Holly Energy Partners, LP (NYSE:HEP) had a big year in 2017, but not because of asset acquisitions or new construction efforts. It purchased parent HollyFrontier's (NYSE:HFC) incentive distribution rights. This move creates an opportunity for a new stage of growth, but also indicates that the master limited partnership is going through a transition period. But at the same time, distribution coverage for its impressive 8.6% yield looks worrisome. Here's why investors shouldn't get too upset just yet.

A lot of units

Holly Energy is controlled by general partner HollyFrontier. Until 2017 this relationship included incentive distribution rights that increased along with the partnership's distribution, which has been increased every quarter for nearly 14 years. Early on, these rights are an incentive for a general partner to grow a partnership's distribution, which benefits unitholders. However, as a partnership grows, the incentives become a headwind because they increase the cost of capital for new investment and acquisitions.   

A man welding an oil pipeline

Image source: Getty Images.

In late 2017, Holly Energy purchased HollyFrontier's incentive distribution rights for $1.25 billion worth of Holly Energy units, increasing the unit count by 37.25 million. A massive increase. HollyFrontier agreed to waive $2.5 million worth of distributions for 12 quarters to allow the partnership to absorb the dilution. At the time, Holly Energy estimated that its cost of capital would fall from around 11% to 7.5%. (The higher distribution yield today changes that math, but even with an 8.6% yield, the cost of capital is materially lower than it was previously.)   

Slow going

Unfortunately, shifting gears to a new phase of growth hasn't been so simple. Previously, Holly Energy's expansion was fueled by assets purchased from HollyFrontier (called dropdowns). But there are few assets left for the parent to sell, which was one of the reasons for the change in the incentive distribution rights. Now Holly Energy has to grow organically or through acquisitions with unaffiliated parties.

The problem is that distribution coverage has been tight, at just 1.04 times in the first quarter and an even more concerning 0.97 times in the second. A big piece of this is the partnership's decision to continue increasing the distribution each quarter. Distribution coverage below 1 means that Holly Energy isn't generating enough cash to fully cover its payout. Investors clearly don't like to see that.

However, management is confident that the weak coverage is a seasonal issue, driven largely by temporarily lower volumes flowing through its midstream assets, and that coverage will be above 1 in the second half of the year. That helps explain the continued distribution increases, but investors have every right to be worried since there's no reason to expect supportive dropdowns from HollyFrontier. In fact, distribution coverage is the number to watch right now, since continued weak coverage could lead to either a pause in quarterly increases or an outright distribution cut.       

But don't get too caught up in that fear. For starters, if seasonality is a factor, the third- and fourth-quarter coverage numbers should pick up. And a quick look back at the partnership's quarterly revenues over the last few years shows a pretty clear annual dip in the middle of the year, related, as noted above, to temporary changes in volume and not some material change in the business. There's no particular reason to doubt management on the seasonality claim, and the third quarter should provide the evidence needed to decide if the current fears are overblown or not. Moreover, that evidence will arrive with plenty of time before a distribution cut is in the cards -- meaning downside risk for the units should be limited.

HEP Revenue (Quarterly) Chart

HEP Revenue (Quarterly) data by YCharts.

Holly Energy has also been working on projects to support the distribution. When it reported second-quarter results, management announced the completion of some projects that should add to cash flow through the rest of the year, including expansions at the partnership's Salt Lake City and Frontier pipelines. And it has a new truck loading facility under construction that it expects to be up and running by the end of the year. That's backed by a contract from parent HollyFrontier. The partnership is also looking to build a new pipeline that, assuming it gets regulatory approval, will be adding to results by the end of 2019.   

Include regular contractual price increases to the mix and, all in, distribution coverage moving back above 1 looks like a very likely scenario. Which means that the fat 8.6% yield could be a nice addition for income investors willing to sit through some uncertainty as Holly Energy continues to shift gears.

What about the long term?

While it looks like Holly Energy's distribution coverage shortfall will be solved pretty soon, there are longer-term issues to consider. Assuming the partnership wants to keep that quarterly increase streak alive, it has to keep finding new assets to build or buy if it wants to grow. The projects it has lined up are an indication that it is, indeed, making progress on that front. But once coverage gets back above 1, as management has promised, the big issue to monitor will be the partnership's capital spending plans.

For now, though, assuming it succeeds on the coverage front, Holly Energy looks like it has earned the benefit of the doubt, making the 8.6% yield a worthwhile risk-reward trade-off for income investors. Just don't forget to monitor the partnership's long-term capital spending plans if you decide to buy in here.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.