DKL - Delek Logistics Partners Could Help Fuel Investor Gains

Summary

• Delek Logistics has outperformed the market over the last five years.
• The firm is aided by improved capital discipline and capital conditions.
• The firm has been able to earn industry leading value spreads.
• Delek Logistics has managed to grow profitably over the last five years.
• The partnership is trading at an attractive relative valuation and FCF yield.

Delek Logistics Partners, LP ( DKL ) has been a beneficiary of the improved capital discipline of the energy industry. This shareholder friendly firm has grown profitably and earned industry-leading value spreads. Given the difficulties of building pipelines and terminals, there are significant barriers to entry protecting the firm. With an attractive relative valuation, and strong FCF yield, investors should consider buying stock in the firm.

A Sector in Resurgence

In the last five years, the Delek Logistics share price has risen by nearly 50%, compared to a nearly 36% rise for the S&P 500.

Delek Logistics' performance would have been unthinkable before, in an age where energy stocks had performed poorly on the stock market. The last two years have been unique: it is the first time since 2010 and 2011, when the MSCI World Energy index has outperformed the MSCI World Index. Across the post-2010 period, the energy sector has been an unloved one. This has been exacerbated by the rise of environmental, social & governance ((ESG)) driven investing.

The highly fragmented oil & gas industry has not been credited with the success it has enjoyed on the market. For many people, energy’s success has been driven by post-pandemic supply chain disruptions. The history of the industry has encouraged skepticism. The industry has been characterized by poor capital discipline and constant boom and bust cycles driven by the ebb and flow of capital. The industry’s fragmentation and the commodity nature of energy encourages a kind of madness in the industry. At the micro level, actors behave rationally and yet in ways that undermine the industry at the macro level. Absent pricing power, actors are forced to grow their assets, by assuming more debt, issuing more equity, and expanding capex during booms. However, given the time lag between production decisions and future prices, managers are likely to overstate their growth opportunities, leading to an excess of supply. At this point, prices collapse, and capital exits the market until the excess supply clears and profitability returns to the market. This stylized capital cycle makes the industry a bad place to invest for the long haul in my opinion.

However, in recent years, capital exits have been heightened due to ESG investor concerns. For instance, impact investor, Engine No.1, has pushed Exxon Mobil ( XOM ) to diversify away from fossil fuels. Dutch pension fund for government employees, Stichting Pensioenfonds ABP , sold their profitable fossil fuel holdings for environmental reasons. This trend away from investing in fossil fuels is unlikely to change with auto transport switching to electric in the coming years.

This is despite the fact that the global energy mix still tilts heavily toward fossil fuels. Between 1970 and 2021, fossil fuel use declined from 87% to 80%. It is highly unlikely that the energy mix will change in a marked way over the next decade.

So what we have now is a situation in which capital is leaving the industry even though the underlying fundamentals have not deteriorated as drastically as the media would have you believe. The result is that actors are enjoying greater profitability, higher and more sustainable prices, and the best period in the industry in a decade.

Delek Logistics Is a Great Value Creator

The partnership is an owner-operator of crude oil, intermediate and refined products pipelines and transportation, storage, wholesale marketing, terminalling and offloading assets. As a midstream energy company, its revenue base is more stable and reliable than that of the industry, at least historically.

Revenues come from three segments: pipelines and transportation; wholesale marketing and terminalling; and investments in pipeline joint ventures. The firm earns revenues largely through fees for gathering, transporting and storing crude oil and marketing, distributing, transporting and storing intermediate and refined products in the southeastern United States and West Texas. These contracts are commonly known as “take-or-pay” contracts and oblige the client to order volumes with a minimum fixed-fee irrespective of demand. The firm also earns revenues from the sale of wholesale products in the West Texas market.

It is very hard to build a pipeline and terminals given the regulatory hurdles involved. However, once established, maintenance capex is often just 10% of operating cash flow. This can lead to very attractive returns. As the chart below shows, between 2015 and 2020, Delek Logistics’ enjoys the highest value spread of its peer group. With a cash return on investments ((CROI)) of 18.7%, Delek had a superior CROI to the median (9.8%) and average (9.4%) of the peer group. While small, the industry has been able to earn a positive value spread across the last five years, with a median 5-year value spread of 2.1%, and an average 5-year value spread of 1.3%.

The company’s success continued into 2021, when it earned a CROI of 20.6%, putting it among the highest of its peer group.

The positive value spreads have been driven by the firm making acquisitions at attractive valuations; the scalability of its platforms and cost controls; capital reimbursements; inflation escalators in contracts; and a largely fee-based cash flow profile. The benefits of take-or-pay contracts really do give midstream firms the possibility to earn attractive value spreads and sustainable, reliable cash flows in my view.

A Shareholder Friendly Business Model

In the past, the industry tended to pay out large dividends, while issuing shares in such large volumes as to offset the dividend yield, and reduce the final shareholder yield. So, for instance, a 5% dividend yield, might be offset by a 4% share issuance rate, leading to a 1% shareholder yield. However, that tendency to grow the equity base -mirroring the asset growth of the energy sector as a whole -, has abated. For Delek Logistics itself, the company has an 8.24% dividend yield and a shareholder yield of 8.13%.

This shift has been a response to the busting of the last great bubble in the industry. With overcapacity defining the 2008-2014 period, the resulting crash in 2015 forced an exit of capital and a greater capital discipline. As discussed above, environmental concerns have kept capital down, which has actually benefited the industry’s profitability.

Strong Financial Performance

Delek Logistics grew revenue from $538.08 million in 2017 to $700.9 million in 2021, for a 5-year revenue compound annual growth rate ((CAGR)) of 5.43%. According to Credit Suisse’s The Base Rate Book , between 1950 and 2015, 24.2% of firms earned a similar rate of growth. In the TTM period, the partnership earned $957.24 million.

Gross profitability rose from 0.19 in 2017, to 0.3. According to Robert Novy-Marx’ research , 0.33 and above mark a firm as attractive. In the TTM period, gross profitability declined to 0.24.

Operating income rose sharply from $88.18 million in 2017, to $190.5 million in 2021, for a 5-year operating income CAGR of 16.66%. In the TTM period, operating income rose to $197.42 million. Operating margin also rose sharply, from 16.39% in 2017, to 27.18% in 2021. That places Delek Logistics’ operating margins among the top tier for the 1950-2015 reference period. In the TTM period, operating margin declined to 20.62%.

Net income rose from $69.41 million in 2017 to $164.82 million in 2021, for a 5-year net income CAGR of 18.88%. In the 1950-2015 period, 20.3% of firms had a similar net income growth. In the TTM period, net income declined to $158.04 million.

Free cash flow ((FCF)) has shot up from $73.07 million in 2017 to $251.42 million in 2021, for a 5-year FCF of 28.04%. In the TTM period, FCF rose to $262 million.

Echoing our earlier observation on the positive value created by the firm, returns on invested capital ((ROIC)) rose from 12.1% in 2017, to 13.1% in 2021. In the TTM period, ROIC declined to 11.1%. ROIC remains at an attractive level.

Attractive Valuation

Delek Logistics has an attractive relative valuation, with a price-earnings ((PE)) multiple of 13.1, compared to the S&P 500’s PE multiple of 20.28 . More profoundly, with $262 million in FCF, and an enterprise value of $3.528 billion, the company has an FCF yield of 7.43%. This is in excess of the 2.1% FCF yield of the 2000 largest firms in the United States, as calculated by New Constructs . This tells us that the firm is likely to outperform the market over time.

Conclusion

Over the last decade, the oil & gas industry has been transformed into a more capital disciplined industry. The midstream energy sector has not been left behind. Delek Logistics has been a key leader in growing profitably and earning attractive returns. The firm is protected given the difficulties of building alternative pipelines and terminals and other logistical infrastructure. In addition, the firm’s revenue model makes it easier to earn positive value spreads and reliable cash flows. With an attractive valuation, investors should consider buying a stake in Delek Logistics.

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