Hess Midstream Stays Undervalued With Chevron-Linked Upside (NYSE:HESM)

Shares of Hess Midstream (NYSE:HESM) have steadily marched to a 12-month excessive and have now returned over 20% together with dividends up to now yr. Since I final wrote about this MLP in early November, shares have returned over 14%. In that article, I argued that Hess Midstream was undervalued on a stand-alone foundation and that Chevron (CVX) could search to amass it after finishing its Hess (HES) buy. The CVX-portion of my thesis stays, and I’ll give attention to HESM’s underlying outcomes to find out stand-alone honest worth and a possible take-out value. I stay bullish on the inventory.

Within the firm’s fourth quarter, HESM earned $0.55 in adjusted earnings as adjusted EBITDA got here in at $264 million, up 8% from final yr. HESM generated $147 million of free money circulate. For the complete yr, HESM generated $1.02 billion in adjusted EBITDA, up about 4%, as HESM’s development has accelerated by way of the yr.

This development was pushed by elevated utilization by way of its Bakken-centric community. Gasoline volumes rose by 24%, oil by 19%, and water gathering rose by 47%, aided by elevated drilling exercise by Hess. As you possibly can see beneath, volumes have been considerably stronger throughout every enterprise line.

One vital optimistic from this development is that HESM is now not counting on minimal quantity commitments (MVC) to guard income. In This autumn, HESM acquired $1.8 million of MVC shortfall funds, down from $41.7 million final yr. MVCs are very useful within the near-term. Basically, the producer (on this case Hess E&P) agrees to pay to make use of the pipe, whether or not it sends oil and fuel by way of them or not. This offers the producers assured pipe entry, and it offers the midstream firm assured minimal income.

Excessive MVCs assist to supply robust certainty round income ranges. Nevertheless, when there’s a giant shortfall, markets are inclined to worth that income much less. That’s as a result of even long-term contracts come to an finish finally. And if there may be low quantity within the pipe, the following contract is prone to be much less favorable with a decrease MVC. MVCs assist to insulate income from cyclical swings in oil & fuel exercise, but when a shale’s manufacturing is in long-term decline, they solely delay the inevitable.

Fortuitously, Hess is drilling actively and rising manufacturing. Furthermore, with Chevron searching for to construct scale and additional develop these belongings, manufacturing out of the Bakken ought to stay wholesome. Not solely is Hess Midstream rising, however the high quality of its outcomes has additionally improved.

Additionally it is essential to notice that HESM’s contracts with HES stretch for a number of years. Additionally they should not have commodity value publicity, and charges are CPI escalated. Fastened charges account for 85% of income with the remaining 15% based mostly on value of companies, tied to CPI. Fastened charges with excessive MVCs and rising underlying manufacturing have created an setting the place HESM steadily grows EBITDA throughout various financial cycles.

As the corporate has grown, its value base has elevated, exacerbated a bit by inflation, and working and upkeep prices rose by a 3rd to $88 million. For the complete yr, free money circulate fell by $5 million to $606 million on account of $14 million greater cap-ex and a $30 million soar in curiosity expense, which must be peaking now. Nearly all of its cap-ex funds is in development initiatives, which ought to assist HESM meet Hess’s rising manufacturing profile.

Alongside earnings, Hess Midstream elevated its distribution by 2.7% to $0.6343, giving shares a couple of 7.4% yield. That is above the 1.2% required quarterly development charge to attain its 5% goal and displays these robust outcomes. HESM additionally executed on $400 million in share repurchases in 2023, just like 2022. The MLP additionally carries comparatively low leverage at 3.2x debt/EBITDA. Given anticipated 2024 development, leverage must be again beneath its 3x goal by Q3.

I used to be additionally inspired by 2024 steerage. Administration expects 10% quantity development in 2024. This could translate to $1.15 billion of EBITDA in 2024, up about 12.5% from final yr, persevering with the acceleration we’ve seen in ends in H2 2023. Whole cap-ex spending might be $250-275 million, with $125 million of upkeep and $125-150 million of development initiatives. That ends in $685-735 million in free money circulate and $115 million of retained free money circulate after distributions. That interprets to a ~1.41x distributable money circulate protection ratio (working money circulate much less upkeep cap-ex divided by the distribution), in-line with its 1.4x goal.

Past 2024, Hess now expects annual distribution development of not less than 5% by way of 2026. Underpinning this outlook, Hess accomplished tariff redeterminations, which elevated the MVCs to supply safety above 2023 ranges. These MVCs suggest 10% fuel throughput development and seven.5% oil development in 2024-2026. As such, it expects to develop adjusted EBITDA by 10% per yr whereas holding cap-ex flat at $250-275 million. At its distribution development, leverage would fall to 2.5x earlier than any buybacks or M&A.

Basically, with these MVCs, it has “locked in” about $950 million of run charge EBITDA in 2024, rising by about 10% from there. In actuality, with Hess manufacturing properly above minimums, precise outcomes might be greater. These MVCs do by way of present a excessive degree of money circulate safety, which, mixed with its fee-based contracts, is why money circulate is so regular and predictable. Based mostly on its anticipated development, HESM additionally could have not less than $1.25 billion of monetary flexibility over the following three years for buybacks whereas sustaining 3x debt/EBITDA. That ought to allow it to proceed its ~$400 million/yr tempo of share repurchases.

I view HESM’s 5% distribution development goal very credible, given these elements, which is why I view shares as very engaging at a 7.4% yield, as that creates a mixture for 12-13% long-term returns (distribution + development), particularly given its steadiness sheet flexibility to repurchase shares. I view honest worth as a 5.5-6% yield, which interprets to not less than $42 as a good standalone worth for HESM.

On the identical time, there may be the potential CVX tries to amass HESM after it completes its HES buy. As I defined in my final article, CVX has finished that previously with Noble and Noble Midstream, and this is able to assist simplify its capital construction. On their earnings call, Chevron administration reiterated that the corporate expects to shut the acquisition of Hess in mid-2024, with a draft S-4 to be filed this quarter. I might count on CVX to attend 3–6 months earlier than making any motion on HESM, that means a deal may very well be introduced in late 2024.

As a reminder, upon shut of Hess acquisition, Chevron will personal 38% of HESM, however all current contracts with legacy Hess stay in place. Chevron can appoint as much as 4 members of the board; there are additionally 3 from GIP and three unbiased administrators who might want to log off on a deal that will even require unitholder approval, that means it’s unlikely to shut earlier than 2025.

Whether or not a deal materializes or not is unknown, however given the relative small measurement of HESM and Chevron’s previous actions, I view one as likelier than not. I might count on CVX to want to supply not less than low-$40’s to get GIP and public shareholders to approve the deal. Within the meantime, traders acquire a 7+% yield in a steady MLP that trades beneath honest worth. With share value upside and distributions, there stays an over 25% return potential, and I proceed to suggest proudly owning Hess Midstream.