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Ben Reynolds
Ben Reynolds
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A Safe 7% Distribution Despite Subordinated Conversion

Exploring the rather complicated investment prospects of Black Stone Minerals

July 14, 2017 | About:

(Published by Nick McCullum on July 14)

Master limited partnerships are fantastic vehicles for generating meaningful portfolio income.

By avoiding tax at the organizational level in exchange for paying out most of their income as unitholder distributions, these investment vehicles create more unitholder income for each dollar of corporate profit.

For this reason, MLPs appeal to retirees and other income investors. This MLP List contains pertinent investment information on all 134 publicly traded master limited partnerships.

Black Stone Minerals LP (NYSE:BSM) is a master limited partnership that holds particular investment appeal because of its remarkably high dividend yield of 7%. This makes the company one of the very few securities with 5%-plus yields in today’s market.

Black Stone Minerals’ high dividend yield and tax-advantaged distribution payments make it an appealing security for income investors.

But, as with any high-yield security, due diligence should be performed to ensure the safety of this security’s distribution payments.

Business overview

Black Stone Minerals is an MLP that owns oil and natural gas mineral rights and royalty interests across much of the domestic United States.

The partnership is the largest publicly traded vehicle focused on oil and gas mineral and royalty interests with a market capitalization of $3.1 billion.

In aggregate, Black Stone Minerals has an interest in more than 18 million energy-rich acres across more than 40 states and 60 producing basins. The partnership does not own a 100% interest in each of its projects. Instead, it has a weighted average ownership interest of approximately 45%, which allows it to have higher diversification.

BSM Black Stone Minerals At A Glance

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 3

Black Stone Minerals is much younger as a publicl -traded security than most of the investments analyzed on Sure Dividend.

The company completed its initial public offering on May 6, 2015, issuing 22.5 million common units at a price of $19 per unit. All said, the IPO raised $401 million of share capital for Black Stone Minerals.

For context, that same security is currently trading at $15.99, which means it has been a very poor investment for the IPO investors. With that said, the future appears brighter than the partnership’s short history as a public security.

It is important to remember Black Stone Minerals operated privately for decades prior to its IPO.

This long private operating history has allowed the partnership to accumulated a geographically diversified asset base, with exposure to many of the most important energy regions in the U.S.

Notably, Black Stone has exposure to the Bakken Formation, the Marcellus Formation, the Permian Basin and the Eagle Ford Shale Formation.

A detailed map of the company's operations is below.

BSM Black Stone Minerals Large, Diversified Portfolio of Assets

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 5

Current events and growth prospects

Black Stone Minerals recently reported its financial performance for the first quarter of fiscal 2017.

All said, it was business as usual and the partnership is expecting a record year for fiscal 2017. In the two years since its 2015 IPO, Black Stone Minerals has meaningfully grown its production.

2017 is expected to be more of the same, with production expected to grow 14% at the midpoint of guidance.

BSM Black Stone Minerals Strong Start to 2017

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 10

Black Stone Minerals’ future growth is expected to be heavily reliant on acquisitions. This is in line with the partnership’s historical growth strategy.

The partnership is a serial acquirer of complete and partial interests in oil and energy assets across the U.S. Now that is it a publicly traded security, it has a new source of capital (common stock) it can tap to raise funds for acquisitions.

BSM Black Stone Minerals Long History of Acquisitions

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 7

Unfortunately, Black Stone’s fundamental performance since its IPO has been short of the partnership’s expectations.

Reduced cash flows relative to prior expectations have brought the protective mechanisms of the company's subordinated units into play. Accordingly, the distribution on Black Stone Minerals subordinated units has been cut. This also means the subordinated units will be converted into common units.

What does this mean for existing investors in Black Stone Minerals common units?

It is not likely to impair the distribution safety of the common units.

The reason for this is the conversion ratio. The partnership’s management and board released a public statement in February stating the subordinated units may convert at a ratio of less than one-to-one to promote continued growth of the common unit’s distribution.

BSM Black Stone Minerals Current Situation BSM

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 21

Some may be wondering why the subordinated units exist at all. After all, all else being equal, a simpler capital structure is generally preferable from an analytical point of view.

The subordinated units were originally put in place as the primary mechanism to minimize dilution of the legacy unitholders at the time of Black Stone Minerals’ IPO. Additional details are below.

BSM Black Stone Minerals Subordination Background or Rationale

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 20

The timeline for the conversion of the company’s subordinated units is not set in stone.

If the partnership earns and pays $1.35 in common and subordinated unit distributions for the four-quarter period ending March 31, 2019, then the subordinated units will automatically be converted on a one-to-one basis.

If this net income and distribution threshold is not met, then a later optional conversion may take place at a conversion ratio calculated based on distributions paid. The full equation is presented in the following slide.

BSM Black Stone Minerals Subordinated Conversion Mechanics

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 17

After the subordinated unit conversion, Black Stone Minerals’ management team is expecting 4% per year distribution growth. Any shortfall in these projections could be absorbed by maintaining a similar post-conversion distribution growth rate.

In addition, there is potential for additional growth based on a recovery in commodity prices, which we view to be extremely likely.

BSM Black Stone Minerals Post-Conversion Distribution Growth

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 18

All said, the major drivers of Black Stone’s growth will be incremental acquisitions and the pending conversion of its subordinated units into common units.

Competitive advantage and recession performance

Black Stone’s competitive advantage comes from owning interests in some of the most desirable energy regions in the U.S.

It is also the largest pure-play oil and natural gas mineral rights and royalty interests MLP, which gives it a size-based competitive advantage over its smaller, financially weaker peers.

Black Stone Minerals was not a publicly traded investment vehicle at the time of the last economic downturn.

As such, it can be difficult to assess the partnership’s ability to endure through future recessions.

With that said, investors should appreciate the company’s conservative financing structure. The partnership has only one source of debt (a senior credit facility) and has a leverage ratio of 1.4 times, which is very low for an MLP.

From a cash flow perspective, Black Stone Minerals is 80% hedged against movements in natural gas prices and 70% hedged against movements in oil prices, which insulates this partnership from the majority of the effects of shifting commodity prices.

BSM Black Stone Minerals Solid Financial Position

Source: Black Stone Minerals 2017 Annual Meeting Presentation, slide 11

Black Stone also has one of the safest dividends of any partnership I have analyzed, at least for its common units.

In the most recent quarter, Black Stone Minerals reported a common unit distribution coverage ratio of 2.4 times, the highest I have seen in an MLP.

After including the partnership’s subordinated units, Black Stone Minerals had a distribution coverage ratio of 1.5 times for all classes of units.

This indicates that even if the subordinated units are converted on a one-to-one basis (the highest conversion possible), Black Stone Minerals’ distribution will still be well covered.

Valuation and expected total returns

As a master limited partnership, Black Stone Minerals makes extensive use of non-GAAP financial metrics, such as distributable cash flow and funds from operations, because of the significant non-cash depreciation and amortization charges its operations incur.

Accordingly, the valuation of this investment vehicle cannot be meaningfully analyzed using typical valuation metrics such as the price-earnings ratio.

The most useful and practical alternative to traditional valuation metrics is to compare the partnership’s current dividend yield to its long-term historical average dividend yield.

Black Stone Minerals currently pays a quarterly distribution of 28.75 cents per unit, which yields 7.2% on the partnership’s current stock price of $16.03.

The following diagram compares Black Stone Minerals’ current dividend yield to its long-term historical average.

BSM Black Stone Minerals Distribution Yield History

Source: YCharts

Black Stone Minerals’ current valuation is above its average valuation since the partnership’s inception in 2015.

While its corporate history to date has been short, it appears the company is trading at a reasonable valuation today.

Additionally, even approximately 3% long-term per-unit growth (remember, the partnership is expecting 4%) gives investors the possibility of achieving double-digit total returns thanks to Black Stone Minerals’ over 7% dividend yield.

Final thoughts

Black Stone Minerals’ MLP organizational structure and over 7% distribution yield help it to immediately stand out to income investors.

Due diligence reveals the partnership is the largest pure-play MLP in the oil and natural gas mineral rights and royalty interests industry, and has one of the safest distributions I have seen among MLPs.

Accordingly, this partnership holds appeal for conservative, high-yield investors.

Disclosure: I am not long any of the stocks mentioned in this article.

About the author:

Ben Reynolds
I run Sure Dividend, a website that finds high quality dividend stocks for long term investors using the 8 Rules of Dividend Investing.

Visit Ben Reynolds's Website

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