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In 2020, I stated that the 11.0% distribution yield that Holly Energy Partners (HEP) was offering back then was safe. This has proved correct so far. In addition, since my article, the stock has rallied 34%. As a result, the distribution yield of the stock has decreased from 11.0% to 8.2%. As the yield remains high, it leads some investors to fear that a distribution cut is just around the corner. However, in this article, I will analyze why the 8.2% distribution yield of this high-quality MLP remains safe while it is also ideal in the current environment of high inflation.
Business overview
Holly Energy Partners owns essentially all the pipeline network of crude oil and refined products as well as the terminal assets that support the refining and marketing business of HollyFrontier (HFC). Among others, this asset portfolio includes storage capacity of approximately 15 million barrels of refined products and 3,400 miles of pipelines of crude oil and refined products.
Holly Energy Partners has one of the most resilient business models in the energy sector. Nearly all its revenues are fee-based and approximately 75% of its revenues are based on minimum-volume contracts. This means that its customers have to pay minimum amounts to Holly Energy Partners even if they transport and store much lower quantities than usual. Moreover, 70% of the revenues of Holly Energy Partners come from HollyFrontier, which owns 57% of the MLP and has contracts with the MLP for the next 10-15 years. To cut a long story short, the cash flows of Holly Energy Partners are as reliable as they can be in the energy sector.
The defensive nature of Holly Energy Partners has been clearly reflected in its performance throughout the coronavirus crisis. In 2020, the lockdowns imposed in response to the pandemic caused an unprecedented plunge in the global demand for oil and refined products. According to the Energy Information Administration [EIA], global oil consumption plunged from 101.1 million barrels per day in 2019 to 91.9 million barrels per day in 2020, the greatest annual decline in history. Consequently, all the refiners and most oil companies incurred hefty losses in that year.
Holly Energy Partners was a bright exception. It greatly benefited from the minimum volume requirements of its contracts and thus it grew its distributable cash flow by 4% in 2020, mostly thanks to lower interest expense and reduced operating expenses.
Moreover, thanks to the massive distribution of vaccines and the immense fiscal stimulus packages offered by most governments, the energy market has almost fully recovered from the pandemic. Global oil consumption surged to 97.1 million barrels per day in 2021 and is expected by EIA to average 100.6 million barrels per day this year, close to the pre-pandemic level of 101.1 million barrels per day.
Holly Energy Partners has greatly benefited from the recovery of the energy market. In its last two earnings reports, the company stated that its comparable volumes have returned close to pre-pandemic levels.
Unfortunately, the MLP is now facing another headwind, namely the conversion of the Cheyenne refinery of HollyFrontier to a renewable diesel plant. Due to this conversion, the volumes transported and stored in the network of this plant have significantly decreased. As a result, Holly Energy Partners saw its distributable cash flow decrease 5% in 2021, from $2.69 to $2.56.
On the bright side, HollyFrontier does not intend to convert other refineries into renewable diesel plants. Therefore, investors should not expect the distributable cash flow of Holly Energy Partners to decrease materially from its current level.
Distribution
Holly Energy Partners raised its distribution for 58 consecutive quarters at a 7% average annual rate until 2020. As this period includes the Great Recession and the downturn caused by the collapse of the oil price from $100 in 2014 to $26 in 2016, the exceptional distribution growth streak of Holly Energy Partners is a testament to its resilient business model.
Unfortunately, Holly Energy Partners cut its distribution by 48% in 2020 due to the uncertainty caused by the pandemic. It is important to note that the MLP could marginally avoid cutting its distribution, as it posted a marginal coverage ratio of 100.4% in that year. However, due to the uncertainty caused by the pandemic, management chose to cut the distribution proactively in order to protect the company from the adverse scenario of a prolonged pandemic.
Despite the distribution cut, Holly Energy Partners is still offering an exceptionally high distribution yield of 8.2%. More importantly, the MLP currently has a distribution coverage ratio of 1.8, which provides a wide margin of safety.
Moreover, Holly Energy Partners has a healthy balance sheet. Its leverage ratio (net debt to EBITDA) has dropped to 3.9 and its credit rating is BB+ (S&P) and Ba2 (Moody’s). Its net interest expense consumes only 14% of its operating income while its net debt (as per Buffett, net debt = total liabilities – cash – receivables) stands at $1.4 billion. This amount is only 5 times the annual distributable cash flow of the company and hence it can be easily serviced.
Even better, management recently stated that it intends to utilize the excessive cash flows of the MLP to reduce the leverage ratio further, from 3.9 to 3.0-3.5. In this way, Holly Energy Partners will strengthen its balance sheet even more and thus its distribution will become even safer.
Valuation
Holly Energy Partners is currently trading at a price-to-distributable cash flow ratio of 6.6, which is much lower than the 5-year average of 9.0 of the stock. The cheap valuation has resulted primarily from the pandemic and the aforementioned headwind from the Cheyenne refinery, which highlighted the risk from the secular shift of many countries from fossil fuels to clean energy sources. However, despite this secular shift, global oil consumption remains on the rise. To be sure, EIA expects global oil demand to continue growing, from 100.6 million barrels per day in 2022 to an all-time high of 102.5 million barrels per day in 2023.
Moreover, as soon as Holly Energy Partners reduces its leverage further, to the above mentioned target of 3.0-3.5, the stock will deserve a higher price-to-distributable cash flow ratio. Overall, the valuation of the stock is likely to improve as soon as the market appreciates the strong balance sheet and the resilient business model of the MLP.
Final thoughts
Investors have panicked lately due to the surge of inflation to a multi-decade high. Indeed, it has become especially hard to protect the real value of a portfolio from eroding due to inflation. Holly Energy Partners is an ideal holding in this investing environment. The stock is offering an 8.2% distribution, which has a wide margin of safety thanks to the robust business model of the MLP, its strong distribution coverage ratio and its solid balance sheet.
