Investors have given master limited partnerships the cold shoulder in recent years due to underperformance and rising interest rates. However, the market recently thawed out enough that Diamondback Energy (NASDAQ:FANG) could complete the IPO of its midstream arm. In this Industry Focus: Energy clip, host Nick Sciple and contributor Matt DiLallo discuss:

  • What Rattler (NASDAQ:RTLR) does
  • Rattler's relationship with Diamondback
  • Rattler's growth potential
  • Why Rattler will pay corporate income taxes despite being structured as an MLP
  • Ways MLPs and Rattler can prove themselves to investors

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 11, 2019.

Nick Sciple: Okay, Matt, on the back half of the show, I want to talk about this IPO of Rattler Midstream. So far it's the biggest IPO of 2019. Began trading on Thursday, May 23rd under the ticker symbol RTLR. Rattler Midstream, you can tell from the name a little bit, they're affiliated with Diamondback Energy, which is an E&P company, primarily based in the Permian. 10,000 foot view, what does Rattler Midstream provide to investors, and what opportunities do they give with this newly public company? What are you buying?

Matt DiLallo: A lot of these E&Ps, especially in the Permian Basin, they've had to build out a lot of the infrastructure near the wells. So, these are called gathering and processing assets. It's pipes that hook to the well, and they gather the oil directly from well, and bring it to major pipelines. Diamondback had been investing in these pipelines so they're not held back by another MLP or midstream company. It's kind of like this just-in-time inventory delivery of their infrastructure. So, they've been investing money to build this out. Rattler is the arm that they've used to do that. They're now trying to cash in on these assets. A lot of energy companies have done that in recent years. They'll either sell them to private equity funds, or they'll do IPOs. But it's been really hard to do IPOs for midstream recently. Interest rates are rising, and that dampened investor enthusiasm in this. And then, MLPs have had a pretty poor track record recently. But this is the first one on the gates, the biggest energy IPO of the year. There might be more to follow. It's an interesting company.

Sciple: Rattler Midstream's cash flows are backed by long-term contracts with Diamondback Energy. That's their key relationship. As you mentioned, these assets were developed by Diamondback in-house and then have just been spun off with the IPO. When you look at the relationship that Rattler has with Diamondback, how attractive does that long-term relationship, with those assets the Diamondback owns and the production that they're tied to, how attractive does that look as an investment from the MLP point of view in Rattler Midstream?

DiLallo: It's kind of a blessing in one sense, but it also has its own drawbacks. Diamondback's one of the fastest growing E&Ps in the Permian Basin. That supports all this fast-paced growth for Rattler. So, you have this built-in growth engine. They're going to support Diamondback. So, as Diamondback's drilling new wells, Rattler's going to be building these gathering pipelines. That's going to fuel a lot of growth. That's really exciting, especially since it's a Permian-based pure play.

However, if something were to happen with Diamondback, they run into trouble, that would hamper Rattler. There's the potential for them, because they're just focused on one company and one basin, that if pipeline constraints rose back in the Permian, or they couldn't drill wells, it would slow down this growth process. It's a riskier play because of that. If they were less risk averse investors, they would be better off going for something that was more diversified.

Sciple: Sure. I saw some stats that Rattler's earnings tripled in 2018 due to Diamondback's continued increasing volumes, and Diamondback expects to increase volumes another 29% or 30% in 2019. Again, you see earnings tripling, do you think that is sustainable going forward? Do you think that's something where, they saw this IPO coming down the line, and wanting to boost earnings for that? Or do you think this is a sustainable trajectory, given Diamondback's continued increasing production in the Permian?

DiLallo: Well, it probably won't triple as quickly in the near term, because that was off a low base. However, Diamondback has a lot of growth coming down the pipeline, to use a pun. Not only are they supporting Diamondback Energy, which is one of the fastest growing E&Ps in the Permian Basin, but in addition to that, they were given stakes in these two long haul pipelines that are coming online, the Gray Oak pipeline, which is being developed by a Philip 66 partner, so it's a big oil pipeline, it's going to move crude oil from the Permian to the Gulf Coast, where it can hit refineries and then export facilities; and then it owns a 10% stake in the EPIC pipeline, which is another big pipeline that's going to kind of do the same thing. When these come online later this year, early next year, there's going to be a huge burst of cash flow from them. And this is stable cash flow because they're backed by long-term contracts that have minimum volume commitments, which means they pay for the space whether they use it or not. That's a little bit different from the gathering and processing. If Diamondback were to stop drilling, the natural production of wells would decline, so Diamondback's growth would be impacted. But this is more stable. And, these pipelines can be expanded. So, it gives them a little bit more diversification than just the gathering and processing business. It should grow very quickly for several years. There's just so much oil that's going to be flowing out of the Permian Basin, especially going toward the Gulf Coast. It's more of a growth stock than a traditional MLP because they're going to be growing earnings really, really fast.

There are a couple of other companies that are doing this. There's Altus Midstream. Apache basically did the same thing. They didn't do an IPO, but they combined it with a blank check company, and it they gave them the funds to do all these projects. It does the same thing. They gather and process oil and gas, and then they own all these stakes in long haul pipelines. But they're going to grow their earnings by [around] 100% over the next couple of years. Again, super, super fast-paced growth, which is something you don't traditionally see in the pipeline sector.

Sciple: Sure. So much demand coming out of the Permian. Growth has been exploding there. One other interesting aspect I saw looking at Rattler Midstream is that they're structured as an MLP, but they still plan to pay corporate taxes rather than passing those on through to investors. I think you looked at this a little bit, Matt. Do you know what was behind this decision for Rattler Midstream, and whether that's something we'll see more of out of these MLPs going forward?

DiLallo: There's been this pushback by regular investors like me, retail type investors, because the K-1s MLPs give you, they delay your taxes and they complicate things. It's much simpler to have a dividend versus an MLP distribution for tax purposes. You get a 1099. It just simplifies things. You can own it in an IRA. That broadens the appeal, the investor base. It can be owned by retirees, they can be owned by a lot more institutions, they can be put into more exchange-traded funds and indexes. It just broadens the investor base. Their share prices should appreciate more, they could be able to raise capital if they wanted to sell stock or units to fund different growth projects. It just gives them more flexibility. That's why we've seen so many MLPs either convert to corporations, or they bought out their general partners and they've become corporations. It's this big trend in the sector, because investors didn't like the MLP model. It didn't work very well for them. There's so much dilution there, they're constantly issuing new units, and the tax issues, that it held down valuations. So, it's just an attempt to broaden the investor base and try to get the valuation of these assets more in line with what a private equity company would pay for them.

Sciple: Sure. To your point, you'd mentioned earlier that we've seen at least in recent years, MLPs not have quite as much enthusiasm from the investor base. But when we look at Rattler Midstream, this is the first IPO of a midstream company in 2018. We didn't have any in 2017. This is a positive sign for the industry, to see companies start to go public again. There seems to be some enthusiasm behind Rattler, as you mentioned, with the opportunities for growth going forward. Does this give you some optimism for renewed enthusiasm for the MLP space going forward?

DiLallo: Not yet, just because there're still so many issues that they have to work on and work toward. There's some conversions that need to happen. They just have to prove themselves. They really disappointed income-seeking investors. They grew and grew and grew, and then they had these bloated balance sheets and couldn't pay for their distribution. They have to get over that hump. It'll take some time to win back investor confidence. I'm not sure how long it'll be. We're starting to see some of that this year. Valuations have come up a bit. But they just have to prove themselves, and prove that this model is sustainable before investors will start buying MLPs again.

Sciple: Sure. Last thing on Rattler. Talking about these companies proving themselves and proving they can maintain over time, what are you going to be watching with this company? Obviously, a new IPO, just been public since late May. What are you going to be watching with this company to really decide that it's proven itself and it might be worth investment dollars going forward? What should investors be paying attention to with Rattler Midstream going forward?

DiLallo: Just their success in completing projects, and whether or not they can fund them internally. That's been one of the big things investors want to see. MLPs use to issue debt and issue new units whenever they wanted to, and the market was like, "Hold on." Now they have to do it internally. We need to see them be able to do that, and to show how the cash flows that they're throwing off are going to support the growth. If they can't do that, you're going to get more dilution, it's going to be a problem and it can hold them back. I want to see a good solid operating plan from them, that they can fund all this growth that they have coming in the future.

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