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Is Holly Energy Partners, L.P. (HEP) a Buy?

By John Bromels - May 29, 2018 at 8:33AM

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The pipeline operator and refiner has a big yield. Is it enough?

Investors looking for big dividends in the energy sector will no doubt be thrilled by Holly Energy Partners' (HEP -1.18%) above-8% yield. The master limited partnership's (MLP) yield trounces many of its peers' as well as that of its parent company HollyFrontier (HFC).

But a top yield isn't all that investors need to look at. And there are signs that Holly may underperform the stock market in coming years. Let's take a closer look to see whether or not Holly is actually a buy.

Big changes

Before you even consider buying an MLP, you should know that in exchange for preferential tax treatment, the U.S. government requires MLPs to pay out almost all of their income in the form of distributions to their unitholders. This usually means they offer big yields...and some extra hoops for investors to jump through at tax time.

A series of pipelines

Holly Energy Partners is a midstream pipeline operator and refiner. Image source: Getty Images.

Hoops or no hoops, Holly has certainly had an impressive track record of rewarding its unitholders with regular quarterly distribution increases. In fact, the partnership has upped its distribution every quarter since going public in 2004. That investor-friendly track record has continued, even as Holly has made some big changes to its operating structure to better align the goals of general partner HollyFrontier with the goals of its other investors, through the elimination of incentive distribution rights.

In order to make this change, though, Holly had to issue a batch of new units, which caused the company's distribution coverage -- the amount of cash it spins off to pay the distribution -- to drop to dangerously low levels. Coverage was just 1.0 times in 2017 and is expected to be just 1.0 times again in 2018 -- in other words, just enough to cover the distribution, and no more. That should be of concern to investors unless there's a solid plan to improve the partnership's cash flow in the near future.

Out of options

Sadly, it looks as though there isn't an easy fix. That's because HollyFrontier has already dropped down -- that is, sold to Holly Energy Partners -- all of its assets that make sense for Holly to take on. With no further dropdowns from its general partner, Holly will have to find other ways to grow its business.

One way would be to acquire another company. But unfortunately, there are slim pickings for viable acquisition targets right now. On the company's first-quarter 2018 earnings call, CEO George Damiris sounded pretty pessimistic about the partnership's prospects for acquisitions in the near future: "[T]here really aren't a whole lot of smaller opportunities in Permian and ... most of the smaller systems are full already. And most of the activity is oriented around new construction, or the new volumes that are coming out in the area."

In other words, why acquire a company that's fueling its growth with new construction when you can just build the new construction yourself? And, in fact, that's just what Holly plans to do: organically grow the business through new projects.

Slow and steady may not win the race

Organic growth may be the only viable option left for Holly, but it isn't necessarily an attractive one. Given its slim coverage ratio, the company would almost certainly have to take on additional debt to finance a major growth project. But that's something management may be loath to do, having just paid down its debt to below 4 times trailing EBITDA (earnings before interest, taxes, depreciation, and amortization), which is the partnership's target level.

Without going into debt -- or issuing new units, which would further stretch the company's distributions -- Holly is left to focus on smaller growth projects. This year, for example, the company will make some small improvements to a pair of recently acquired pipelines to improve their capacity, and add a new truck loading rack to the Delaware Basin to accommodate increased diesel demand in the region.

If that doesn't sound like much, it's because it's really not. The truck loading rack is estimated to cost between $10 million and $20 million, while the pipeline improvements, according to CFO Rich Voliva, are in the "single-digit-million range." For a $3 billion company, that's not going to move the needle much. And indeed, the projection is for quarterly distribution growth to come in at just $0.005 -- half a cent -- each quarter, or 4% for the year, a far cry from the robust 6% to 8% growth we've seen over the last five years. That may not be something investors want to sign on for.

Investor takeaway

An 8.8% yield -- which is what Holly is currently offering -- is nothing to sneeze at, and the partnership may be worth buying on that basis alone. Certainly, management has an excellent track record of regularly upping its distribution, and even though the coverage is a bit thin at present, Holly sports a solid balance sheet and has enough liquidity to cover its bases for a few quarters if it needs to.

However, the lack of apparent options for robust growth -- no dropdowns, no obvious acquisition targets -- may hamstring the company's growth moving forward, so it's tough to call Holly a definite buy. There are other players in the oil and gas space that you might want to check out first. Still, an energy investor with a diversified portfolio probably won't be unhappy making Holly Energy Partners a part of it.

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Stocks Mentioned

Holly Energy Partners, L.P. Stock Quote
Holly Energy Partners, L.P.
$15.97 (-1.18%) $0.19
HollyFrontier Corporation Stock Quote
HollyFrontier Corporation

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