What to Buy: Crestwood Midstream Partners LP (NYSE: CMLP)

Why to Buy Now: Houston, Texas-based Crestwood Midstream Partners LP (NYSE: CMLP) owns and operates natural gas gathering and processing assets in several of the largest US shale plays, including the Marcellus, Bakken, Niobrara and Barnett formations.

It also owns and operates natural gas storage and transportation facilities in the Northeast, crude oil storage and terminalling assets in the Bakken, and a salt-mining business.

The master limited partnership (MLP) underwent a game-changing transformation last October as the result of a complicated merger with Inergy Midstream LP, which greatly expanded the resulting entity’s geographic footprint, customer diversity, and range of services.

The new MLP boasts a more stable business, with roughly 96 percent of gross profits derived from fee-based contracts. It also has strong prospects for organic growth, as well as growth via dropdown acquisitions.

Equally important, Crestwood’s units currently yield 7 percent, with the payout recently rising to $0.41 per quarter. And management is targeting distribution growth in a range of 6 percent to 10 percent annually. Buy Crestwood Midstream Partners LP below 25.

Ari: The energy patch is one of the best sources for high-yielding securities, thanks in part to the master limited partnership (MLP) structure. Though we’ve offered a diverse array of recommendations since taking over this service last May, the energy space is once again beckoning.

While most of the highest yielding MLPs are involved in exploration and production, midstream MLPs, which handle gathering, processing, storage, and transportation of energy commodities, typically offer more stable payouts due to the fact that they derive most of their revenue from long-term, fee-based contracts. These stable cash flows help support an MLP’s payout which, in turn, bolsters its unit price.

Houston, Texas-based Crestwood Midstream Partners LP (NYSE: CMLP) owns and operates natural gas gathering and processing assets in several of the largest US shale plays, including the Marcellus, Bakken, Niobrara and Barnett formations. It also owns and operates natural gas storage and transportation facilities in the Northeast, crude oil storage and terminalling assets (known as the COLT Hub) in the Bakken, and a salt-mining business.

This MLP underwent a game-changing transformation last October as the result of a complicated merger with Inergy Midstream LP, which greatly expanded the resulting entity’s geographic footprint, customer diversity and range of services. With a market capitalization of $4.2 billion, Crestwood is small in comparison to some of the midstream space’s more established players. But that also means it has ample room to grow.

The new MLP boasts a more stable business, with roughly 96 percent of gross profits derived from fee-based contracts. It also has strong prospects for organic growth, as well as growth via acquisitions from dropdowns.

Equally important, Crestwood’s units currently yield 7 percent, with the payout recently rising to $0.41 per quarter. And management is targeting distribution growth in a range of 6 percent to 10 percent annually.

Based upon the aforementioned sources of growth, analysts with Wells Fargo forecast distribution growth of 6.4 percent annually over the next five years, with a coverage ratio of 1.1x, which means the payout will be more than covered by distributable cash flow (DCF).

The new entity’s larger scale and greater growth prospects should also help reduce Crestwood’s leverage, which in time should also lower its cost of capital. The MLP’s standalone leverage was previously 5.5 times EBITDA (earnings before interest, taxation, depreciation and amortization), but management is targeting long-term leverage of 3.5 times to 4 times EBITDA. Wells Fargo predicts leverage will drop to 4 times EBITDA by the end of 2014.

Khoa: What’s the breakdown of the contributions from its various businesses?

Ari: For the combined entity, management has estimated full-year 2013 EBITDA will be derived from the following segments: 40 percent from natural gas gathering and processing, 32 percent from natural gas liquids (NGL) and crude oil services, and 28 percent from storage and transportation.

Crestwood is well diversified: No single customer, asset or business unit accounts for more than 15 percent of cash flows.

Khoa: Given how new the combined entity is, what kind of guidance has management provided for the coming year?

Ari: The MLP currently has more than $1.2 billion of identified multi-year growth projects, including a substantial backlog of internally generated capital projects in the Marcellus, Bakken and Niobrara formations.

In 2014, capital expenditures on growth projects are expected to range from $400 million to $425 million. This program is essentially prefunded by nearly $1.6 billion in debt and secondary equity issuances that were completed last year.

Management forecasts adjusted EBITDA will grow 34 percent year over year, based on the midpoint of its projected range of $465 million to $510 million.

DCF will range from $330 million to $360 million, for a coverage ratio of 1.05x to 1.1x.

Khoa: In addition to the organic growth projects we just discussed, you also mentioned the potential for dropdown acquisitions.

Ari: Crestwood’s general partner (GP), Crestwood Equity Partners LP (NYSE: CEQP) operates midstream assets, including NGL logistics operations, NGL assets on the West Coast, and a natural gas storage facility near Houston.

While analysts aren’t expecting these dropdowns to necessarily occur anytime soon, the MLP will eventually acquire these assets when management fulfills its intention of transitioning CEQP into a traditional GP that manages the MLP, but doesn’t directly own any of the operating assets. Management estimates that these assets would generate an additional $60 million to $70 million in EBITDA.

Crestwood has also been a serial acquirer, undertaking eight acquisitions since 2010, totaling $1.1 billion, so it will likely pursue additional mergers and acquisitions in the years to come.

Khoa: We’ve already covered future distribution growth. And I realize this is a much different company than it was just six months ago, but how has distribution growth been historically?

Ari: Crestwood has only been a public company for a little more than two years, with its initial public offering (IPO) occurring in late 2011. To confuse matters further, technically speaking Inergy Midstream was the successor company of that merger, but it decided to adopt the Crestwood name.

However, it’s important to note that Crestwood is helmed by Robert G. Phillips, who has extensive experience in the energy sector, including serving as president and CEO of Enterprise Products Partners LP (NYSE: EPD) from 2005 through 2007 before he joined Crestwood.

Nevertheless, it’s still worthwhile to gauge management’s intent with regard to distribution growth by looking at what they’ve done in the past. The MLP’s first full distribution was a quarterly payout of $0.37 in May 2012, and since then the distribution has grown by 10.8 percent, to $0.41 per quarter.

Khoa: What does analyst sentiment look like on Wall Street?

Ari: Crestwood currently has nine “buys,” five “holds” and no “sells.” The consensus 12-month target price is $26.56, which suggests potential price appreciation of 13.7 percent.

For calendar-year 2014, EBITDA is projected to grow 94 percent, to $499.5 million, based on the forecasts of 11 analysts aggregated by Bloomberg. Obviously, a significant portion of that rise is due to comparing the results of the new entity with the former entity.

As such, forecasts for the following year are probably more instructive. For calendar-year 2015, EBITDA is projected to increase by 13 percent, to $566 million, based on the estimates of nine analysts.

Khoa: What about tax considerations?

Ari: Before proceeding, it should be noted that we’re not tax professionals, and that subscribers should consult their accountant or tax advisor to confirm the treatment of these distributions.

In general, MLPs should be owned in taxable accounts, as a significant percentage of the distribution is considered a return of capital and is therefore tax-deferred. With each payout, the tax-deferred portion of the distribution reduces an investor’s cost basis by an equivalent amount. Assuming units are held for the long term, this means these distributions will essentially be taxed at the long-term capital gains rate upon sale of the security.

Of course, in the interim, this means contending with a Schedule K-1 at tax time, but the high yield coupled with the ability to shelter income from taxes more than offsets the tedium of dealing with this tax form.

Khoa: How have the units performed in terms of price?

Ari: Since the IPO in late 2011, Crestwood’s units have risen as high as $26.01 in April 2013, then fell to a near-term low of $20.40 in early November. By year-end, the units had climbed to nearly $25.00, then sold off through early February before regaining some upward momentum. The units currently trade near $23.47, down about 9.8 percent from the trailing-year high. Buy Crestwood Midstream Partners LP below 25.

A handful of Portfolio companies have reported earnings since our last update. We’re in the midst of writing a detailed analysis of each company’s results and will issue an update via email next week.