Image source: Shell Midstream Partners.
Unlike many midstream MLPs during the oil crash, Shell Midstream Partners (SHLX) has managed to hold up remarkably well thanks to some of the fastest distribution growth in its industry.
SHLX Total Return Price data by YCharts
Read on to find out why Shell Midstream's dividend is likely to continue its torrid growth rate for the next few years, and also what risks could derail that dream.
Fast asset growth continues unabated by oil crash
Image source: Shell Midstream Partners investor presentation.
On May 17, Shell Midstream Partners said it was acquiring additional interests in three pipeline systems owned by an affiliate of its sponsor, Royal Dutch Shell (RDS.A).
The $700 million deal will leave Shell Midstream with not just increased, long-term contracted cash flow, but also additional future acquisition opportunities, given that its ownership stake in the Bengal and Colonial pipelines will still come to only 50%, and 6%, respectively.
To fund the dropdown, Shell Midstream is selling an additional 10.5 million to 12.1 million units as part of a $350 million to $400 million equity raise, with the rest of the acquisition funded with debt.
While this secondary offering does represent dilution of about 12% to current investors, the price the MLP is paying, 8.8 times next year's projected adjusted EBITDA, means the deal is expected to immediately boost distributable cash flow per unit. That, in turn, should allow Shell Midstream not just to continue its short but impressive track record of payout growth, but also to maintain a strong coverage ratio that allows for retaining more future cash flow to fund internal growth.
Source: Shell Midstream Partners Q1 presentation.
Spectacular growth creating superb payout profile
| MLP | Forward Yield | Q1 2016 DCR | Long-Term Payout Growth Projections |
|---|---|---|---|
| Shell Midstream Partners | 2.8% | 1.40 | 28% |
| Phillips 66 Partners | 3.7% | 1.15 | 30% through 2018 |
| Valero Energy Partners | 3.2% | 2.0 | 24% |
| MPLX | 6.1% | 1.18 | 12%-15% in 2016 |
Sources: earnings reports, investor presentations, Fastgraphs.
Shell Midstream Partners doesn't offer the highest yield among other fast-growing refiner-sponsored MLPs such as Phillips 66 Partners, (NYSE: PSX), Valero Energy Partners (NYSE: VLP), or MPLX (MPLX 0.52%). However, yield alone isn't what determines long-term investing success.
In fact, yield is far less important than the sustainability of the distributions, for which the distribution coverage ratio is a key metric to watch to make sure distributions are well matched by rising cash flows. Similarly, strong long-term growth potential can be critical.
That's both because growing payouts drive long-term unit appreciation, but also because the midstream MLP business models requires at least some access to cheap equity growth capital, which is what allows the majority of distributable cash flow to be paid out to investors.
Of course, analyst projections or management payout growth forecasts are mere estimates, and investors need to think critically about how large and realistic the growth runway of an MLP is.
Long-term potential remains enormous, but ...
Image source: Shell Midstream Partners investor presentation.
Royal Dutch Shell, as one of the largest integrated oil giants on Earth, seemingly has an endless amount of midstream assets to potentially sell to its midstream MLP. In fact, only MPLX, which recently acquired MarkWest Energy Partners, and thanks to its vast access to the gas rich Marcellus and Utica shale, as well as Marathon Petroleum's midstream assets, has the potential to grow cash flows at consistently high rates for 10 to 15 years.
Of course, MPLX's $16 billion acquisition came with a massively increased debt burden, which brings me to two major risks that investors in fast growing midstream MLPs like Shell Midstream, Phillips 66 Partners' and Valero Energy Partners must guard against.
Watch out for these risks
Income investors love hyper-dividend growers such as Shell Midstream Partners because they promise sky-high payout growth that seems sure to generate market-smashing total returns. However, a torrid distribution growth can be a double-edged sword, potentially causing management to reach for growth with a potentially bad deal.
For example, MPLX's megamerger was supposed to ensure 25% distribution growth through 2020 but instead increased that MLP's cash flows to volatile natural gas prices and forced management to cut expectations for payout growth in half.
Similarly, Shell Midstream, Phillips 66 Partners, and Valero Energy Partners are all very young MLPs, with short operating track records. Thus, there's a risk that management could potentially either make a major mistake or even try to take advantage of the MLPs by selling them overpriced assets later down the line, should their sponsors hit hard financial times and need a sudden large capital infusion.
Even something as simple as attempting to grow too quickly can result in a Kinder Morgan-like scenario, where too much debt puts the payout at the mercy of creditors should energy prices move in the wrong direction. Thus it's important that investors watch to ensure that an MLP's balance sheet doesn't become over-leveraged to potentially dangerous levels (credit rating agencies usually prefer debt/EBITDA levels of 4.5 or less), or that new acquisitions don't stray too far from the MLP's existing business model.
Bottom line
Shell Midstream Partners has yet to prove itself over the long term. However, given its impressive cash flow, rich asset base, enormous growth potential via its sponsor's vast midstream holdings, and ongoing strong access to cheap growth capital, it's definitely one energy dividend stock worth considering for a long-term, diversified dividend growth portfolio.
