Hess Midstream: Beyond 7.3% Yield, A Perfect Investment For Income And Growth (NYSE:HESM)

Introduction

“Americans Have More Investment Income Than Ever Before.” is a headline the Wall Street Journal ran a few days ago.

To me, this is a highly fascinating title that highlights a topic I will discuss (a lot) more in the future.

Using the chart below, we see that consumers, in general, are not very upbeat. While the top-third incomes are seeing a rebound of consumer sentiment to the long-term average, the bottom two-thirds are stuck close to Great Financial Crisis lows.

So, why do headlines like the one above keep popping up?

The answer is two very specific words in the Wall Street Journal’s title: “investment income.“

See, this is turning a bit into the economy of the “haves” and “have-nots.”

As we can see below, the top 20% owns more than $100 trillion in assets. That’s more than 40% of the total wealth. The bottom 40% own close to nothing.

I’m not bringing this up to start a left-wing party but as a segue to my next point.

In an environment where even short-term money market funds offer a 5% yield (risk-free), it is close to impossible for low-income people to keep up with average wealth.

For example, a $500 thousand investment in such a fund ends up paying $25 thousand in annual interest.

Americans in the first quarter earned about $3.7 trillion from interest and dividends at a seasonally adjusted annual rate, according to the Commerce Department, up roughly $770 billion from four years earlier. In the last quarter of 2023, wealth held in stocks, real estate and other assets such as pensions reached the highest level ever observed by the Federal Reserve. – The Wall Street Journal (emphasis added)

With that said, one of the biggest mistakes investors in lower-income groups tend to make is betting on high-yield investments in high-risk areas to compensate for the fact that they cannot keep up with people who can invest large amounts in lower-risk assets with satisfying yields.

After all, if someone in a higher-income group makes the median annual income by simply buying risk-free bonds, I need to find ways to somehow keep up with that.

With all of this in mind, in this article, I’ll discuss a company that has become one of my favorite high-yield investments after I started coverage earlier this year.

That company is Hess Midstream LP (NYSE:HESM), a company that owns major midstream assets of oil and gas giant Hess (HES).

On January 29, I started bullish coverage, highlighting the attractiveness of owning infrastructure.

Infrastructure investments favored by billionaires like Cornelius Vanderbilt, Warren Buffett, and Bill Gates offer defensive characteristics, stability, and exposure to long-term growth drivers.

[…] Regardless of Chevron’s acquisition of Hess Corporation, HESM remains a resilient income vehicle, targeting 5% annual dividend growth and offering a current yield of 7.3%, which is well-protected by its distributable cash flow.

Since then, HESM has returned 6%, slightly lagging the S&P 500’s 9% return.

In this article, I’ll update my thesis and explain why I truly believe HESM is one of the best income plays on the market.

So, let’s get to it!

A Bakken-Focused Infrastructure Play

Last time, there was some confusion about what kind of company we’re dealing with here. I’m to blame for that.

Initially, Hess Midstream was a traditional Master Limited Partnership. However, in 2019, it acquired Hess Infrastructure Partners LP and simplified its incentive distribution rights.

Long story short, this included a conversion to an Up-C corporate structure.

• The company is taxed as a corporation.
• It issues a 1099-DIV to shareholders instead of a K-1 form.
• Ownership is based on Class A shares instead of “units.”

With that said, the company is a midstream operator, which means it supports the upstream operations of oil and gas companies.

As its name already gave away, it supports the operations of the Hess Corporation and third-party customers in the Bakken Formation, part of the massive Williston Basin.

In this region, the company’s operations consist of three segments.

As I wrote in my prior article, these consist of gathering, processing, and terminaling.

• Gathering Segment: Hess Midstream’s gathering segment includes an extensive pipeline network covering over 1,380 miles dedicated to transporting natural gas, crude oil, and produced water. This system ensures the efficient movement of resources from well sites to processing facilities and export terminals.
• Processing Segment: In the processing segment, the company operates state-of-the-art facilities like the Tioga Gas Plant and the LM4 Joint Venture, with a combined capacity of more than 600 MMcf/d. These facilities play a crucial role in extracting value from natural gas and NGLs extracted from the Bakken and Three Forks shale plays.
• Terminaling Segment: Hess Midstream’s terminaling segment focuses on key facilities like the Ramberg Terminal and the Tioga Rail Terminal. These facilities enable the storage, transportation, and export of crude oil and NGLs.

While this business does not directly benefit from rising oil and gas prices (for that, I prefer companies that actually produce these commodities), it comes with a high degree of safety.

For example, the company has long-term commercial contracts through 2033, which I expect to be extended for many more years.

On top of that, 100% of its business is based on fees with minimum volume commitments through 2026.

Essentially, this is what makes midstream companies so powerful. They are great ways to benefit from strong throughput in the energy sector without the volatility of commodities prices.

Sometimes that’s good. Sometimes that’s bad (less favorable).

Personally, I like to own both upstream and midstream, as it provides a good balance of growth and income in an environment of steadily rising production with pricing benefits on top.

The biggest bull case for midstream companies – in general – is steadily rising production supporting high utilization rates and infrastructure expansion projects.

Great News For Shareholders

As we’re currently in an environment of favorable energy prices and healthy demand, midstream companies are doing well.

In the first quarter, Hess Midstream’s throughput volumes averaged 393 million cubic feet per day for gas, 117 thousand barrels of oil per day for crude terminaling, and 116 thousand barrels of water per day for water gathering.

This resulted in $276 million in adjusted EBITDA, up from $264 million in the fourth quarter of 2023. This was driven by a significant decline in operating costs, which allowed the company to maintain an EBITDA margin in the 70% range.

Moreover, as we can see below, the company’s guidance for 2024 is favorable, as it expects gas processing volumes to average between 395 million and 405 million cubic feet per day, crude terminaling volumes between 120 and 130 thousand barrels of oil per day, and water gathering volumes between 105 and 115 thousand barrels of water per day.

Essentially, the numbers above represent a 10% increase across the company’s oil and gas systems compared to 2023.

Financially speaking, the company expects net income of $670 million to $720 million and adjusted EBITDA of $1.125 billion to $1.175 billion.

Free cash flow is expected to be at least $685 million.

$685 million is 8.4% of the company’s $8.1 billion market cap – and that’s the low end of its guidance.

In 2026, analysts expect $766 million in free cash flow. That would be more than 9% of its current market cap!

This bodes well for shareholders, as it also has a healthy balance sheet with a leverage ratio close to 3x EBITDA. That number is expected to drop to 2.5x in the years ahead.

Hence, as financial health is no priority, the company targets annual dividend growth of at least 5% through 2026.

Moreover, as the free cash flow numbers showed, these dividends are fully funded by internal cash flow.

Hence, beyond dividend growth, the company is using buybacks for additional cash distribution.

Currently, the company pays $0.6343 per share per quarter. This translates to a yield of 7.3%.

This strong free cash flow profile reminds me of my investment in Antero Midstream (AM), which has a lower yield but similar protection from free cash flow and a fantastic relationship with its owner, Antero Resources (AR).

I also believe that HESM is too cheap, as it has an implied 2026 free cash flow yield of roughly 9.5% with a 7.3% CAGR (2023-2026).

If we assume an unchanged free cash flow multiple/yield (valuation), the stock could easily return 7% annually. That’s without its dividend.

Including its dividend, I expect the stock to return between 13-15% annually, which is another reason why I like midstream companies so much.

The mix of growth and value is so attractive!

To be honest, if it weren’t for my investment in AM and my preference to keep a concentrated portfolio, I would be a buyer at these levels.

Takeaway

While top earners see improved consumer sentiment, the majority struggle.

This disparity is fueled by the higher-income group’s access to low-risk, high-yield investments.

That’s where Hess comes in. While it’s not low risk, it offers most investors a good opportunity to buy both income and growth.

The company stands out as a robust income investment, offering stability through long-term contracts and a juicy yield of 7.3%.

Essentially, HESM’s strong free cash flow, defensive characteristics, and commitment to dividend growth make it an attractive investment for those seeking reliable income.

Pros & Cons

Pros:

• Stable Income: HESM offers a juicy yield of 7.3%, supported by long-term contracts and elevated free cash flow.
• Defensive Play: With a focus on infrastructure, HESM provides stability and less exposure to commodity price volatility.
• Growth Potential: The company targets 5% annual dividend growth and is expected to report significant free cash flow increases in the years ahead.
• Strong Fundamentals: HESM has a healthy balance sheet, with a leverage ratio expected to drop to 2.5x EBITDA.

Cons:

• Limited Upside: Investors looking to bet on rising commodity prices may be better off buying upstream companies.
• Market Sensitivity: Although less volatile than upstream operations, midstream companies can still suffer when the market corrects.
• Takeover: Although this is not necessarily a “risk,” I see a situation where HESM is being bought out, as its free cash flow profile is highly attractive – especially given the expected free cash flow yield in the years ahead.
• Chevron (CVX) buying Hess: As I wrote in my last article, the planned takeover of the Hess Corporation is unlikely to have a major impact on HESM.