Midstream energy partnerships Holly Energy Partners, L.P. (HEP) and Magellan Midstream Partners, L.P. (MMP) both have impressive histories when it comes to rewarding investors with distribution increases. Holly's streak is up to 13 consecutive years while Magellan's is at 17 years. Holly's 7.2% yield, however, is over two percentage points higher than what Magellan offers, but that doesn't necessarily mean you should jump on the higher yield.
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Holly Energy is controlled by general partner HollyFrontier Corp (HFC). That's been a net benefit as HollyFrontier has been selling fee-based assets to Holly Energy, known as a drop-down in the partnership space, to fuel its growth. That's meant that Holly Energy, with its $2.2 billion market cap, hasn't had to look hard to find acquisitions.
Image source: Getty Images.
But this relationship comes with a cost. Holly Energy has to pay parent HollyFrontier a management fee and incentive payments based on the growth of its distribution. Those incentive payments increase the partnership's cost of capital, making future growth spending more costly. That's a big issue because the limited partnership structure is specifically designed to pass income through to unitholders. In other words, Holly Energy has to tap the capital markets (selling debt and new units) to fund its growth plans.
That leads to a second notable point. Holly Energy's debt to EBITDA ratio has risen significantly over the last year or so. This is a mixed blessing since the added leverage helped to fund acquisitions that will keep the distribution growing. For reference, Holly's distribution has grown at an annualized rate of around 6% over the past decade -- roughly twice the historical rate of inflation growth. But more leverage means more risk and it also limits the partnership's ability to ink new deals.
Holly's relationship with HollyFrontier. Image source: Holly Energy Partners, L.P.
None of this is to suggest that Holly Energy Partners is a bad investment, but these facts are important when you consider the 7.2% yield and compare Holly to Magellan.
Bigger but faster growing
Magellan's business is largely fee-based, just like Holly's. However, it's $16 billion market cap makes it a much bigger entity. Magellan, then, needs bigger deals and spending to keep its business growing. To put some numbers on that, Holly expects to spend as much as $40 million in 2017 on capital projects. Magellan's looking to spend $600 million.
Magellan, however, doesn't have a general partner -- it needs to find new deals on its own. So far that hasn't been a problem. And, even at $16 billion, relatively small deals can still move the needle. What Magellan doesn't have to do is pay a general partner incentive fees, so its cost of capital is lower than Holly's. The partnership's 5% yield also helps to keep costs down, since it doesn't have to pay as much as Holly on each new unit it issues.
Magellan is big on being financially conservative. Image source: Magellan Midstream Partners.
In addition to this, Magellan has traditionally taken a conservative approach to leverage. It's debt to EBITDA ratio sits at the low end of the industry. Not only does this keep interest expense low, but it also gives Magellan plenty of flexibility to fund growth without worrying about weighing itself down with debt payments.
But there's another end result you'll want to note. Magellan's distribution has grown at an annualized rate of 11% over the past decade. It's currently targeting 8% growth for 2017 and 2018, but once you start to compound that, the annualized rate begins to tick higher over time. In other words, Magellan's lower cost of capital and lower leverage have led to higher distribution growth than peer Holly Energy.
What do you really want
Don't underestimate the impact of this. A decade ago Holly's quarterly distribution was $0.3525 per unit. It's most recent distribution was $0.6325, a nearly 80% increase. Magellan's quarterly distribution, meanwhile, went from $0.315 per unit a decade ago to $0.89 -- an increase of more than 180%! A big part of that difference can be found in the fact that Magellan doesn't have to deal with incentive distributions, and its low leverage allows more income to flow through to unitholders. If finding a high yield is important to you, then you might favor Holly Energy Partners. But if you want a mix of yield and growth, then Magellan's 5% yield and higher distribution growth will probably be more appealing. My pick between this pair? Magellan.
