The giants in the midstream pipeline sector are bellwether Kinder Morgan, Inc. (NYSE: KMI) and limited partnership Enterprise Products Partners LP (NYSE: EPD). However, relatively tiny Phillips 66 Partners (NYSE: PSXP) and its 5.6% yield may be the better deal for investors today. Here's why.
Background on the business
Phillips 66 Partners went public in 2013. The purpose of the partnership was, essentially, to buy midstream assets from independent refiner and general partner Phillips 66 (NYSE: PSX). This allowed parent Phillips 66 the opportunity to raise cash it could invest in its business while retaining control of vital assets, since it effectively controls the partnership. Phillips 66 Partners and its unitholders, meanwhile, benefit from a supportive parent that is willing to grow the partnership by selling it additional assets. Those assets, in turn, fuel distribution growth over time.
Image source: Getty Images.
Phillips 66 Partners' portfolio of assets is largely fee-based, providing the partnership with a reliable income stream. On that score, it's a fairly safe business. That said, parent Phillips 66 is its largest customer, which leads to notable concentration risk. However, this has to be balanced against the fact that the relationship provides Phillips 66 Partners a willing counterpart for acquisitions, even though the refiner isn't likely to let go of its most rewarding midstream assets.
Neither Enterprise nor Kinder Morgan have parents willing to sell (or drop down, in industry lingo) them assets. They have to build assets, which on the positive side usually means higher rates of return, or buy from unaffiliated third parties. The problem is that both construction and acquisitions from third parties are generally more difficult and time-consuming processes.
That said, Phillips 66 Partners also builds from scratch. For example, it recently started construction on the Gray Oak pipeline in the Permian Basin. While dropdowns have historically been the largest growth engine, the partnership is currently balancing organic growth and acquisitions to meet its financial goals. During the first-quarter conference call, CFO Kevin Mitchell suggested that dropdowns through the rest of 2018 would only be inked if internal growth projects fell short of expectations. Parent Phillips 66 is, clearly, still providing important support, just on an as-needed basis as the partnership shifts to a new stage in its growth plan.
Note that general partner Phillips 66 is entitled to incentive payments as Phillips 66 Partners' distribution grows, which increases the partnership's cost of capital. Many partnerships have eliminated these incentives for this very reason. However, at this point, the incentives appear to be aligning the interests of Phillips 66 Partners' unitholders and Phillips 66, with the partnership specifically focused on rapidly growing its midstream business so it can quickly increase its distribution. That growth, meanwhile, hasn't come at the expense of its balance sheet (more on that below).
To put a number on its distribution growth, Phillips 66 Partners has increased its disbursement for 16 consecutive quarters (every quarter since its IPO) at a compound annual growth rate of 31%. That's roughly the target it laid out for its first five years as a public entity. That is, of course, off of a low starting base. The year-over-year increase in the first-quarter distribution was around 20% -- still a very impressive number when peers like Enterprise and Magellan Midstream Partners (NYSE: MMP) are offering up mid-to-high single-digit increases. (Kinder Morgan's dividend growth will be huge in the coming years, but that's a function of increasing the dividend after a painful cut.)
Growth on the cheap
The most compelling thing about Phillips 66 Partners today, however, may be its valuation. The partnership's price to tangible book value is a modest 3.2 times. That's lower than either Enterprise or Kinder Morgan, which have price-to-tangible-book-value ratios of around 4.8 and 4.4, respectively. And it's way lower than Magellan's 6.2. Magellan is one of the most conservative midstream partnerships in the industry and has long commanded a premium valuation.
But fast-growing Phillips 66 Partners isn't exactly a risky play deserving of a discounted price. As noted above, it has a supportive parent, which is a net positive at this early stage in its development. But it also has a relatively low level of leverage, too. Debt to EBITDA at Phillips 66 Partners is just 3.1 times, lower than Magellan (3.5 times), Enterprise (4.3 times), and Kinder (6.2 times). In some ways that makes Phillips 66 Partners the most conservative of this group, even though debt has increased relatively quickly in recent years as it has grown. In the end, it still appears to have ample room on the balance sheet for future asset purchases and capital investments.
Distribution coverage has been strong at Phillips 66 Partners. Image source: Phillips 66 Partners.
Distribution coverage at Phillips 66 Partners is also robust. It has maintained a coverage ratio of 1.1 or better every quarter since its IPO. Coverage in the most recent quarter was a robust 1.4 times, leaving plenty of room for a continuation of the growth trend over the near term. Conservative Magellan's target is 1.2 times right now. Although having a general partner to which it has material business exposure is a risk for Phillips 66 Partners, there's little else that suggests it is a high-risk investment even as it switches to a model built more on internal growth. Of course that historical 30% distribution growth isn't a permanently sustainable level, but management is still looking to be at the high end of the industry as it shifts its model. At this point there's no reason to doubt it can achieve the goal.
Not perfect, but perhaps worth the risks
With a distribution yield that's roughly in line with its larger peers, a financially strong business, a supportive parent, and a history of rapid distribution growth that looks set to continue (though likely at lower levels), income investors would do well to take a closer look at relatively cheap Phillips 66 Partners. There are some risks to consider, like exposure to parent Phillips 66 and shift toward internal growth, but the risk/reward trade-off here looks very reasonable at today's prices.
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