By: Dividend Sensei
Risks To Consider
There are three risks to consider before buying into an MLP IPO. The first is most obvious, which is that with no track record to speak of investors can’t necessarily know ahead of time what kind of yield or payout growth they can expect.
In the case of Rattler Midstream the highly conservative nature of this MLP, specifically its plans to self fund its growth with free cash flow (not retained DCF like most self funders in the industry) might cause it to generate slower distribution growth than other hyper growth MLPs like Oasis Midstream (OMP), Noble Midstream (NBLX), or Antero Midstream (AM, AMGP). However, the lack of IDRs and Diamondback Energy’s massive growth plans in the red hot Permian basin means that most likely investors will see at least 10% to 15% long-term payout growth and possibly 20% to 30% early on.
However, anyone interested in investing in RTLR must be comfortable with the fact that at least for the first few years the MLP will be extremely dependent (initially 100%) on just one oil company, operating in just one shale formation, for its cash flow. While that cash flow is locked up under long-term contracts RTLR will not enjoy any minimum volume commitments. This means that in the event of another oil crash, its sponsor might run into financial trouble or pull back on production enough to cause a fall in its cash flow. That doesn’t necessarily mean that Rattler would be facing a distribution cut, if the distribution coverage ratio is high enough. Management’s plans to self fund with free cash flow means that the coverage ratio should be among the highest in the industry (possible 1.8 to 2.2) which should allow the payout to survive a recession or oil downturn. That’s because in the midstream industry a coverage ratio of 1.1 is considered safe, and most self funding MLPs have coverage ratios of 1.2 to 2.0.
However, until Rattler is able to diversify its cash flow stream to third party oil producers, it will always be at risk of a worst case scenario in which Diamondback Energy might go bust. The odds of that are low but not zero. That’s because Diamondback has a BB (junk bond) credit rating, though that is likely to improve given the low 1.1 debt/EBITDA (leverage) ratio. For context the industry average for oil & gas companies is 3.0 and Diamondback’s interest coverage ratio (operating cash flow/interest) is 16.5. That’s compared to 10.6 for most of its peers, showing the company is very easily able to service its debt.
But the point is that as exciting as Rattler Midstream’s growth potential might be, investors will want to carefully watch this newest of MLP’s to see what kind of long-term payout growth, distribution coverage, and leverage ratio guidance management provides when it goes public next year.
Bottom Line: Rattler Midstream Partners Is A Potentially Exciting IPO To Watch In 2019
Many income investors understandably shy away from MLPs due to their complex structure (including incentive distribution rights) and K1 tax forms. Rattler Midstream, when it IPOs in 2019, will have none of these downsides. It will be treated as a corporation for tax purposes (so no K1) and having no IDRs to raise its cost of capital and slow its long-term payout growth. Combined with the rapid long-term growth plans of its sponsor, Diamondback Energy, in the booming Permian basin, this means that Rattler Midstream may soon become the fastest growing MLP in the country. Which in turn means this stock might prove to be one of the best performing income growth investments of 2019, the next few years, and possibly the next decade.