Hess Midstream Stock: One Of The Strongest Buys In The Space (NYSE:HESM)

Hess Midstream LP (NYSE:NYSE:HESM) is a fee-based midstream player that owns major midstream assets of one of the largest oil and gas companies, Hess (HES). Its oil, gas and produced water handling assets are not only used by third party customers, but also by HES itself. This automatically creates an unique advantage in securing stable and predictable demand in the future.

As with most midstream operators, since 2020 HESM has delivered very solid returns. Yet, as we can see in the chart below HESM has managed to register a significant alpha relative to the midstream index.

Such outperformance might automatically lead to a question of whether HESM has reached a point of overvaluation. Plus, it might also raise a concern of whether beating the index by such a wide margin is sustainable, especially against the backdrop of midstream sector dynamics where it is very difficult to record strong growth figures (higher than in the sector) without assuming excessive amounts of debt.

However, if we zoom into the details of HESM’s fundamentals, we will realize that this midstream player has some gas left in the tank to create value going forward, with a quite high probability of beating the index.

On top of this, in my opinion HESM presents an attractive case for dividend investors seeking income predictability in combination with a gradual growth in the distribution levels.

Let me explain this.

Thesis

There are three important aspects I would like to underscore that are also the key drivers of my bullish view:

First, in terms of the valuations HESM is trading at very reasonable levels despite the massive outperformance that we could observe in the chart above. The FWD EV/EBITDA of HESM is at 5.9x, which is actually one of the lowest levels in the midstream space. For example, let’s take some other well-known midstream companies and check their FWD EV/EBITDA multiples:

• Energy Transfer LP (NYSE:ET) – 7.8x
• Enterprise Products Partners (NYSE:EPD) – 9.5x
• Enbridge Inc. (NYSE:ENB) – 11.1x
• Plains All American Pipeline (NASDAQ:PAA) – 15.7x
• MPLX LP (NYSE:MPLX) – 9.7x

It is clear that we are not talking about any premium but rather a notable discount that HESM still carries relative to peers.

Theoretically, this could be justified if HESM had a weak balance sheet, declining cash flows or just too speculative of a future. However, as we will understand from the next two aspects, this is clearly not the case.

Second, the overall cash generation profile is arguably one of the most defensive in the midstream space. The key element that allows HESM to enjoy de-risked cash flows is the combination of HES as a main offtaker and 100% fee-based contracts that isolate the business from direct commodity risk.

Eighty-five percent of total revenues are based on fixed-fee contracts with attached periodic CPI escalators that stimulate the organic growth prospects. The remaining 15% is linked to cost-of-service contracts, where the fees are recalculated annually for all forward years to maintain contractual return on capital deployed.

Another critical element here is the fact that HESM has stipulated its agreements so that at least 80% of revenues are secured on a three-year forward basis, thereby introducing an inherent floor as to how far the total revenues can drop. For instance, in 2024 almost 85% of total projected revenues are protected by minimum volume commitments. Furthermore, the table below illustrates how the MVC component is set to increase each year until 2026.

Finally, we have to also appreciate the fact that management has outlined an ambitoius strategy to expand EBITDA generation by at least 10% per year until 2026. Part of the growth will be accommodated through periodic escalators, but the most notable driver will be the capital deployment in organic CapEx projects.

Third, the capital structure of HESM could be easily deemed as one of the safest in the sector. The current leverage ratio is 3.2x (in terms of adjusted EBITDA), which is a very conservative level. Here management has communicated plans to strengthen the balance sheet even further by reducing the leverage ratio to below 2.5x by the end of 2025. While the increased EBITDA should mathematically bring down the relevant metric, the organic debt repayment component is likely to be the key source for achieving this target. For example, the midpoint of 2024 adjusted free cash flow target is set at circa $700 million, which already covers the projected organic CapEx spend of around $260 million. If we adjust this figure for the TTM dividend distributions, we will arrive at a net cash flow of ~ $550 million, which explains roughly 15% of the total long-term borrowings of HESM.

Yet, as Jennifer Gordon – VP, IR – has commented this in the most recent earnings call, part of the cash flow retention will also be directed towards buying back the shares, which really makes sense given the relatively depressed multiples:

As we have done in the past, with the reduced share count following the repurchase, this distribution level increase maintains our distributed cash flow at approximately the same amount as before the repurchase. Following the unit repurchase, we expect to continue to have more than $1.25 billion of financial flexibility through 2026 that can be used for continued execution of a return of capital framework, including potential ongoing unit repurchases.

With that being said, we could still expect HESM to gradually reduce the leverage even further from already a conservative level.

The risks

While as we can see HESM enjoys durable cash flows and carries a defensive capital structure, there are still some risks that we have to consider.

From the valuation perspective, investors might not be able to capture gains from full multiple convergence any time soon. This has to do with the fact that HESM has been trading at a discount for more than five years in a row (even before the pandemic period). So to neutralize the discount, HESM has to register some meaningful catalysts that could drive multiple expansion.

However, here I would argue that we can already see (from the return chart above) that there has been a gradual process of multiple expansion taking place. While it is indeed difficult to predict whether it will continue at this pace, considering the deleveraging aspect and continued EBITDA growth it seems very likely that investors could capture incremental price appreciation returns.

Another risk that might damage the investment case is the lower demand volumes from HESM offtakers. It is clear that all of HESM’s assets are linked to fee-based contracts, but in the case of a steep decline in natural gas and oil production, the stored and transported volumes could drop. In such instance, HESM’s EBITDA should fall accordingly. In my opinion, this is a rather unlikely scenario given the prevailing energy market dynamics. In addition, we have to remember that HESM’s MVC component provides a downside risk hedge to an extent where the adjusted free cash flows would still be positive and sufficient to service the dividend.

The bottom line

All in all, in my view there is a clear disconnect between HESM’s multiple and its underlying fundamentals. By assessing these fundamentals both from the cash generation and capital structure perspective, I would argue that HESM actually deserves a premium over peers. However, the opposite is currently the case; HESM trades a notable discount.

For me this provides an opportunity to enter HESM before the multiple convergence takes place, which is a realistic scenario given the further deleveraging and EBITDA growth process.

As a result I am assigning a strong buy to Hess Midstream LP.