The US midstream space has generally been a slow motion train wreck. Bad capital allocations, declining customer health over the 2015-2020 time frame and contracting valuations have chased all but the most optimistic fans out of the space. The result has been a sector of high yields which most don’t want to chase. We have a similar opinion in general, as there are certainly better places to invest at present. At the same time, there are certain stocks that do make a lot of sense from an income point of view, especially if you choose your entries carefully. We go over Shell Midstream Partners, L.P. (SHLX) today and tell you why we favor it over the rest of the bunch.
SHLX generates revenue from the transportation and storage of crude oil, refined, intermediate and finished products. They do this via their ownership pipelines, storage tanks, docks and other logistical assets. They outright own or maintain effective control over a majority of their assets.
Like many other midstream companies, SHLX went through an IDR (incentive distribution rights) elimination. This happened in 2020, which was possibly not the best time to hold a negotiation for this.
Upon the closing of the April 2020 Transaction, the Partnership had 393,289,537 common units outstanding, of which SPLC’s wholly-owned subsidiary, Shell Midstream LP Holdings LLC (“LP Holdings”), owned 269,457,304 common units in the Partnership, representing an aggregate 68.5% limited partner interest. The Partnership also had 50,782,904 of Series A Preferred Units outstanding, which are entitled to receive a quarterly distribution of $0.2363 per unit and all of which are owned by LP Holdings.
Source: SHLX 10-Q
The $1.2 billion in preferred equity is convertible into common units but currently pays a ridiculously low rate of 4% to Royal Dutch Shell (RDS.A). That conversion, when it happens, will reduce distributable cash flow for common units to a good extent.
There are a few things that we dislike about the midstream sector and all of those reasons don’t really apply to SHLX. The first is that the extreme capex investment cycle of the past has created an abundance of midstream assets relative to demand for the same. We see this playing out slowly as contracts roll over and new ones are priced lower. Now, every case is of course different and pricing power will depend a lot on what volumes look like in 2022 and beyond. Overall though, we expect EBITDA in the sector to be pressured by this. SHLX though has a rather unique set of assets, where there are no real competing ones.
For most of its assets, we don’t expect competition and that gives SHLX an edge in our books. The second issue we have with midstream is that capex cycles are still running strong, despite promises to unwind the spending. SHLX fits in here a bit differently.
There is, of course, a size differential (the remaining 3 are much larger), but even adjusted for that, SHLX is not spending remotely as much. We think that is the better approach in this environment, and SHLX gets another tick mark because of this.
SHLX has also focused on its debt right from the start, and it never got unwieldy. Current levels are good, and the focus on smaller bolt-on projects should prevent any problems there.
While other companies like Energy Transfer LP (ET) are prioritizing debt paydown, SHLX has already reached where they want to go. One thing to keep in mind here though is that SHLX reported numbers for 2021 are definitely higher than this 3.0-3.5X in the picture above. This was due to one-off factors impacting EBITDA, and we expect 2022 numbers to look a lot better.
- As of September 30, 2021, the Partnership had total debt of $2.7 billion, equating to 4.7x Debt to annualized Q3 2021 Adjusted EBITDA. Q3 2021 EBITDA was significantly impacted by Hurricane Ida, which the Partnership views as a temporary event and we expect results to normalize in Q4 2021. Current debt levels are well within our targeted range and provide flexibility to the Partnership.
Source: SHLX 10-Q
The volume story is a good way to visualize the abnormality of the most recently reported quarter.
Valuation & Verdict
SHLX’s appeal comes primarily from its business advantages relative to other midstream plays in our opinion. On a valuation front, SHLX is not the most appealing. Even normalizing for what 2022 will produce, without hurricane impacts, you are looking at close to 8X distributable cash flow multiple. On an EV to EBITDA basis, SHLX is definitely more expensive than most peers and in line with the sector leader Enterprise Products Partners L.P. (EPD).
That, of course, creates a more complicated situation where SHLX could lag its peers, either by just underperforming or actually dropping lower. Of course, the beauty of options is that it helps us mitigate these risks. Since we were interested in this, only for the income, we took advantage of the opportunity in late December. With SHLX trading at $10.90 at the time, we saw attractive prices for both the January 2023 and July 2022 Cash Secured Puts and Covered Calls.
The January 2023 $10 Cash Secured Puts were quite long dated in nature but offered a 18.40% yield as long as the price stayed over $10.00.
That position appears a safe bet here, regardless of how SHLX navigates the next 11 months. In the unlikely chance the position is put to us, we are happy to go long SHLX under $10.00. At present prices, we see this as more of a “hold/neutral” and it is definitely not one which we will be chasing.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.