Written by The Dividend Sensei, (https://dividendsensei.com/)
One of the best way for income growth investors to profit from rapid payout growth is to get in on the ground floor of a great midstream MLP IPO. That’s because these stocks tend to enjoy sensational distribution growth on the order of 20% to 40% annually which can lead to long-term total returns of 30+%. Recently Rattler Midstream Partners (RTLR) filed its S-1 form, setting the stage for what I consider to be the most exciting MLP IPO of 2019. Find out why I’m so excited and planning to add it to my high-yield income growth retirement portfolio next year.
Rattler Midstream Partners: An Exciting IPO To Watch In 2019
On August 7th, Rattler Midstream Partners filed an S-1 with the SEC informing investors that it intends to sell $100 million worth of stock during its IPO (no data specified by almost certain in 2019). Rattler Midstream is an MLP formed by Diamondback Energy (its sponsor), one of the dominant oil & gas producers in the red hot Permian super basin in West Texas, and New Mexico. According to analyst firm RS Energy, the Permian holds about 250 billion barrels worth of oil equivalent, including half which can be economically recovered at just $40 per barrel oil (currently $72.5). Thanks to those low break even prices production from the Permian is expected to double over the next five years to over 6 million bpd. For context that’s more than the entire US produced in 2008, from just one shale formation.
In the last three years Diamondback (FANG) has tripled it oil production from the Permian. And that’s hardly the most impressive thing about Diamondback’s growth. Since its 2012 IPO Diamondback spent over $5 billion on buying land in the Permian basin, and was thus able to grow its EBITDA/share by 800% over the past 6 years. That’s during a time when average oil prices fell 23%. As a result the oil company’s stock price rose 600%, outperforming not just almost all other oil stocks but the S&P 500 as well. And recently the company announced it was buying rival Energen in a $9.2 billion deal that will be immediately accretive to EPS. More importantly that deal (brings the total to eight acquisitions totalling $15 billion in six years) will nearly double Diamondback’s Permian acreage and make it the third largest pure play oil producer in America. In fact, the company’s daily oil production will jump to 215,000 barrels per day, a 616% increase from 30,000 bpd in early 2015.
Diamondback management says the Energen acquisitions will increase its low cost drillable sites by 60% (from less than 3,000 to over 7,000), which analysts believe should allow it to increase oil production at a 20% annual rate for the next few years. Most importantly the oil company plans to fund all future growth with cash flow, which is sustainable and low risk strategy that should deleverage its already industry leading balance sheet. To make that kind of super growth possible Diamondback will need rapid expansion of its midstream (gathering, processing, storage and transportation) infrastructure which is where Rattler Midstream Partners come in.
At IPO Rattler Midstream will own:
- 528 miles of pipeline across the Midland and Delaware Basins with approximately 216,000 Bbl/d of crude oil gathering capacity
- 589,000 Bbl/d of saltwater disposal, or SWD, capacity
- 740,700 Bbl/d of freshwater gathering capacity
- 36,000 Mcf/d of natural gas compression capability
- 150,000 Mcf/d of natural gas gathering capacity
In addition the MLP will have the right to acquire a 10% equity stake in the EPIC long-haul crude oil pipeline. This will run from the Permian to the export facilities on the Texas Gulf Coast.
Rattler Midstream’s distribution (which will be taxed as a qualified dividend for tax purposes) will be supported by highly stable contracted cash flow with Diamondback that will have 15 year terms (expiring in 2034). Better yet, unlike most new MLPs Rattler will have no incentive distribution rights or IDRs. These are rights that grant the sponsor up to 50% of marginal cash flow above certain quarterly distribution rates. This means that Rattler Midstream will immediately have lower costs of capital that will allow it to grow faster, more profitably (EBITDA margins on current assets are 70%) and increase its payout at a faster rate for longer. How fast might that payout grow? Well we have no growth guidance as of yet, but given that the MLP’s revenue and EBITDA is growing at over 170% per year it’s safe to assume it will be one of the fastest payout growth rates of any MLP or income stock in America.
Even more attractive is that Rattler plans to be a self funding MLP from the start. That means funding its rapid asset growth through retained cash flow and modest amounts of low cost debt, rather than equity issuances. That means its growth potential will be 100% independent of fickle equity markets and its distribution coverage ratio is likely to be among the highest in the industry. Management also says that its top priority is to pay sustainable and growing distributions out of free cash flow while maintaining low leverage (debt/EBITDA). This makes Rattler’s business model one of the most conservative and low risk in the midstream industry.
And for those income investors who hate K1 tax forms that usually come with MLPs, you’ll be happy to know that Rattler will be using a 1099 form, and paying qualified dividends as far as the IRS is concerned. That will make this MLP safe to own in retirement accounts and mean simpler tax preparation each April.
The bottom line is this new MLP is likely to debut with a generous, safe and fast growing payout that should result in excellent (20% to 40%) long-term annualized total return potential. This is why I’m so excited about this IPO and plan to add Rattler Midstream to my portfolio soon after it begins trading next year. But of course before buying any stock, much less an IPO, you need to be comfortable with the risk profile.
Risks To Consider
There are three risks to consider before buying into an MLP IPO. The first is most obvious, which is that with no track record to speak of investors can’t necessarily know ahead of time what kind of yield or payout growth they can expect.
In the case of Rattler Midstream the highly conservative nature of this MLP, specifically its plans to self fund its growth with free cash flow (not retained DCF like most self funders in the industry) might cause it to generate slower distribution growth than other hyper growth MLPs like Oasis Midstream (OMP), Noble Midstream (NBLX), or Antero Midstream (AM, AMGP). However, the lack of IDRs and Diamondback Energy’s massive growth plans in the red hot Permian basin means that most likely investors will see at least 10% to 15% long-term payout growth and possibly 20% to 30% early on.
However, anyone interested in investing in RTLR must be comfortable with the fact that at least for the first few years the MLP will be extremely dependent (initially 100%) on just one oil company, operating in just one shale formation, for its cash flow. While that cash flow is locked up under long-term contracts RTLR will not enjoy any minimum volume commitments. This means that in the event of another oil crash, its sponsor might run into financial trouble or pull back on production enough to cause a fall in its cash flow. That doesn’t necessarily mean that Rattler would be facing a distribution cut, if the distribution coverage ratio is high enough. Management’s plans to self fund with free cash flow means that the coverage ratio should be among the highest in the industry (possible 1.8 to 2.2) which should allow the payout to survive a recession or oil downturn. That’s because in the midstream industry a coverage ratio of 1.1 is considered safe, and most self funding MLPs have coverage ratios of 1.2 to 2.0.
However, until Rattler is able to diversify its cash flow stream to third party oil producers, it will always be at risk of a worst case scenario in which Diamondback Energy might go bust. The odds of that are low but not zero. That’s because Diamondback has a BB (junk bond) credit rating, though that is likely to improve given the low 1.1 debt/EBITDA (leverage) ratio. For context the industry average for oil & gas companies is 3.0 and Diamondback’s interest coverage ratio (operating cash flow/interest) is 16.5. That’s compared to 10.6 for most of its peers, showing the company is very easily able to service its debt.
But the point is that as exciting as Rattler Midstream’s growth potential might be, investors will want to carefully watch this newest of MLP’s to see what kind of long-term payout growth, distribution coverage, and leverage ratio guidance management provides when it goes public next year.
Bottom Line: Rattler Midstream Partners Is A Potentially Exciting IPO To Watch In 2019
Many income investors understandably shy away from MLPs due to their complex structure (including incentive distribution rights) and K1 tax forms. Rattler Midstream, when it IPOs in 2019, will have none of these downsides. It will be treated as a corporation for tax purposes (so no K1) and having no IDRs to raise its cost of capital and slow its long-term payout growth. Combined with the rapid long-term growth plans of its sponsor, Diamondback Energy, in the booming Permian basin, this means that Rattler Midstream may soon become the fastest growing MLP in the country. Which in turn means this stock might prove to be one of the best performing income growth investments of 2019, the next few years, and possibly the next decade.
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