A Closer Look At Magellan Midstream Partners' Q1 2016 Results

| About: Magellan Midstream (MMP)
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MMP’s reliance on commodity-related activities has been diminishing.

Coverage ratio in 1Q16 was substantially below MMP’s historical levels.

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

DCF per unit has recently been growing at a slower pace than distributions per unit. This trend threatens the ability to combine strong coverage with distribution growth in later years.

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 1Q16 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 below:

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

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, as shown in Table 2:

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

Lower commodity prices drove the decrease in margins generated by non fee-based activities. This was somewhat offset by the gains recognized from MMP's hedging activities.

Fee-based (i.e., derived from fees, tariffs, contractual commitments) gross margin accounts for the bulk of the total and has been increasing for at least 9 consecutive quarters. The portion derived from commodity-related activities has been declining. It stood at 11% in 1Q16, down from 13% in 4Q15 and from 12.5% in 1Q15. On a trailing twelve-month ("TTM") basis it decreased to 14% in the period ending 3/31/16 from 18% in the prior-year period.

Total operating margin in 1Q16 is flat vs. 1Q15 (see Table 1), while earnings before interest, depreciation & amortization and income taxes (EBITDA) increased by $28 million and Adjusted EBITDA decreased by $15 million:

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:

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

Table 4 indicates that coverage ratio in 1Q16 was substantially below MMP's historical levels. Granted, these levels were outstanding in comparison to other MLPs. Nevertheless, the drop deserves a closer look.

In 1Q16 MMP recorded a gain on the transfer of its 50% interest in Osage Pipe Line Company, LLC, an affiliate of HollyFrontier Corporation, in exchange for long-term refined products terminals agreements. Absent this gain, net income would have been flat vs. 1Q15. That, coupled with lower commodity adjustments due to lower oil prices and higher maintenance capital expenditures, explains the bulk of the $28 million decrease in DCF between 1Q15 and 1Q16. While this drop may not be large, when accompanied by increases in distributions it results in a substantially lower coverage ratio.

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:

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:

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

Table 7 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:

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, exceeded distributions by $531 million and by $322 million in the TTM ended 3/31/16 and 3/31/15, respectively. 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 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 1Q16 results and higher than expected commodity prices so far this year, management slightly increased its guidance for 2016 for selected metrics (e.g., net income, Adjusted EBITDA, DCF per unit) after lowering them 3 months ago:

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 $800 million in 2016 and $150 million thereafter 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 10% increase from the current EBITDA level. The 10% distribution growth guidance with 1.2x coverage for 2016 therefore seems achievable.

However, in 5 of the 6 most recent quarters, DCF per unit grew at a slower pace than distributions per unit. This gap, shown in Table 4, 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 beyond the $950 million currently under construction.

Potential growth projects beyond those currently under construction total well in excess of $500 million. Refined products pipeline opportunities include a joint venture pipeline from Corpus Christi to Brownsville, Texas. Marine infrastructure opportunities include new storage in Houston, Corpus Christi and expansion of Seabrook Logistics. MMP expects its investments in these projects to average 6-8x EBITDA, but will consider higher multiples for strategic value creation.

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 consistently exceeds distributions per unit:

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.