A Closer Look At Magellan Midstream Partners' Results For 2Q16

| About: Magellan Midstream (MMP)

Summary

Operating margin in 2Q16 is up 6% vs. 2Q15; reliance on commodity-related activities has been diminishing; correspondingly, the fee-based portion is increasing.

For 7 of the last 9 quarters, distribution growth has outpaced DCF growth when measured on a per unit basis and each quarter is compared to the corresponding prior-year quarter.

Consequently, coverage ratios, while still very robust, are declining.

Projects under construction being placed into service in 2016 will increase EBITDA by ~9%; the 10% distribution growth guidance with 1.2x coverage for 2016 seems achievable.

By various qualitative and other measures, MMP receives top marks; I continue to hold it.

This article analyses some of the key facts and trends revealed by 2Q16 results reported by Magellan Midstream Partners L.P. (NYSE:MMP).

MMP is engaged in the transportation, storage and distribution of refined petroleum products and crude oil. Its 3 operating segments are:

  • Refined Products: this segment primarily transports gasoline and diesel fuels and includes an 9,700-mile refined products pipeline system with 54 terminals, 42 million barrels of storage, as well as 26 independent terminals not connected to MMP's pipeline system, and its 1,100-mile ammonia pipeline system;
  • Crude Oil: this segment is comprised of ~1,600 miles of crude oil pipelines and storage facilities with an aggregate storage capacity of approximately 22 million barrels; and
  • Marine Storage: this segment consists of 5 marine terminals located along coastal waterways with an aggregate storage capacity of ~26 million barrels.

Operating margin is a one of the key non-GAAP metric used by management to evaluate performance of its business segments. It includes revenue from affiliates and external customers, operating expenses, cost of product sales and earnings of non-controlled entities. Operating margin by segment for recent quarters is presented in Table 1:

Click to enlarge Table 1: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Total operating margin in 2Q16 is up 6% vs. 2Q15. Fee-based (i.e., derived from fees, tariffs, contractual commitments) gross margin accounts for the bulk of total operating margin and has been increasing for at least 10 consecutive quarters.

The bulk of MMP's commodity-related activities occur within the Refined Products segment. They include butane blending and fractionation. Operating margin generated by these activities are, relative to fee-based activities, far more volatile. In recent quarters, MMP's reliance on commodity-related activities has been diminishing. These activities generated 14.7% of total operating margin in the trailing twelve months ("TTM") ending 6/30/16 vs. 16.8% for the TTM ending 630/15 and 18.6% for the TTM ended 6/30/14. A high level of unrealized losses in 2Q15 accounts for the 81% increase in commodity operating margin shown in Table 2 for 2Q16:

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Table 2: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Earnings before interest, depreciation & amortization and income taxes (EBITDA) increased by $19 million and Adjusted EBITDA increased by $11 million in 2Q16 vs. 2Q15:

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Table 3: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Adjusted EBITDA is another key metric used by management to evaluate its financial results. The adjustments include adding back equity based compensation and impairment charges, deducting derivative gains, and adding back derivative losses on commodity transactions.

Distributable Cash Flow ("DCF") is one of the primary measures typically used by a midstream energy master limited partnership ("MLP") to evaluate its operating results. Because there is no standard definition of DCF, each MLP can derive this metric as it sees fit: and because the definitions used indeed vary considerably, it is exceedingly difficult to compare across entities using this metric. Additionally, because the DCF definitions are usually complex, and because some of the items they typically include are non-sustainable, it is important (albeit quite difficult) to qualitatively assess DCF numbers reported by MLPs.

MMP derives DCF as follows:

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Table 4: Figures in $ Millions (except ratios and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Coverage ratio was down compared to the prior year quarter because DCF in 2Q16 was substantially the same as 2Q15 ($221 million vs. $223 million) while distributions increased by 11%. The level of distribution coverage in 2Q16 was still outstanding in comparison to other MLPs. However, for 7 of the last 9 quarters, distribution growth has outpaced DCF growth when measured on a per unit basis and each quarter is compared to the corresponding prior-year quarter. Consequently, coverage ratios, while still very robust, are declining.

The generic reasons why DCF as reported by an MLP may differ from what I call sustainable DCF are reviewed in an article titled " Estimating sustainable DCF-why and how". A comparison between the two is presented in Table 5. It indicates no material differences between reported and sustainable DCF for the TTM periods under review:

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Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

In calculating sustainable DCF, I ignore cash generated by liquidating working capital (because I do not consider it a sustainable source) but deduct funds consumed by working capital (because cash consumed is not available to be distributed). In contrast, reported DCF always excludes working capital changes, whether positive or negative. My sustainable DCF calculation also excludes cash flows related to risk management and "other" activities.

Table 6 compares coverage ratios based on reported and sustainable DCF. Fluctuations in working capital account are the major reason for the discrepancy in the quarterly numbers. There are no material differences on a TTM basis:

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Table 6: Figures in $ Millions, except ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.

Table 7 presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:

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Table 7: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

Net cash from operations, less maintenance capital expenditures, fell short of covering distributions by $16 million in 2Q16. It exceeded distributions by $250 million and by $345 million in the TTM ended 6/30/16 and 6/30/15, respectively. MMP is not using cash raised from issuance of debt to fund distributions. On the contrary, the excess cash generated constitutes a significant source of capital for MMP and enables it to reduce reliance on the issuance of additional partnership units or debt to fund growth projects. The importance of this is magnified in the current environment that imposes a much higher cost of capital on all midstream energy MLPs.

Based on 2Q16 results management reaffirmed its DCF guidance of $910 million for 2016. The changed in selected guidance metrics (e.g., net income, Adjusted EBITDA, DCF per unit) for 2016 are detailed in Table 8:

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Table 8: Figures in $ Millions (except ratios and number of units). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Management's initial goal of increasing distributions by 10% in 2016 and 8% in 2017 while maintaining coverage of 1.2x remains unchanged.

Expansion capital spending totaled ~$750 million in 2015 and MMP expects to spend $850 million in 2016, $250 million in 2017 and $200 million in 2018 to complete projects currently under construction. MMP expects its investments in expansion projects to average 7-9x EBITDA.

Based on that, EBITDA would increase by over ~$100 million based on projects currently under construction that will be placed into service in 2016. This is a 9% increase from the current EBITDA level. The 10% distribution growth guidance with 1.2x coverage for 2016 therefore seems achievable.

As noted in the discussion of Table 4, in 7 of the last 9 quarters, distribution growth has been outpaced DCF growth when both are measured on a per unit basis and each quarter is compared to the corresponding prior-year quarter. This gap may threaten the 8% growth target with 1.2x coverage set for 2017 and threaten strong coverage of distribution growth in later years unless the trend is reversed through improved operational results from existing assets and contributions from additional projects meet their EBITDA multiple projections.

By various qualitative and other measures, MMP should receive top marks on. In over four years (since 3Q 2010), MMP has not issued additional partnership units (excluding units issued in connection with compensation arrangements), a significant accomplishment and rare achievement in the MLP universe. Nor does management anticipate needing to issue units in the foreseeable future. This is all the more impressive given that MMP has kept its leverage much lower than most MLPs (currently 3.1x Adjusted EBITDA on a TTM basis).

Also impressive is the fact that, unlike most MLPs, MMP's net income per unit exceeds distributions per unit almost every quarter:

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Table 9: Figures in $ per unit. Source: company 10-Q, 10-K, 8-K filings and author estimates.

MMP has a disciplined management, outstanding track record, superior distribution coverage, lower leverage, an ability to generate significant excess cash from operations, and good growth prospects. For all these reasons, I continue to hold it.

Disclosure: I am/we are long MMP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.