2023-06-06 09:23:32 ET
Summary
- NuStar Energy is a master limited partnership with a stable annual gross profit of $800 million and a high yield of 9.4% for its common units.
- Despite its less-than-perfect financial standing, NuStar is cash-rich and has a strong distribution coverage ratio for its preferred shares, making them an attractive investment option.
- Despite the attractiveness of NS preferred shares, I believe there is an even better option to get exposure to NuStar Energy.
- The NSS baby bond offers a potentially generous 12% yield and added safety compared to common units and preferred shares, making it a strong buy for income investors.
Overview
NuStar Energy ( NS ) is a master limited partnership engaging in the transportation and storage of a diversified range of liquids, including crude oil, refined products, renewable fuels, and ammonia. The company owns assets worth approximately $5 billion, which generated roughly $1.7 billion in revenues last year. NuStar's business has proven to be steady, producing a stable $800 million annual gross profit since 2019, unfazed even by the gyrations of the pandemic economy. The apparent limitation here seems represented by the lack of growth, but NS common units seem a decent income vehicle, with a high yield of $1.60 per unit or about 9.4% as of this writing.
Credit Rating Review
The crucial question income investors want answered concerns the distribution’s safety. A quick review of the company’s credit rating gives us a good hunch. NS only earns a BB- rating from Fitch and S&P (and an equivalent Ba3 from Moody’s), so this is a speculative investment. A clear warning comes from the fact NuStar has cut distributions twice (in 2018 and 2020) and now pays slightly less than it did 20 years ago. Nonetheless, on the flip side, the remarkable stability of its operations ensured NuStar paid distributions for 22 consecutive years since its listing in 2001. NuStar owns long-life assets that should continue contributing for decades to come. However, the shift towards renewables could, in the long run, impair the value of these assets as the demand for oil and refined products declines.
Even so, this is a risk so far away in the future that it seems almost pointless to worry now. The reason for the low standing of NuStar is more mundane and unrelated to business risk or the firm’s competitive position, which S&P evaluates as satisfactory. Liquidity is seen as adequate, as well as management and corporate governance. Financial risk, caused by NuStar's sheer amount of leverage, is the primary consideration weighing down the rating. Hence, the distribution is subject to risks related to shifts in capital allocation priorities (e.g., a focus on debt repayment).
S&P said it would consider upgrading NuStar's rating if it achieves Net Debt/EBITDA below 5.5x. However, NuStar management has claimed leverage is already “well below 4x”. As per reported during the Q1 call:
This year, we expect to once again self-fund all of our cash requirements, including all of our growth capital spending and our distributions, and we also expect to finish the year with a healthy debt-to-EBITDA metric well below 4x.
So, what’s the catch? Simply put, management plays with the number a little bit too much. Even if adjusted EBITDA should reach between $700 and $760 million in FY23, NS used a trailing $780 million figure as the denominator. In addition, even if net debt stands at $3.1 billion, NuStar has a large capital buffer in the form of preferred shares and convertibles for a whopping total of $1.2 billion, plus $400 million of floating subordinated notes (more on that later). Management excludes all these from its leverage calculations and gets to a ((3,100-400)/780) 3.5x ratio. Even if management’s way is technically correct and probably the technique used as a covenant on the credit facilities, the more conservative way I would approach this includes at least the convertible (if not also 50% of the preferreds) and divides it by mid-point forward EBITDA range so the ratio would stand at (3,100/730) 4.2x. Credit rating companies likely go even one step further by including the preferreds issued as debt and derive a ratio close to 6x (4,300/730), thus leaving NuStar ineligible for a rating upgrade.
NuStar Energy investment thesis
Despite the less-than-perfect financial standing, NuStar is a cash-rich business, and the company is also showing improving company results, which is the main reason why I believe, at this time, an investment could be attractive. The company is producing excess cash flow that will be used to decrease leverage rather than increase the distribution on the common units, which seems the prudent course of action.
NuStar reported strong results in last month’s Q1 earnings call. Net income of $106 million for the first quarter of 2023 was a whopping +118 million vs. the year before, although both years had significant, opposite one-off effects contributing to the difference. Normalized results showed a $65 million income for 1Q23 vs. $57 million for 1Q22, which is still a 14% increase. Adjusted EBITDA increased by 8%, reaching $187 million vs. $173 million for the year-ago period. Annualizing NS's current pace, EBITDA could end up close to $750 million, towards the high end of the guidance range provided. With interest expenses in the ballpark of $210 million being the main detractor to cash flow, OCF could easily hit $530 to $550 million, which leaves ~$400 million after the CapEx plan of $130-$150 million illustrated in Q1 earnings call. Even with distributions on the common units of ~$180 million and ~$120 million on the preferreds, that would leave approximately $100 million to reduce leverage further.
Even if the common units distribution seems thus well covered, I expect income investors to appreciate the wider coverage on NS preferred shares even more.
Introducing NuStar Energy Preferred shares
NuStar has three outstanding, tradable series of preferred shares currently available:
- NS-PA (NS.PA), trading past call date as of 12/15/2021. Floats at LIBOR plus 6.766%
- NS-PB ( NS.PB ). trading past call date as of 06/15/2022. Floats at LIBOR plus 5.643%
- NS-PC ( NS.PC ). trading past call date as of 12/15/2022. Floats at LIBOR plus 6.880%
Even though these are all technically callable anytime, NuStar has been focusing on redeeming a fourth, non-publicly traded series (series D), which management expects to complete by the end of 2024. The next likely candidate in line for redemption afterward could be series C, which carries the highest spread and represents the logical subsequent financial burden to be removed. However, this seems still pretty far off in the future, even after considering that I expect NS to (slightly) increase its debt load by the end of this year to eliminate the series D.
After completing phase 1 (30% reduction) last November, I expect management to move on and repurchase another ~$200 million of preferred series D (another 35% of the total placed) by the end of this year. The action was telegraphed again by management during its most recent presentation:
The repurchase would leave just a final 35% tranche to be acquired next year. Because I expect a total debt reduction of $100 million for this year (as supported by cash flow), NS will likely slightly increase its net debt in the process, which ties with the management’s remark to close the year at 4x, an increase of 0.5x from here (in management’s view).
Regardless of the capital plan, with LIBOR/SOFR cruising past 5% and these shares routinely trading just slightly below par (which shields investors from capital loss when these are eventually redeemed), the yield on these shares has now soared to about 12%. Even in the event of a FED’s pivot and rates finally turning lower, I don’t see the cost of borrowing crossing below 3% anytime soon, at least not before 2026. And even afterward, reaching a long-term target of 2.5%, the yield on series A and C would still be likely in the 9%-9.5% zone, at least on par with the common, but much safer.
For the reasons above, I believe NS preferred issues represent a better play than the common units. If I were to pick one, I would probably go with series A, as I try to maximize yield but at the same time defer the redemption risk as much as possible, expecting management to redeem series C first.
I have a bullish rating on these preferreds, and I believe they will do very well for income investors over time.
But I am not buying them.
Why?
Introducing NuStar Energy Baby Bond
Because the afore-mentioned floating subordinated notes ( NSS ) are effectively the greatest play among them all, moving one step higher on the capital ladder and available for purchase at the same $25 (par) value of the preferreds. Investors are not paying much more than a tiny extra for the added security. NSS's most recent price of $25.65 is not significantly above the current $24.8 for NS-PA or $25 for NS-PC, and the most recently declared quarterly payment of $0.758 could represent a potential annualized payment of $3.032 or 11.8% based on the recent $25.65 price. NSS floats at LIBOR plus 6.734%, essentially the same as NS-PA, but it is debt and therefore pays interest, not distributions.
To further prove this point, NSS holders receive no K-1, unlike holders of the preferred stock, and for the tax man, any gains from NSS are from a fixed-income instrument.
At the end of 2022, foreign investors like myself have been chased away from MLPs because of a tax code revision (IRS section 1446-f) requiring the payment of a 10% tax whenever a stake in a publicly traded partnership ((PTP)) is sold. The withholding tax is assessed on the total proceeds of the sale, not only the capital gain. The changes affect both NS common units and preferred shares of NS. However, because NSS is a bond and, therefore, a credit against the company, not a partnership stake, the change did not affect the baby bonds for tax purposes.
This fact alone puts NSS ahead of any other investment choices for international investors.
Takeaway
While a decent distribution coverage ratio (DCR) of 2.3x ((540-120)/180) supports the current common distribution, the DCR on NuStar preferred shares is an excellent 4.5x (540/120).
Because I regard all potential investments in NuStar as income, high-yield driven choices, I recommend that investors prioritize distribution safety and seek the highest current payout over uncertain growth opportunities. Luckily, as the situation currently stands, NS preferred shares offer a higher yield and an added layer of safety vs. NS common units. While I believe NS preferred shares are attractive, I am not buying them as there is an even better way to get exposure to NuStar Energy.
The NSS baby bond offers a potentially generous 12% yield. Even if this is a floating rate instrument, the reward will continue to be generous for many years. While a quick turnaround in interest rates would reduce the payout, the wide 6.7% spread over the LIBOR rate protects investors.
There is minimal risk of this bond being called anytime soon. NS management will likely focus on repurchasing the preferred shares series D and C first, as they carry a higher financial burden for the company. While questionable, NSS gets excluded from calculating the Net Debt/EBITDA ratio in covenants, effectively placing it on par with the preferred for this specific purpose but remaining one step above on the capital ladder.
For these reasons, I am rating NSS a STRONG BUY for income investors seeking a decently safe, high-yield instrument, well-hedged against interest rates trends.
For further details see:
NuStar Energy: A Better Option Than The 12%-Yielding Preferreds