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Rattler Midstream LP (RTLR)
Q3 2020 Earnings Call
Nov 5, 2020, 10:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Ladies and gentlemen, thank you for standing by, and welcome to the Rattler Midstream Third Quarter 2020 Conference Call. [Operator Instructions]
I would now like to hand the conference over to your first speaker for today, Mr. Adam Lawlis, Vice President for Investor Relations. Thank you, sir. Please go ahead.
Adam Lawlis -- Vice President Of Investor Relations
Thank you, AJ. Good morning, and welcome to Rattler Midstream's Third Quarter 2020 Conference Call. During our call today, we will reference an updated investor presentation, which can be found on Rattler's website. Representing Rattler today are Travis Stice, CEO; and Kaes Van't Hof, President. During this conference call, the participants may make certain forward-looking statements relating to the company's financial conditions, results of operations, plans, objectives, future performance and businesses. We caution you that actual results could differ materially from those that are indicated in these forward-looking statements due to a variety of factors. Information concerning these factors can be found in the company's filings with the SEC. In addition, we will make reference to certain non-GAAP measures. The reconciliations with the appropriate GAAP measures can be found in our earnings release issued yesterday afternoon.
I will now turn the call over to Travis Stice.
Travis Stice -- Chief Executive Officer
Thank you, Adam. Welcome, everyone, and thank you for listening to Rattler's Midstream Third Quarter Earnings Call. The third quarter of 2020 witnessed a normalization of Rattler operations after the disruption caused by the historic volatility during the second quarter of this year. With Diamondback resuming completion operations in the third quarter, sourced water volumes rebounded strongly and volumes in the produced water, crude oil and natural gas gathering segments stabilized after declining sequentially in step with Diamondback's volumes in the second quarter of 2020. This normalization was reflected in the 32% quarter-over-quarter increase in EBITDA to over $71 million in the third quarter. Net income of almost $39 million, also more than tripled quarter-over-quarter. This level of activity and cash flow can be seen as a baseline for Rattler's business for the coming quarters as Diamondback plans to maintain relatively flat production and activity levels at current commodity prices.
Moving forward, Rattler is well positioned due to the strength of its parent company, Diamondback, who has a strong balance sheet, an industry-leading cost structure and downside protection offered by its hedge book. Even when discounting the potential for Diamondback to resume volume growth in the future, Rattler will grow free cash flow through its declining operated capex program and completion of its equity method investment build cycle. We currently estimate Rattler's 2021 operated capex program will be approximately half the level of the 2020 program and less than 1/3 of the 2019 budget. Additionally, with three of five equity method investment joint ventures in full service, distributions from these projects should exceed the remaining contributions by the first quarter 2021. Wink to Webster will further add to this cash flow inflection when it enters into full service in late 2021. Turning to capital allocation. This quarter, the Board of Directors of Rattler's general partner elected to reduce the annual distribution by 31% from $1.16 to $0.80 per unit. While we believe the current outlook would have supported the distribution while keeping leverage around our 2 times leverage target, the current distribution yield of our equity indicated that such a view was not supported by the market. Accordingly, we elected to reduce the distribution and offensively reallocate the retained cash flow to a common unit repurchase program with $100 million authorization through year-end 2021. To be clear, this is not a buy-in of Rattler by Diamondback, and Diamondback will not be selling its position as part of this program.
This is instead a reallocation of capital to the best returning project in our portfolio, which is retiring units with an over 18% forward return. Should the dislocation between the internal view of our forward outlook and the market perception of that outlook realigned, we will return to distributing more cash flow on a per unit basis than prior to the implementation of this buyback program. We have studied the relationship between E&P parent companies and captive subsidiaries in our industry very closely and hope this buyback program is seen as further aligning the interests of parent and subsidiary. With this buyback, our partners are presented with an option. Remain partners and hold or increase your position or sale to us. In conclusion, when we created Rattler to build out the infrastructure necessary to develop Diamondback's assets, we envisioned a midstream entity that combined conservative financial management, visibility to volumes and a clear and honest relationship with its sponsor, the low-cost independent producer in North America. We still believe that each of these attributes apply today and is a clear advantage as Rattler adapts its business model from accommodating growth to optimizing operations. The resiliency of this business model will be proven out in the quarters ahead.
With these comments now complete, operator, please open the line for questions.
Questions and Answers:
Operator
[Operator Instructions] The first question comes from the line of Jeremy Tonet from JPMorgan. Your line is now open.
James Kirby -- JPMorgan -- Analyst
Good morning, guys. This is James on for Jeremy. I just want to start with the buyback and maybe just confirm that the program is active now. So maybe if we can expect any buybacks for this quarter. And you touched upon it in your prepared remarks. But just looking ahead 2021, what factors kind of impacts the pace of buybacks that you're looking to execute on?
Kaes Van't Hof -- President
Yes, James, we -- our window is still closed with earnings, but the buyback is in place. It's authorized. It's ready to start once the window opens in a couple of days. So we expect to be active in the fourth quarter and pretty consistently active through next year. So I think for us, we wanted to frame this as obviously leverage-neutral, so using free cash to buy back shares in an offensive fashion, and I think we'll be consistently buying back stock probably starting next week.
Travis Stice -- Chief Executive Officer
James, just as a reminder, we intend to maintain and grow the distributions from here, but we just think that today using this excess cash flow is really taking advantage of an extraordinary opportunity. We're doing this because we think that long term, the strategy rewards our unitholders.
James Kirby -- JPMorgan -- Analyst
No, I got it. That makes sense. And then maybe just given the M&A, call it, consolidation, upstream and particularly in the Permian. Just maybe want to hear your thoughts on if Diamondback is involved on that end on either side of the deal. If you could just talk to the sponsor relationship and the confidence you have that the current contracts in place won't be impacted? And maybe just talk to the strength of the relationship there.
Travis Stice -- Chief Executive Officer
Sure, James. Well, I was pretty clear in the Diamondback call on Tuesday, Diamondback's perception or our view of basin consolidation. We're only going to do -- grow our asset base, like we always have, which is when we can drive shareholder value. And I think the relationship that we have with Rattler is going to benefit with that laser-like focus on driving shareholder value at the parent level.
Kaes Van't Hof -- President
Yes. I mean I think Rattler's assets are so integral to Diamondback's operations that they're going to be vital to any acquirer or continue to be vital to us. So I think Rattler will benefit if Diamondback consolidate and I don't see a lot of downside if Diamondback is consolidating, just because all of these assets are integrated into the seven big development areas that we have today.
James Kirby -- JPMorgan -- Analyst
Got it. Thanks for the question. That's all there.
Kaes Van't Hof -- President
Thanks, James.
Operator
Next question comes from the line of Jeff Grampp from Northland. Your line is now open.
Jeff Grampp -- Northland -- Analyst
Good morning, guys. I was curious, Travis. Diamondback on their call, and I think for months now, has kind of talked about getting to a 4Q kind of stabilized maintenance mode keeping through 2021. I know that's maybe a little bit fluid here given how the commodity is bouncing around. But should we think about Rattler volumes largely kind of keeping to that cadence? Or is there an opportunity to maybe outperform the parent given enhanced economics of Diamondback relative to areas where maybe there's third party midstream?
Kaes Van't Hof -- President
Jeff, I think the base case is that Q4 volumes will be a good run rate for the next few quarters for both Rattler and Diamondback. And I think overall, while Diamondback is moving a little bit to the Midland Basin from the Delaware Basin from a capital allocation perspective, I think investors will be surprised with the resiliency of the water business and the water production in both basins.
Jeff Grampp -- Northland -- Analyst
Alright. Thanks, Kaes. And for my follow-up on the capital side, you guys talked about kind of half of '20 levels next year. Is that -- should we think about that as being pretty sustainable to the extent Diamondback stays in maintenance mode? And if there was a situation in the commodity where Diamondback let volumes slide, does Rattler still have that flexibility to rein in capital further? Or is that level we're talking about for '21, kind of the low end of the spectrum?
Kaes Van't Hof -- President
No. I think it's logical that if Diamondback stays flat longer or even declines, the Rattler budget is going to react even further. We kind of put out this number of at least half of 2020 or 2021. And I think with the security yielding 18%, this kind of ties to our buyback capital allocation philosophy. There's not a lot of capital projects that we have in the portfolio that generate a higher return than that in year 1. So capital dollars are going to be very scarce at Rattler. And if we continue in a maintenance mode for 2022, it's anyone's guess. But if that were the case, capital will continue to come down at Rattler from even the 2021 levels.
Jeff Grampp -- Northland -- Analyst
Okay. Great. That's all I got. Thanks, guys.
Kaes Van't Hof -- President
Thank you, Jeff.
Operator
[Operator Instructions] Next question comes from the line of Ujjwal Pradhan from Bank of America. Your line is now open.
Alex -- Bank of America -- Analyst
Hi, everyone. This is Alex [Phonetic] on for Ujjwal. Maybe just starting off on capital allocation. Should we anticipate you to renew the buyback program after it expires in '21? And what would kind of be the puts and takes of further capital return here?
Travis Stice -- Chief Executive Officer
Yes. Alex, what the Board is committed to is the $100 million, and we'll evaluate that just like any other investment decision that we make, we'll evaluate that probably on a quarterly basis, but the Board is very comfortable with the $100 million allocation right now.
Alex -- Bank of America -- Analyst
Understood. And then maybe just one more. Regarding some of the Diamondback's comments with reducing flaring in the Permian. Is there an incremental opportunity for Rattler to capture some more gas heading into '21?
Travis Stice -- Chief Executive Officer
Yes. Certainly, the benefits that we've seen in the almost 75% reduction in flaring from this time last year at the parent level is in large part through the efforts of what Rattler has done. And as we continue to see whether they're emerging technologies in methane monitor or methane road gas capturing, I expect Rattler to be on the front of that conversation.
Alex -- Bank of America -- Analyst
Perfect. Thank you both.
Travis Stice -- Chief Executive Officer
Thank you, Alex.
Operator
Next question comes from the line of Pearce Hammond from Simmons Energy. Your line is now open.
Pearce Hammond -- Simmons Energy -- Analyst
Good morning. And thanks for taking my questions. Just a quick statement. I think it's smart to cut the distribution and allocate the capital to buyback. So I think that's a smart capital allocation decision. The first question, though, is when you think about growth opportunities over the next few years above and beyond Diamondback, do you see opportunities to grow your third-party business? And are there opportunities to make maybe small acquisitions or bolt-ons that would help facilitate that?
Kaes Van't Hof -- President
Yes, Pearce. I mean, I think there certainly are smaller opportunities on our existing asset base to improve margins. We pay a lot of royalties to the landowners for disposal and for freshwater. So trying to reduce that burden will increase margins. Outside of that, small bolt-ons to our existing systems if we need capacity is certainly on the table. But we have to then do the build versus buy analysis. And most of the time, it's cheaper for us to -- or a higher return for us to build than buy. Overall, on top of that, I don't think we're trying to keep this business model pretty simple and buying third-party exposure reduces that line of sight that we like to our operations, and that starts to cloud it a little bit. So I think staying pretty consistent on the story that rather should benefit -- should Diamondback be a consolidator. But outside of that, sticking to the base business rather than a lot of third-party exposure.
Travis Stice -- Chief Executive Officer
Yes. Pearce, if you just circle back to some of my opening comments, and I think it was in the first question, Rattler's going to always look at things that can drive unitholder value, just like at the parent level, that's that singular focus of trying to deliver value to people that own the company is, first and foremost, on our minds. So Kaes' comments are entirely correct, but let's not forget that we're always here to try to drive unit value and shareholder value creation.
Pearce Hammond -- Simmons Energy -- Analyst
Thank you, Travis and Kaes. Then my follow-up question is you've done a -- Rattler has done a good job on reducing costs during the downturn and becoming more efficient. Are there still opportunities to further do that in a meaningful way that could impact cash flows? Or is a lot of that behind you at this point?
Travis Stice -- Chief Executive Officer
Yes. Pearce, that's a laser-focus always, regardless of external factors is to reduce cost across the board whether it's at the Diamondback level or you're at the Rattler level. I think cost reduction is actually more -- is geared faster at the Rattler level than it is at the Diamondback level, was it Kaes, $0.01, $2.5 million of...
Kaes Van't Hof -- President
Yes, Pearce. I mean, the stuff -- the things we're looking at operating costs on disposal $0.01 of operating cost reduction is $2.5 million of EBITDA net to Rattler. So I mean, that's 1% or so of our EBITDA. And so that, as Travis was saying, that gearing is a lot higher on the Rattler side than even Diamondback.
Travis Stice -- Chief Executive Officer
And Pearce, we're actually reallocating some internal resources from Diamondback into Rattler to help focus on all of that. Rattler was on such a meteoric trajectory on growth over the last 18 months. Now we've got extra eyes, really focused on our cost reduction as Kaes just highlighted, $0.01 makes a big difference. So that's what we're looking to do currently.
Pearce Hammond -- Simmons Energy -- Analyst
Well, thanks, guys. That's a great quarter.
Operator
[Operator Instructions] Last question comes from the line of Tristan Richardson from Truist Securities. Your line is now open
Tristan Richardson -- Truist Securities -- Analyst
Hi, good morning. I really appreciate the commentary on capital priorities. And the return profile you're seeing in projects out there. Curious, to the extent you remain active on the repurchase, as you look out into '21 and '22, just curious your thoughts on use of free cash flow net of distributions in a maintenance mode environment. Is there a level -- is there a balance sheet level that would be suboptimal such that you might actually add leverage to accelerate repurchase or return of cash to shareholders in other ways?
Kaes Van't Hof -- President
Yes, Tristan, I mean, I think for us, being around 2 times levered versus other midstream companies is best-in-class. I don't think we're looking to step on that and increase it in any meaningful way, just given how we think about leverage on a consolidated basis with a parent company and our two subsidiaries. So I think growing leverage to buy back more stock is not on the table. But I think should be in the fortunate position to have free cash flow above the distribution and get through the buyback program. I think we're going to bring back the distribution with lower units, that distribution is going up. So we've created this vehicle to be a cash return vehicle. That's still the base case, particularly with 70% of our free cash flow still going toward the distribution. But with the forward yield of 18%, 19%, we had to put our hand up and say, I think allocating some capital to buying back stock at these levels is the right decision. Now longer term, do we go back to more of a distribution model? I hope so. But it's a rare opportunity to be able to buy back stock at the bottom of the cycle.
Travis Stice -- Chief Executive Officer
Yes, using debt to buy back stock or buy back units has never been part of the strategy. I go back to my opening comments, Tristan, that this is just taking advantage of an extraordinary opportunity. And the Board still intends to maintain and grow the distribution from here. That has been unwavering from the very beginning.
Tristan Richardson -- Truist Securities -- Analyst
That's helpful. And Kaes, you kind of touched on my follow-up there. But do you see this model evolving into somewhat of a variable model, where you adjust the payout on a more regular basis, depending on what you see in the stock, what you see in capital project returns, profiles, etc?
Kaes Van't Hof -- President
We're familiar with the variable model with Diamondback -- or sorry, with Viper, excuse me. But I think we planned on this being a pretty fixed distribution model and this opportunity that presented itself because of the market dislocation is probably the exception versus the norm. I hope we don't have to go through 2020 again in a few years. So hopefully, we're bringing back the distribution and growing it with a reduced unit count and hopefully happy unitholders.
Tristan Richardson -- Truist Securities -- Analyst
Helpful. Thank you guys very much.
Kaes Van't Hof -- President
Thank you, Tristan.
Operator
Thank you for all those questions from the participants. I'm now turning the call back over to our CEO, Travis Stice.
Travis Stice -- Chief Executive Officer
Thanks again to everyone participating in today's call. If you've got any questions, please reach out and contact us using the information provided.
Operator
[Operator Closing Remarks]
Duration: 22 minutes
Call participants:
Adam Lawlis -- Vice President Of Investor Relations
Travis Stice -- Chief Executive Officer
Kaes Van't Hof -- President
James Kirby -- JPMorgan -- Analyst
Jeff Grampp -- Northland -- Analyst
Alex -- Bank of America -- Analyst
Pearce Hammond -- Simmons Energy -- Analyst
Tristan Richardson -- Truist Securities -- Analyst
