America’s Midspace has generally been a slow-motion train wreck. Poor capital allocations, declining client health over the 2015-2020 period, and contract valuations have driven all but the most optimistic fans out of the space. The result has been a high yield sector that most don’t want to chase. We have a similar view in general, as there are definitely better places to invest right now. At the same time, some stocks make a lot of sense from an income perspective, especially if you choose your entries carefully. We review Shell Midstream Partners, LP (SHLX) today and tell you why we prefer it to the rest of the bunch.
SHLX generates revenue from the transportation and storage of crude oil, refined, intermediate and finished products. They do this through their proprietary pipelines, storage tanks, docks, and other logistics assets. They own or retain effective control over the majority of their assets.
Like many other midstream companies, SHLX underwent an IDR (Incentive Distribution Rights) elimination. It happened in 2020, which was perhaps not the best time to hold a negotiation on this subject.
At the closing of the April 2020 Transaction, the Partnership had 393,289,537 common units outstanding, of which SPLC’s wholly-owned subsidiary Shell Midstream LP Holdings LLC (“LP Holdings”) held 269,457,304 common shares of the limited partnership, representing a total of 68.5%. sponsor interest. The Partnership also had 50,782,904 Series A Preferred Units outstanding, which are entitled to a quarterly distribution of $0.2363 per unit and all of which are held by LP Holdings.
Source: SHLX 10-Q
The $1.2 billion in preferred stock is convertible into common stock, but currently pays a ridiculously low rate of 4% to Royal Dutch Shell (RDS.A). This conversion, when it occurs, will significantly reduce the distributable cash flow for the Common Units.
There are some things we don’t like about the mid-range, and all of those reasons don’t really apply to SHLX. The first is that the extreme capex investment cycle of the past has created an abundance of intermediate assets relative to the demand for them. We see this slowly unfolding as contracts are renewed and new ones get cheaper. Now, each case is of course different and pricing power will very much depend on what volumes look like in 2022 and beyond. Overall, however, we expect the sector’s EBITDA to be under pressure. SHLX has a fairly unique set of assets, however, where there are no real competitors.
For most of its assets, we don’t expect competition and that gives SHLX an edge on our books. The second problem we have with midstream is that investment cycles are still strong, despite promises to cut spending. SHLX fits in here a little differently.
There is, of course, a size differential (the remaining 3 are much larger), but even adjusted for that, SHLX doesn’t spend as much on range. We think this is the best approach in this environment, and SHLX gets another tick because of it.
SHLX also focused on its debt from the start, and it was never unwieldy. Current levels are good, and the focus on smaller add-on projects should avoid any issues there.
While other companies like Energy Transfer LP (ET) are prioritizing debt repayment, SHLX has already achieved its goal. One thing to keep in mind here is that SHLX’s reported numbers for 2021 are significantly higher than that 3.0-3.5X in the image above. This was due to one-off factors impacting EBITDA, and we expect 2022 numbers to be much better.
- As of September 30, 2021, the Partnership had total debt of $2.7 billion, which equates to 4.7 times debt to third quarter 2021 annualized adjusted EBITDA. Q3 2021 EBITDA was heavily impacted by Hurricane Ida, which the Partnership views as a temporary event and we expect results to normalize in Q4 2021. Current debt levels are well within our target range and provide flexibility to the Partnership.
Source: SHLX 10-Q
The volume history is a good way to visualize the anomaly of the last reported quarter.
Evaluation and verdict
The appeal of SHLX mainly comes from its business advantages over other midstream players, in our opinion. Valuation-wise, SHLX isn’t the most attractive. Even normalizing for what 2022 will produce, without hurricane impacts, you’re looking at a distributable cash flow multiple close to 8X. On an EV to EBITDA basis, SHLX is significantly more expensive than most peers and in line with industry leader Enterprise Products Partners LP (EPD).
This, of course, creates a more complicated situation where SHLX could lag behind its peers, either by underperforming or falling lower. Of course, the beauty of options is that they help us mitigate those risks. Since we were interested in this, purely for income, we took advantage of the opportunity at the end of December. With SHLX trading at $10.90 at the time, we saw attractive prices for January 2023 and July 2022 put options and covered calls.
The January 2023 $10 Cash Secured Put Options were quite old in nature, but offered an 18.40% return as long as the price remained above $10.00.
This position appears here as a safe bet, regardless of how SHLX navigates in the next 11 months. In the unlikely event that the position is offered to us, we are happy to have a long SHLX position below $10.00. At current prices, we see this more as a “hold/neutral” and it is definitely not one we will be chasing.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.