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Energy's Biggest IPO This Year

Matthew DiLallo, The Motley Fool

The name may have tipped you off: The recently public Rattler Midstream (NASDAQ: RTLR) is closely tied to Diamondback Energy (NASDAQ: FANG). In this week's episode of Industry Focus: Energy, analysts Nick Sciple and Matt DiLallo explain what investors need to know about how this company operates, why Diamondback spun Rattler out on its own, how Rattler's ties with its parent company help and hurt its long-term prospects, risks to watch out for, and more.

Also, the hosts look at the latest acquisition by Brookfield Infrastructure Partners (NYSE: BIP). Tune in to find out what Genesee & Wyoming (NYSE: GWR) does for Brookfield, and why the Brookfield family of companies should definitely be on your radar if they aren't already.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on July 11, 2019.

Editor's note: At one point Nick Sciple misspoke; he should have said: "But when we look at Rattler Midstream, this is the first IPO of a midstream company in 2019; we didn't have any in 2018."

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, July 11, and we're breaking down Brookfield Infrastructure's acquisition of the Genesee & Wyoming railroad, and we're diving into the biggest energy IPO [initial public offering] of 2019 so far. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Matt DiLallo via Skype. How's it going, Matt?

Matt DiLallo: Going pretty well. How you doing?

Sciple: I'm doing all right. We were just chatting before the show: You just moved into a new house. How has life been treating you these couple weeks? I know it's probably pretty stressful, unpacking a lot of boxes. What's life been like for you?

DiLallo: Oh, yeah, it's been incredibly busy, boxes everywhere. I think we move boxes two or three times just to get to another box that we want. It's been stressful. I'm exhausted. But it's nice to be in a new place.

Sciple: Exactly, exactly. It's the whole process. Once you get there and actually get the stuff physically there, it's all downhill. We'll see how long it takes to get those last boxes unpacked.

We've got a good show today. First story I want to talk about is: Earlier this month, Brookfield Infrastructure Partners announced that it's going to participate in a transaction to take regional railroad operator Genesee & Wyoming private. They're partnering with GIC -- that's Singapore's sovereign wealth fund, as well as an institutional investor; [they're] partners with Brookfield Asset Management (NYSE: BAM), buying the railroad [at] $112 a share in cash, almost a 40% premium to the price it was trading on March 8, the day rumors started swirling that this deal might happen.

When you saw the news of this deal drop, Matt, what was your first reaction to see Brookfield acquiring this railroad?

DiLallo: I wasn't too surprised. I've actually covered Genesee & Wyoming for several years for Fool.com. They were recommended by Stock Advisor. I know them pretty well. It's a good fit for them. Brookfield loves these backbone infrastructure businesses, and that's what Genesee & Wyoming does. They move freight basically from point A to point B, basically between the bigger railroads. They're kind of an intermediary. It fits in well with the globalization that Brookfield's looking for, because they're huge in North America, they've got railroads in Australia and Europe. It fits in very well with that.

It's not a typical Brookfield-type transaction where it's all contractual cash flows. But it's very steady. It is economically sensitive, so it gives them that upside and downside with the economy. But it's a good deal for them. It bolsters their transportation segment, which is something they've been looking at. It's another good investment by Brookfield.

Sciple: Yeah, you look at these short line railroads, they serve some of that role as the last-mile carrier. As we see more and more the way commerce is moving, there's more and more demand for those last-mile services that folks like Genesee & Wyoming can help provide.

When you look at the price that Brookfield paid, do you think they got great value here? There have been some grumblings from some investors that maybe Genesee & Wyoming undervalued its U.S. assets relative to, maybe, folks' impressions of their assets abroad. Do you feel like Brookfield was able to get an attractive valuation for Genesee, acquiring it today?

DiLallo: Well, I don't think Brookfield would ever do a deal where they didn't get a good value. I think that's what drew them to them. Obviously, the near-40% premium suggests that they paid a lot more than it was trading at on the public market. However, Genesee & Wyoming has had some issues overseas. There's issues with the currencies and things like that. So that has been weighing on them. Weather has been an issue for them. The economy: While the global economy has continued to grow, railroads went through a speed bump about a year or two ago. That put pressure on them. They were able to get this for -- it's one of those, a good business for a fair price. It's not like a screaming bargain, like they got in Brazil when they bought a pipeline, but it's a good deal.

Sciple: Right. This also adds to Brookfield's presence -- I think it's on almost all major continents now. They were previously in Australia. Obviously, they add Genesee & Wyoming's assets there in Australia. But now, that moves them into North America, as well as some assets in Europe. Adding to that portfolio for Brookfield, [are] there any synergies bringing this in with the rest of their real assets, that they can leverage this and get more out of it than maybe the assets as they sit today?

DiLallo: There's some potential, especially in Australia, where Brookfield has done well and Genesee & Wyoming struggled a bit. There might be some synergies there. Maybe they'll end up combining those businesses. But North America is a separate thing. The U.K., Europe -- there might even be some synergies in the U.K. Brookfield has a good ports business over there. They just sold a European port business. That's not the same. So, yeah, there's some, but probably, as they do in a lot of cases, they'll operate this business separately. It's not like they're going to make this big global railroad giant. I don't see that happening.

Sciple: Cool. This deal also fits into Brookfield's continued capital recycling strategy, where they take some of their assets that they've held for a period of time -- for example, their Chilean toll-road business -- that, when they reach close to fair value, Brookfield will realize those gains, then recycle those assets into new investments. Genesee & Wyoming is one of those. They've also been doing some further investments; another one of those was, they acquired Vodafone's telecom business in New Zealand. Can you break down how that fits into Brookfield's investments, and maybe how this capital recycling strategy is continuing to play out for the company?

DiLallo: Brookfield, they're really smart about how they go about funding their business. They'll look for opportunities to cash in on things that the market or other buyers value higher than Brookfield does. They'll sell theirs for above fair value. Then they'll use that to buy things that they see as underpriced, maybe it doesn't fit in with a bigger business. That's what you see with this telecom business in New Zealand. It wasn't part of Vodafone's massive global strategy, but it's a good business for Brookfield because it fits into one of the four components that they invest in, which is the energy businesses, utility businesses, transportation, and then data infrastructure is their new platform that they're building out. This is data infrastructure. This business owns cell towers, they own fiber-optic cables. But it's also a little bit different from just the infrastructure, because it's got the consumer component, because they also provide cellphone services and broadband to customers over there in New Zealand. So, it's a little bit of a blend business for them, it's an integrated business.

But their whole focus is on data. They see data as being this huge growth opportunity, because we just continue to use more and more data, especially mobile data. They're building out this platform to capture different aspects of it. Cell towers [are] big; these fiber-optic cables, which you got your broadband on; and then data centers. So, it fits into that. They've been buying data centers all over the world, and now they've got this. They see this as a huge growth opportunity because not only do they get the growth in the acquisitions, but the organic growth. They can raise prices, they can build out new cell towers, build out new data centers. It kind of gives that dual growth driver that they're looking to juice their returns with.

Sciple: Right. You look at the way the cell towers and data centers fit. To transmit data and continue this progression that we've been on, you have to have this infrastructure to communicate and allow data to transmit. It's the same thing when you look at Genesee & Wyoming. For our continued move into e-commerce and buying things remotely, you need more and more logistics. Brookfield Infrastructure getting in the middle of that -- extract a toll, and continue to drive cash flows. That's the whole idea behind this continued capital recycling strategy, is to continue increasing cash flows and distributions over time. As you see those opportunities, as they continue recycling cash flows, what opportunities do you see for Brookfield to continue increasing its distribution going forward, and continue returning capital to investors as it continues this capital recycling program?

DiLallo: The reason they're selling these assets is that they see a lot of opportunities in infrastructure. There's a huge gap between what governments can fund and what they need to fund. One of the ways that they can do this -- and the same thing with private businesses -- is to sell assets. So, Brookfield will sell something that a private equity fund or pension fund would really want for a premium price, then they'll use that to fill in these gaps, where it's a business that really fits in well with their infrastructure portfolio.

Some of the places that they're looking at, they're looking for this: where they can not only buy something that's producing cash flows to fund the dividend, but that can grow organically. So they're looking at water. They see water infrastructure as being a big opportunity for them. They only have done, I think, one $115 million deal for a water pipeline in Peru, but they would love to get into more water. U.S. and North American midstream, which is pipelines, processing plants, that sort of stuff. They see, I think, it was a $150 billion opportunity over the next several years as MLPs [master limited partnerships] consolidate and they need capital. They own some of these assets, but they see that as another growth thing. And then, in different countries -- in South America, you mentioned they sold assets in Chile. They would love to buy more assets in Chile. India's another place that they see growth.

It's a cool business to own because they're into so many different things. It's kind of like the backbone infrastructure and growth of these countries. They're cash flow driven, so they can pay these great distributions that they'll continue to grow.

Sciple: Yeah. I think Brookfield Infrastructure provides the services that allow the things that we think that the world is heading toward. Whether it's continued e-commerce, whether it's more and more data usage, they provide the infrastructure that allows that to happen. If you're an investor and can profit a little bit from that continued progression, definitely an interesting business to be involved in.

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Okay, Matt, on the back half of the show, I want to talk about this IPO of Rattler Midstream. So far it's the biggest IPO of 2019. Began trading on Thursday, May 23, under the ticker symbol RTLR. Rattler Midstream, you can tell from the name a little bit, they're affiliated with Diamondback Energy, which is an E&P [exploration and production] company, primarily based in the Permian. Ten-thousand-foot view: What does Rattler Midstream provide to investors, and what opportunities do they give with this newly public company? What are you buying?

DiLallo: A lot of these E&Ps, especially in the Permian Basin, they've had to build out a lot of the infrastructure near the wells, so these are called gathering and processing assets. It's pipes that hook to the well, and they gather the oil directly from the well, and bring it to major pipelines. Diamondback had been investing in these pipelines, so they're not held back by another MLP or midstream company. It's kind of like this just-in-time inventory delivery of their infrastructure.

So, they've been investing money to build this out. Rattler is the arm that they've used to do that. They're now trying to cash in on these assets. A lot of energy companies have done that in recent years. They'll either sell them to private equity funds, or they'll do IPOs. But it's been really hard to do IPOs for midstream recently. Interest rates are rising, and that dampened investor enthusiasm in this. And then, MLPs have had a pretty poor track record recently. But this is the first one on the gates, the biggest energy IPO of the year. There might be more to follow. It's an interesting company.

Sciple: Rattler Midstream's cash flows are backed by long-term contracts with Diamondback Energy. That's their key relationship. As you mentioned, these assets were developed by Diamondback in-house, and then have just been spun off with the IPO. When you look at the relationship that Rattler has with Diamondback, how attractive does that long-term relationship -- with those assets the Diamondback owns and the production that they're tied to -- how attractive does that look as an investment, from the MLP point of view, in Rattler Midstream?

DiLallo: It's kind of a blessing in one sense, but it also has its own drawbacks. Diamondback's one of the fastest growing E&Ps in the Permian Basin. That supports all this fast-paced growth for Rattler, so you have this built-in growth engine. They're going to support Diamondback. So, as Diamondback's drilling new wells, Rattler's going to be building these gathering pipelines. That's going to fuel a lot of growth. That's really exciting, especially since it's a Permian-based pure play.

However, if something were to happen with Diamondback, they run into trouble, that would hamper Rattler. There's the potential for them, because they're just focused on one company and one basin, that if pipeline constraints rose back in the Permian, or they couldn't drill wells, it would slow down this growth process. It's a riskier play because of that. If they were less risk-averse investors, they would be better off going for something that was more diversified.

Sciple: Sure. I saw some stats that Rattler's earnings tripled in 2018 due to Diamondback's continued increasing volumes, and Diamondback expects to increase volumes another 29% or 30% in 2019. Again, you see earnings tripling; do you think that is sustainable going forward? Do you think that's something where they saw this IPO coming down the line, and wanted to boost earnings for that? Or do you think this is a sustainable trajectory, given Diamondback's continued increasing production in the Permian?

DiLallo: Well, it probably won't triple as quickly in the near term, because that was off a low base. However, Diamondback has a lot of growth coming down the pipeline, to use a pun. Not only are they supporting Diamondback Energy, which is one of the fastest-growing E&Ps in the Permian Basin, but in addition to that, they were given stakes in these two long-haul pipelines that are coming online: the Gray Oak pipeline, which is being developed by a Phillips 66 partner, so it's a big oil pipeline, it's going to move crude oil from the Permian to the Gulf Coast, where it can hit refineries and then export facilities; and then it owns a 10% stake in the EPIC pipeline, which is another big pipeline that's going to kind of do the same thing. When these come online later this year, early next year, there's going to be a huge burst of cash flow from them. And this is stable cash flow because they're backed by long-term contracts that have minimum volume commitments, which means they pay for the space whether they use it or not. That's a little bit different from the gathering and processing. If Diamondback were to stop drilling, the natural production of wells would decline, so Diamondback's growth would be impacted. But this is more stable. And these pipelines can be expanded. So, it gives them a little bit more diversification than just the gathering and processing business. It should grow very quickly for several years. There's just so much oil that's going to be flowing out of the Permian Basin, especially going toward the Gulf Coast. It's more of a growth stock than a traditional MLP because they're going to be growing earnings really, really fast.

There are a couple of other companies that are doing this. There's Altus Midstream. Apache basically did the same thing: They didn't do an IPO, but they combined it with a blank-check company, and it gave them the funds to do all these projects. And it does the same thing; they gather and process oil and gas, and then they own all these stakes in long-haul pipelines. But they're going to grow their earnings by [around] 100% over the next couple of years. Again, super, super fast-paced growth, which is something you don't traditionally see in the pipeline sector.

Sciple: Sure. So much demand coming out of the Permian. Growth has been exploding there. One other interesting aspect I saw looking at Rattler Midstream is that they're structured as an MLP, but they still plan to pay corporate taxes rather than passing those on through to investors. I think you looked at this a little bit, Matt. Do you know what was behind this decision for Rattler Midstream, and whether that's something we'll see more of out of these MLPs going forward?

DiLallo: There's been this pushback by regular investors like me, retail-type investors, because the K-1s MLPs give you, they delay your taxes and they complicate things. It's much simpler to have a dividend versus an MLP distribution for tax purposes. You get a 1099; it just simplifies things. You can own it in an IRA: That broadens the appeal, the investor base. It can be owned by retirees, they can be owned by a lot more institutions, they can be put into more exchange-traded funds and indexes. It just broadens the investor base. Their share prices should appreciate more; they could be able to raise capital if they wanted to sell stock or units to fund different growth projects. It just gives them more flexibility.

That's why we've seen so many MLPs either convert to corporations, or they bought out their general partners and they've become corporations. It's this big trend in the sector, because investors didn't like the MLP model. It didn't work very well for them. There's so much dilution there, they're constantly issuing new units, and the tax issues, that it held down valuations. So, it's just an attempt to broaden the investor base and try to get the valuation of these assets more in line with what a private equity company would pay for them.

Sciple: Sure. To your point, you'd mentioned earlier that we've seen, at least in recent years, MLPs not have quite as much enthusiasm from the investor base. But when we look at Rattler Midstream, this is the first IPO of a midstream company in 2018; we didn't have any in 2017. [Editor's note: Those years should be 2019 and 2018.] This is a positive sign for the industry, to see companies start to go public again. There seems to be some enthusiasm behind Rattler, as you mentioned, with the opportunities for growth going forward. Does this give you some optimism for renewed enthusiasm for the MLP space going forward?

DiLallo: Not yet, just because there're still so many issues that they have to work on and work toward. There's some conversions that need to happen. They just have to prove themselves. They really disappointed income-seeking investors. They grew and grew and grew, and then they had these bloated balance sheets and couldn't pay for their distribution. They have to get over that hump. It'll take some time to win back investor confidence. I'm not sure how long it'll be. We're starting to see some of that this year. Valuations have come up a bit. But they just have to prove themselves, and prove that this model is sustainable before investors will start buying MLPs again.

Sciple: Sure. Last thing on Rattler: Talking about these companies proving themselves and proving they can maintain over time, what are you going to be watching with this company? Obviously, a new IPO, just been public since late May. What are you going to be watching with this company to really decide that it's proven itself, and it might be worth investment dollars going forward? What should investors be paying attention to with Rattler Midstream going forward?

DiLallo: Just their success in completing projects, and whether or not they can fund them internally. That's been one of the big things investors want to see. MLPs used to issue debt and issue new units whenever they wanted to, and the market was like, "Hold on." Now they have to do it internally. We need to see them be able to do that, and to show how the cash flows that they're throwing off are going to support the growth. If they can't do that, you're going to get more dilution; it's going to be a problem, and it can hold them back. I want to see a good solid operating plan from them, that they can fund all this growth that they have coming in the future.

Sciple: Awesome. Going away, I'm going to borrow Mac Greer's question that he likes to do on Market Foolery. You're on a desert island for five years. You can only pick one company to own within these two that we talked about today: Brookfield Infrastructure Partners, or Rattler Midstream. Which would you choose, and why?

DiLallo: It's a no-brainer for me: Brookville Infrastructure. I've owned that for years, and they've been so successful in creating value for investors. They've outperformed the market year in and year out, basically. They have a solid business plan. They tweak it as needed. As we mentioned with the capital recycling, they're not issuing units and diluting investors anymore. They've matured to a point where they can sell assets to fund the growth. They've become less risky. I really think they're going to continue to be a solid performer.

Rattler's one of those high-growth, high-risk stocks. It's interesting to watch, but I wouldn't touch it.

Sciple: Yeah, I think I tend to agree with you there, Matt. You talked about Brookfield Infrastructure, you get some of that exposure to pipelines as well, with significantly more diversification. Not to say anything against Rattler Midstream, I just want to see how this company operates as an independent company for a while going forward. Brookfield has such a strong track record, it's hard to go against them at any time.

Matt, always love having you on the show. I'm sure we'll have more to discuss sometime soon. Looking forward to it!

DiLallo: Me too, thanks!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Matt DiLallo, I'm Nick Sciple, thanks for listening and Fool on!

Matthew DiLallo owns shares of Brookfield Asset Management, Brookfield Infrastructure Partners, and Phillips 66. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Brookfield Asset Management. The Motley Fool recommends Brookfield Infrastructure Partners. The Motley Fool has a disclosure policy.