities in the Gulf of Mexico to the Gulf Coast through a 20% stake in the Mardi Gras system and a 28.5% joint venture interest in the Mars oil pipeline. Mars is the second-largest contributor to cash flow, supplying an anticipated 29.2% of this year's total. Overall, these assets should provide BP Midstream with steadily increasing cash flow for the next few years due to the long-term contracts and regulated tariffs supporting the pipelines.

Those assets supplied BP Midstream with $23.3 million in cash available for distribution in the fourth quarter, which was enough to cover its high-yielding distribution by a comfortable 1.2 times. Providing further support for that payout is the fact that BP Midstream had only borrowed $15 million of its $600 million in available credit, giving it a microscopic debt-to-EBITDA ratio of 0.6. That's well below its 3.5 times target, which is less than the 4.0 times comfort level of most MLPs.

Following a successful blueprint for income growth

BP Midstream's current portfolio of pipelines should supply it with enough organic cash flow growth to raise its distribution at a 5% to 6% annual rate through 2020. However, it expects to increase the payout at a much faster mid-teens pace by acquiring additional midstream assets from BP. With ample liquidity in its credit facility and a long way from hitting its leverage target, the company certainly has the financial flexibility to start making deals, with the first one anticipated in the second half of 2018. The companies expect to complete one dropdown transaction each year, subject to market conditions.

BP Midstream currently holds the right of first offer on BP's pipeline assets for seven years. However, BP owns more than just pipelines that it could sell to its MLP and diversify its business in the coming years including storage terminals, loading docks, and its fuels distribution service business. Still, in the near term, the company will likely focus on acquiring pipelines from its parent, including buying the 80% of the Mardi Gras offshore oil and gas pipeline system it doesn't currently own.

This strategy of acquiring assets from a large parent company to grow an MLP's payout has worked well over the years. Refining giant Phillips 66 (NYSE: PSX) has been one of the most successful with this strategy since creating Phillips 66 Partners (NYSE: PSXP) in 2013. At that time, Phillips 66 launched an ambitious plan to grow its MLP's distribution at a 30% compound annual rate through 2018 via a steady stream of dropdown transactions. Phillips 66 Partners is right on target, having increased the payout at a 31% compound annual growth rate since the IPO while maintaining solid financial metrics, including covering the payout with cash flow by a very comfortable 1.33 times last quarter and maintaining a conservative debt-to-EBITDA ratio of 3.2 in 2017. This strategy has also richly rewarded investors in Phillips 66 Partners, which has generated a total return of 89% since its IPO despite a recent sell-off, easily ahead of the S&P 500's nearly 73% total return over that time frame.

Income with ample upside

BP Midstream Partners already offers a decent yield of more than 6% that it can increase at a mid-single-digit rate over the next few years just from the embedded growth of its current assets. However, what makes it a potential gold mine for income investors is the company's plan to acquire additional assets from BP. That strategy will diversify its portfolio and provide accelerated income growth potential, which could fuel a market-beating total return for investors in the upcoming years.

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Matthew DiLallo owns shares of Phillips 66. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.