A Closer Look At Magellan Midstream Partners' Q2'14 Distributable Cash Flow

| About: Magellan Midstream (MMP)
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Strong DCF coverage ratios; no material differences between reported and sustainable DCF.

Growth in DCF per unit far exceeding growth in distributions.

MMP has not issued additional partnership units in over 3 years.

Favorable structure: no IDRs, low leverage.

Ability to increase distributions beyond the 20% and 15% projected for 2014 and 2015; premium price vs. other MLPs justified.

This article analyses some of the key facts and trends revealed by 2Q14 results reported by Magellan Midstream Partners L.P. (NYSE:MMP). It evaluates the sustainability of the partnership's Distributable Cash Flow ("DCF") and assesses whether MMP is financing its distributions via issuance of new units or debt.

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

  1. Refined products: this segment primarily transports gasoline and diesel fuels and includes an 9,500-mile refined products pipeline system with 54 terminals, 41 million barrels of storage, as well as 27 independent terminals not connected to MMP's pipeline system, and its 1,100-mile ammonia pipeline system;
  2. Crude oil: this segment is comprised of ~1,100 miles of crude oil pipelines and storage facilities with an aggregate storage capacity of approximately 18 million barrels; and
  3. Marine storage: this segment consists of 5 marine terminals located along coastal waterways with an aggregate storage capacity of ~27 million barrels

Operating margin by segment for recent quarters and the trailing twelve months ("TTM") ended 6/30/14 and 6/30/13 is presented in Table 1 below. Operating margin is a key metric used by management to evaluate performance of its business segments. Following very strong results in 4Q13 and outstanding results for 1Q14, total operating margin increased by just 5% in 2Q14 over 2Q13:

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

Operating margins generated by the Refined Products and Marine Storage segments actually decreased in 2Q14, primarily due to one-time favorable adjustment in 2Q13 of an accrual for potential air emission charges. This adjustment lowered operating expenses in 2Q13 for both segments. Comparisons to 2Q13 for both segments were also adversely affected by mark-to-market adjustments on commodity-related hedges (losses in 2Q14 vs. gains in 2Q13).

Operating margins generated by the Crude Oil segment increased significantly in 2Q14 over 2Q13. This is largely due to the commencement of crude deliveries on the Longhorn pipeline in April 2013. Longhorn (the $375 million conversion of a large portion of the partnership's Houston-to-El Paso pipeline to crude oil service) is an expansion project of particular note. The reversed pipeline system transports crude oil from Crane, Texas, to refiners or third-party pipelines in Houston and Texas City, Texas. Deliveries of crude oil began in mid-April 2013 and averaged 90,000 barrels per day ("bpd") in 2013 vs. 225,000 bpd in the first 6 months of 2014. MMP received regulatory approval to increase the capacity of the pipeline to 275,000 bpd and expects to average ~250,000 bpd during the second half of 2014.

Approximately 11% of the $264 million total operating margins in 2Q14 shown in Table 1 was generated by commodity-related activities (mostly butane blending sales less costs of sales). The balance was generated by fee-based transportation and terminals services. Commodity-related activities are a more volatile source of operating margin. For example, in 1Q14 they accounted for a far higher portion of total operating margins (28%). For the TTM ended 6/30/14 I estimate commodity-related activities accounted for 19% vs. 17% in the TTM ended 6/30/13.

Higher operating margins in the quarter and TTM ending 6/30/14 vs. the corresponding prior-year periods drove improvements in operating income (operating margin differs from operating income in that it excludes expense items, such as depreciation and amortization and general and administrative expenses). They also drove increases in earnings before interest, depreciation & amortization and income taxes (EBITDA), and in Adjusted EBITDA, as shown in Table 2 below. Adjusted EBITDA is another key metric used by management to evaluate its financial results. The adjustments include adding back equity-based compensation, impairment charges and derivative gains or losses on commodity transactions. Adjustments in 2Q14 include a $9.4 million impairment charge in the Refined Products segment related to a non-strategic pipeline terminal that may be sold in the future.

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

MMP's definition of DCF is presented in an article titled "Distributable Cash Flow". The article also provides definitions used by other master limited partnerships ("MLPs"). Based on this definition, DCF reported by MMP for the TTM ended 6/30/14 was $827 million ($3.64 per unit), up from $572 million ($2.52 per unit) in the corresponding prior-year period. Growth in DCF per unit has far exceeded growth in distributions in the latest TTM period, as shown in Table 3 below:

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

Reported DCF may differ from sustainable DCF for a variety of reasons. These are reviewed in an article titled "Estimating sustainable DCF-why and how". Applying the method described there to MMP's results generates the following comparison between reported and sustainable DCF:

Table 4: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

Table 4 indicates the differences between reported and sustainable DCF in the periods under review are not material.

MMP's strong coverage ratios are shown in Table 5:

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

Table 6 below 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.

Simplified Sources and Uses of Funds

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

Net cash from operations, less maintenance capital expenditures, exceeded distributions by $314 million in the TTM ended 6/31/14 and by $131 million in the TTM ended 6/31/13. Clearly, 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 that dilute existing holders, or issuance of debt to fund expansion projects.

BridgeTex Pipeline Company, LLC ("BridgeTex") is MMP's largest construction project to date. It is a joint venture formed in November 2012 by MMP and affiliates of Occidental Petroleum Corporation for the purpose of constructing and operating a 400-mile pipeline capable of transporting 300,000 barrels per day of Permian Basin crude oil from Colorado City, Texas for delivery to MMP's East Houston, Texas terminal; a 50-mile pipeline between East Houston and Texas City, Texas; and approximately 2.6 million barrels of storage. Shipments are expected to begin in September 2014. MMP expects to spend a total of $625 million for its 50% stake in BridgeTex (of which $528 million had been spent as of 6/30/14). Contracts already at hand are sufficient to generate an 8x EBITDA multiple on this investment, with a significant upside.

In 2013 MMP spent $773 million on growth projects, acquisitions and investments in non-controlled entities. The total amount to be spent on expansion capital in 2014 is currently estimated at $775 million, with additional spending of $350 million in 2015 and $75 million in 2016 to complete projects now in process.

Based on 1Q14 results, management raised its 2014 EBITDA guidance by $76 million to $1,011 million and its 2014 DCF guidance by $80 million to $810 million. Following 2Q14 results 2014 guidance was raised again (by $33 million to $1,044 million EBITDA and by $30 million to $840 million DCF). Distributions are projected to increase by 20% in 2014 and to be covered 1.4x by DCF. A further increase of 15% is projected for 2015.

MMP's current yield is the lowest of the MLPs I follow and its EV/EBITDA multiple is the highest. It not surprising to see MLPs that do not pay their general partner incentive distributions ("IDRs"), such as BPL, EPD and MMP, trade at higher EBITDA multiples. This is because IDRs siphon off a significant portion of cash available for distribution to limited partners (typically 48%). After adjusting for IDRs, the gap is not as glaring. On the other hand, MMP has a management team that is disciplined and unwilling to pay the premiums that other MLPs have been paying for acquisitions, an impressive portfolio of growth projects, an ability to generate significant excess cash from operations, and a proven performance track record. On top of all that, MMP has been able to minimize limited partner dilution.

In over three 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 2.8x Adjusted EBITDA on a TTM basis). Another impressive performance metric is MMP's net income per unit. It exceeded distributions per unit in the TTM ended 6/30/14 and 6/30/13. That too is unusual for an MLP.

Given these factors, I consider MMP to be a high quality, core holding, MLP and would continue to accumulate on weakness.

Disclosure: The author is long MMP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.