DKL - Delek Logistics Partners: Solid Results But A Few Concerns

Summary

• Delek Logistics Partners, LP reported solid results that showed strong YOY growth.
• This growth was mostly driven by the company's acquisition of 3Bear's Permian, gathering assets in the middle of 2022.
• The company has guided for 5% growth in 2023 but did not provide any specifics of how it would achieve this.
• The company's leverage ratio is quite high, which could pose a risk for investors.
• The Delek Logistics Partners, LP distribution coverage is very tight, which is a concerning sign.

On Tuesday, February 28, 2023, midstream dropdown partnership Delek Logistics Partners, LP ( DKL ) announced its fourth-quarter 2022 earnings results. At first glance, these results were disappointing, as Delek missed the expectations of its analysts in terms of both revenues and net income. However, the market seemed pleased with these results, as the company's partnership units jumped in the trading session that followed the earnings release:

As I have pointed out before, though, net income is not really a good metric to use in evaluating the performance of a midstream company like Delek Logistics Partners. Rather, we should use the company's cash flow, and its results here were mixed. The company did see its EBITDA increase significantly year-over-year, but distributable cash flow was down over the same period. Nonetheless, Delek Logistics Partners increased its distribution for the fortieth consecutive quarter to $1.02 per unit. That brings the company's annualized yield up to 8.32% at the current price. This is certainly a respectable yield, so let us investigate whether Delek Logistics Partners, LP would be good for our income portfolios today.

Earnings Results Analysis

As my long-time readers are no doubt well aware, it is my usual practice to share the highlights from a company's earnings report before delving into an analysis of its results. This is because these highlights provide a background for the remainder of the article as well as serve as a framework for the resultant analysis.

Therefore, here are the highlights from Delek Logistics Partners' fourth-quarter 2022 earnings report :

• Delek Logistics Partners reported net revenue of $269.051 million in the fourth quarter of 2022. This represents a 41.69% increase over the $189.884 million that the company reported in the prior-year quarter.
• The company reported an operating income of $61.621 million in the most recent quarter. This compares quite favorably to the $49.355 million that the company reported in the year-ago quarter.
• Delek Logistics Partners' gathering system in the Midland Basin handled an average of 191,119 barrels of crude oil per day during the fourth quarter. This represents a substantial 129.29% increase over the 83,353 barrels of crude oil per day that the system handled during the equivalent quarter of last year.
• The company reported a distributable cash flow of $51.351 million in the reporting period. This represents a slight decline from the $53.853 million that the company reported last year.
• Delek Logistics Partners reported a net income of $42.700 million in the fourth quarter of 2022. This represents a 2.43% increase over the $41.685 million that the company reported in the fourth quarter of 2021.

It seems certain that the first thing anyone reviewing these highlights will notice is that several of the company's metrics of financial performance improved significantly compared to the prior-year quarter. This extends to the company's EBITDA, which is frequently used by midstream companies as a proxy for pre-tax cash flow. Delek Logistics Partners reported an EBITDA of $92.466 million in the most recent quarter, which set a new quarterly record for the company and represents a significant increase over the $69.690 million that the company reported in the year-ago quarter.

The biggest reason for these improved metrics was the acquisition of 3Bear Energy which occurred during the middle of the year. Prior to the acquisition, 3Bear owned a network of gathering and processing assets that included 485 miles of pipelines, 88 million cubic feet per day of natural gas processing capacity, and 120,000 barrels of crude oil storage capacity. Naturally, all of these assets became the property of Delek Logistics Partners after the acquisition was completed. Perhaps the nicest thing about these assets is that they came with long-term contracts with customers for their use. Thus, they produced positive cash flow at the time of the acquisition, which immediately provided a boost to Delek Logistics Partners.

This practice of ensuring long-term contracts for the use of its assets is a core aspect of Delek Logistics Partners' business model and it is something that we appreciate as investors because of the stability that it provides for the company. Basically, Delek Logistics Partners secures long-term contracts under which it provides transportation, storage, and other services for crude oil and natural gas. The company's customers pay it a fee based on the volume of the resources that it handles, not on their value. This is quite nice because it provides the company with a great deal of insulation against fluctuations in the price of crude oil and natural gas. That is important for income investors because it provides the company with stable cash flows that it can use to support the distribution that it pays us. As stated earlier in the article, Delek Logistics Partners has increased its distribution in each of the past forty quarters and never reduced it so we can clearly see the strength of this business model.

Curiously, Delek Logistics Partners provided no insight into its near-term growth potential in its earnings report. It is essential that the company continues to produce growth if it wishes to continue its track record of growing its distribution quarterly. It may have some options, however. Most notably, we are seeing crude oil and natural gas production growth in the Permian region:

While this production growth is not nearly as strong as some politicians bemoaning high gas prices would like, it is definitely occurring. That could benefit Delek Logistics Partners, as the company has an extensive network of gathering infrastructure throughout the Permian Basin. That could provide it with some growth potential as someone will need to bring this incremental growth to the market. If new production comes online within Delek Logistics' gathering network's footprint, the partnership should see new volumes. However, the company made no mention of this in its press release or conference call so we do not know for certain how much of this new production the company will be able to get moving through its network. It is possible and not altogether unlikely that much of the company's forward growth will come from new acquisitions like we saw this year with 3Bear. It has not publicly announced any new acquisitions, however.

Financial Considerations

It is always important that we investigate the way that a company is financing its operations before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. This is usually accomplished by issuing new debt and using the proceeds to repay the existing debt, which can cause a company's interest expenses to increase after the rollover depending on conditions in the market. As interest rates have been rising over the past year, this could be an especially big concern today. In addition to this, a company must make regular payments on its debt if it is to remain solvent. Thus, an event that causes a company's cash flows to decline could push it into insolvency if it has too much debt. Although Delek Logistics Partners has remarkably stable cash flow due to its contract-based business model, this is still a concern that we should not ignore.

The usual way that we judge a midstream company's ability to carry its debt is by looking at its leverage ratio, which is also known as the net debt-to-EBITDA ratio. This ratio essentially tells us how long it would take the company to completely pay off its debt if it were to devote all its pre-tax cash flow to that task. During the twelve-month period that ended on December 31, 2022, Delek Logistics Partners, LP had an EBITDA of $311.937 million and a net debt of $1.6737 billion. This gives the company a leverage ratio of 5.37x, which is very high. Wall Street analysts generally consider anything under 5.0x to be acceptable, and Delek Logistics Partners is clearly above that. The company is far above the 4.0x that the strongest companies in the sector possess, which is likewise concerning.

Unfortunately, Delek Logistics Partners, LP has made no statements about reducing this in the near future, so it is unclear whether management perceives the company's high leverage relative to its peers as a problem. The company could theoretically reduce this by increasing its EBITDA and not taking on any more debt, however. The company stated that it expects to increase its EBITDA by 5% in 2023 compared to 2022, but did not provide any details on how exactly it plans to accomplish this. We have already discussed this. Overall, I recommend keeping an eye on the company's leverage and remaining cautious.

Distribution Analysis

One of the biggest reasons why many investors purchase shares of midstream partnerships is the incredibly high yields that these companies typically possess. Delek Logistics Partners is certainly no exception to this. Alongside its earnings release, it announced a quarterly distribution of $1.02 per share, which is its fortieth consecutive quarterly increase. That gives it a better track record than just about any other company in the industry along with an 8.32% annualized yield. However, this does not mean that the company can actually afford its distribution. We should investigate this as we do not want to be the victims of a distribution cut since such a move would reduce our incomes and most likely cause the company's stock to decline.

The usual way that we judge a midstream partnership's ability to maintain its distribution is by looking at its distributable cash flow. The distributable cash flow is a non-GAAP metric that theoretically tells us the amount of money that was generated by a company's ordinary operations and is available to be distributed to limited partners. As stated in the highlights, Delek Logistics Partners reported a distributable cash flow of $51.351 million during the fourth quarter of 2022. That is sufficient to cover the declared distribution 1.16 times over, which is concerning. Wall Street analysts generally want to see a ratio higher than 1.20x in order to consider a distribution to be reasonable and sustainable. I am somewhat more conservative than this and like to see the ratio over 1.30x to add a margin of safety to the distribution. As we can clearly see, Delek Logistics Partners is below both of these requirements. This could be a sign that the company is over-distributing and may be at risk of a cut. I will admit that I am hesitant to predict such a cut, but this low distribution coverage ratio and high leverage ratio are both making me be exceedingly cautious.

Conclusion

In conclusion, Delek Logistics Partners, LP reported very solid fourth-quarter 2022 earnings results, despite the fact that it missed analysts' expectations. The market seems to have understood that the results are solid considering the reaction that it gave to the unit price. The results were driven by an acquisition that probably will not be repeated in 2023 so we should not expect similar growth this year. In fact, management stated that the company will increase its EBITDA by 5% this year but did not provide any method by which it would be accomplished.

This limited forward guidance combined with the company's high leverage and tight distribution coverage makes me hesitant to recommend Delek Logistics Partners, LP for new money today. The yield is nice, though, so existing unitholders may want to hold onto their positions.

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