Midstream energy partnership Holly Energy Partners, L.P. (HEP) offers investors a fat 9% distribution yield. That's partly driven by concerns over the partnership's tight coverage ratio, which is just one of several key issues that came up during the latest earnings call. However, if you look beyond the distribution, there are a number of positives taking shape. Here's what CEO George Damiris had to say about the fourth-quarter and full-year 2017 results.

1. It was a decent year

One of the key numbers for a partnership is distributable cash flow, which is the cash available to support the distributions that make limited partnerships an income investor favorite. On that front, the CEO was able to highlight a strong improvement in the fourth quarter, saying, "HEP generated distributable cash flow of $66 million in the quarter, a 12% increase compared to the same period of 2016." For the year, that figure advanced roughly 11% -- both respectable numbers.   

A man welding a midstream pipeline

Image source: Getty Images.

The full-year and quarter advances were driven by a late 2016 acquisition and the purchase of the remaining interest in the Salt Lake City and Frontier pipelines in the fourth quarter. The big takeaway, however, is that Holly Energy is continuing to find ways to grow its distributable cash flow.     

2. We're going organic

That said, Damiris made a point of highlighting that the partnership "will continue to leverage our existing footprint to grow organically, especially in the Permian." Three key internal projects in 2018 include a debottlenecking at one asset and expansions at the now fully owned Salt Lake City and Frontier pipelines. This is good but not great news.

Acquisitions would likely generate higher growth, but he didn't discuss potential deals. In fact, he specifically shied away from the topic when asked during the question-and-answer portion of the call. While the partnership's late 2017 purchases should lead to a another good year in 2018 for distributable cash flow, there's a notable question mark here that investors need to think about longer term.

3. We made a big change

That said, there's good reason for the company to be stepping back from the deal table. As Damiris explained, "We also completed the IDR simplification agreement with HollyFrontier in October. The IDR Simplification provides HEP with a more competitive cost of capital, better equipping us to pursue both organic projects and third-party acquisitions."

HEP Average Diluted Shares Outstanding (Quarterly) Chart

HEP average diluted shares outstanding (quarterly). Data by YCharts.

This is a good move for Holly Energy, since it no longer has to pay incentive distributions to parent HollyFrontier Corp. (HFC). But it required the issuance of 37.25 million new units. So it was a costly change, even though it is likely to be a beneficial one over the long term. Those additional units partly explain why the partnership isn't looking to expand aggressively via acquisitions right now, even though the IDR simplification would make it easier to finance deals. This brings us to the distribution.   

4. Distribution growth will be slower this year

The distributable cash flow number highlighted by Damiris above was an overall figure -- it didn't take into account what was being paid out to unitholders. The relevant metric there is the coverage ratio, which he discussed later in the conference call: "We had a distribution coverage ratio of 1.03x for the quarter and 1.00x for the full year of 2017." That's rather tight, since the partnership just managed to cover its distribution for the full year.

Worse yet, every additional share increases the money flowing out the door. So the simplification agreement actually made Holly Energy's life a little more complicated over the near term. "Looking ahead in 2018," Damiris explained, "We expect to increase the quarterly distribution by $0.005 per unit per quarter, resulting in an annual distribution growth rate of 4%. Distribution coverage is expected to average approximately 1 for the full year." For reference, the distribution grew by 7% last year.     

Distribution coverage is expected to improve as the year progresses and as contractual rate increases kick in. That suggests that the coverage in the early part of the year could dip below 1. Until this metric starts to improve, Holly Energy is probably right to be cautious about its spending plans.

5. We're still focusing on leverage

In addition to the coverage ratio, CFO Richard Voliva stepped in to highlight the partnership's debt goal of achieving a four times net debt-to-EBITDA ratio. He noted, "As of December 31, HEP had $1.5 billion in total debt outstanding, resulting in year-end net-debt-to-EBITDA ratio of 4.4x." However, that number was partly because of a decision to fund the two fourth-quarter acquisitions with debt.

A timeline showing the acquisitions and construction projects that have driven Holly Energy's growth, ending with the elimination of the incentive distribution rights.

A timeline of Holly Energy's growth. Don't expect big moves in 2018. Image source: Holly Energy Partners, L.P.

Voliva added, "In February 2018, we issued a $110 million of limited partner equity through a private placement, with the proceeds used to repay a portion of the debt associated with the Frontier and SLC acquisitions. Following this issuance, our liquidity was over $500 million and our pro forma debt to trailing EBITDA stood at approximately 4.1x." That's much better and suggests that the four times figure is within reach this year. That said, reducing leverage is yet another demand on the partnership's cash -- one more reason for avoiding acquisitions and focusing on internal growth projects.

A mixed bag

It's hard to suggest that Holly Energy's conference call was bad, but you would be equally challenged to call it good. The truth is that 2017 was a decent year that included a notable business change: the simplification transaction with HollyFrontier. That move is likely to be a long-term benefit even if the issuance of new shares will be a near-term drag on performance. So, as 2018 progresses, look for incremental improvements, not dramatic change, as the partnership works to adjust to a new normal. For investors with a long-term focus, Holly Energy and its high yield are probably worth a deep dive.