Magellan: Top-Tier MLP, Attractive Risk-Adjusted Yield, And The Dangers Of Indexing

Summary

• MLPs are currently a modest 7.50% of the Institutional Income Plus portfolio. Magellan earns the highest weight within that allocation.
• We'll outline why Megallan is not only an attractive company but is also attractively priced.
• In line with WER's standard practice, we incorporate education into our first MLP-focused article with the goal that you'll be a little wiser in this area than yesterday.
• This will include key aspects of MLP analysis and taxation.
• Looking for a portfolio of ideas like this one? Members of Institutional Income Plus get exclusive access to our model portfolio. Start your free trial today »

Source: Company website

We all know happened to crude oil prices in 2014 and the resulting bankruptcy of a slew of master limited partnerships ("MLPs"), service providers, and upstream oriented energy companies. To start, let's put Magellan Midstream Partners (NYSE:MMP), the focus of this article, up against the popular Alerian MLP Index (AMLP) and see how it performed.

Source: Yahoo Finance and WER

The market had significantly higher confidence in Magellan than its peer group, as the above chart demonstrates. Even more impressive is the fact that Magellan is one of the Alerian MLP's largest holdings (9.98%). A major contributor to the market's confidence is the company's simplified business model.

• Magellan is an investment grade MLP.
• Magellan's structure does not incorporate incentive distribution rights ("IDRs"), which are to the detriment of unitholders long term.
• Not only does Magellan utilize an independent board, but those members are chosen by the limited partner investor base rather than management. Strong corporate governance matters.

Including dividends, Magellan has generated a positive annualized return ~4% since the start of the commodity collapse and energy credit depression, compared to a -6% annualized loss for AMLP. I use depression because energy credits outside of strong investment grade traded lower in the period following the 2014 downturn than during the Great Recession as measured by traditional yield spreads, and many have yet to recover.

Most energy infrastructure master limited partnerships ("MLPs") experienced better financial performance in recent years than the average market participant probably believes given commodity prices. One of those skeptics' primary concerns, however, is potentially justified: even MLPs that managed to do well in the short term will eventually slash distributions if commodity prices remain depressed. Easier said than done, it is nonetheless critical to evaluate the bull and bear thesis thoroughly no matter your personal bias. This bear thesis may well come to fruition for those with infrastructure assets concentrated in geological basins that are not competitive in a lower commodity price environment.

This is why having a strong understanding of a geological basin's current economics, including transportation costs, is a necessity as well as obtaining knowledge on a basin's future economics using a wide array of input costs and commodity prices. As we'll see, Magellan's assets are concentrated in the Gulf Coast with connections to the Delaware and broader Permian basin, as well as several other prime locations, including the Mid-Continent.

We will systematically tackle the chief variables, starting with what the firm has generated financially for investors.

Distribution History

How has the firm's cash flow generation supported distributions since 2014?

Source

Magellan had a quarterly payment of $0.6125 in Q1 2014 or an annual yield of 4.0%, or $2.45 per share, using the average share price over the period. This date is chosen as it is the beginning of the troublesome period for energy companies of effectively every discipline. The distribution amount has increased every single quarter since, and is now $3.99 per share annually. This is a 6.65% annual yield, which is among the absolute highest yields MMP has provided investors. In fact, Magellan has made 65 consecutive distribution increases at a 12% CAGR.

Source: Magellan Midstream Partners, Tulsa MLP & Midstream Conference presentation, December 13, 2018

Whenever a company's cash distributions to investors have increased both in dollar amount and percentage, there are a few things we want to check immediately.

First, we want to ensure the firm's leverage has not increased dramatically and to the point we need a higher yield as compensation for that risk. I'll include in this category leverage obtained through dilution, or the act of issuing shares for money instead of bonds. The impact on investors is similar in the end.

Second, we need to verify that the firm is not using resources previously allocated to capital expenditures or other uses to fund investor distributions. That is not sustainable, and will eventually come back to haunt us. This item includes analyzing the distribution payout ratio.

Third, we need to review the firm's projected performance and activities with a critical eye and determine if there is a reasonable probability it'll be able to achieve the financial results it needs to hit its goals. Ideally, we want even the bottom range of its reasonable forecasts to meet our needs, with anything beyond that considered a bonus. This gives us a cushion in case the macro environment moves against us.

Leverage and Cash Flow

Despite averaging $540 million in expansion capital spending over the last decade, Magellan has issued only $260 million in equity over the entire period via a single transaction in 2010 (shown in blue).

Source: Magellan Midstream Partners, Tulsa MLP & Midstream Conference presentation, December 13, 2018

The firm is on the record stating that no equity issuance is anticipated to fund current growth projects, which we'll touch on shortly. The firm maintains $1 billion in liquidity via its credit facility, with additional resources on hand through its commercial paper program. Magellan is one of the highest-rated MLPs at BBB+/Baa1. A powerful illustration of the benefits associated with this is the firm's $500,000,000 4.850% Senior Notes Due 2049 issuance last year. To reiterate, that is a yield below 5.0% for a bond maturing in 2049! We noted that monitoring leverage over time is especially important when a firm appears to have a flawless record of increasing distributions while the broader industry it's associated with is experiencing difficulties. Magellan has consistently maintained maximum leverage below 4x, and 9/30/2018's figure was below 3x. The company's current leverage is well under its long-term stated limit.

Source

Magellan's relentless focus exclusively on the highest-return projects have enabled it to earn positive free cash flow for more than 10 consecutive years. It increased that cash flow in seven of those 10 years, or 70% of the time, with two of the three annual decreases coming in at less than 10%. How is that cash flow generated? We cannot ascertain the durability or reliability of a company's cash flows, which are what power investor returns in the long run, without an understanding of the underlying business model.

Critical Assets Overview

Magellan owns the longest refined petroleum products pipeline system in the entire United States.

Source: Company Investor Presentation - Targeting Annual Distribution Growth of 5–8% for 2019 and 2020

That complex involves 9,700 miles of pipeline, 53 terminals, and 44,000,000 barrels of storage facilities. Volumes and tariffs, which is industry jargon for the fees charged by MLPs to those shipping their oil or natural gas product, have been strong. Tariffs increased in 2.0% in mid-2016 and mid-2017, which jumped to 4.4% on July 1, 2018. DCF has increased proportionately, and per the firm's latest quarterly results filed with the SEC, is up significantly year over year.

Source: SEC.gov

Crude Oil Division Highlights

Its crude oil segment includes 2,200 miles of crude oil pipelines, the majority of which are backed by long-term throughput commitments. Magellan is one of the largest crude oil storage providers in Cushing, Oklahoma, arguably the most important hub in North America.

A major change and potentially bullish tailwind for MLPs has been exporting oil and gas products overseas. Magellan entered into a 50/50 joint venture with LBC tank terminals on the Seabrook Logistics project, which has 2,400,000 barrels of crude oil storage capacity and connectivity to the firm's Houston crude oil distribution system. Seabrook has an estimated 2,500,000 more barrels of capacity with the potential to integrate into the same Houston system. The East Houston-to-Hearne pipeline provides incremental capacity of 85,000 barrels or a nearly 50% increase in service to the growing Mid-continent and Little Rock, AR markets. The firm is also expanding capacity between its large Gulf Coast assets to several areas of West Texas to solidify its foothold in the growing Permian Basin exploration activity. Ongoing development will enable exports to occur if market conditions are appropriate.

Source

Marine Division Highlights

The key here, as it is in many business segments for MLPs, is utilization rate. Magellan's figure has consistently been above 90%, which is favorable and is spread across five storage facilities with 26,000,000 million in aggregate with another 1,400,000 in spare dock capacity. The Pasadena, TX, marine terminal joint venture with Valero Energy (VLO), which is another holding of the Institutional Income Plus portfolio, is entering phase one of two with the ability to double capacity again if market conditions are favorable. Magellan is expecting a 9x EBITDA multiple on the project excluding whatever may take place after phase two.

As we can see from all the major projects within each division, the especially large and or complex ones usually involve joint venture partners. This lessens the capital burden on Magellan and general project risk. It also means Magellan needs to partner with only the best firms and on favorable terms. Thus far, it has done both. All the target EBTIDA multiples I reviewed fell between 6x and 9x, which, when coupled with their magnitude relative to Magellan's existing operations, are sufficient to drive attractive distribution growth over time.

Looking Forward

Source: Magellan Midstream Partners, Tulsa MLP & Midstream Conference presentation, December 13, 2018

Operating margins are expected to be comprised of 85%+ of fee-based, low-risk projects going forward. We can see that nearly two-thirds of current revenue is already derived from its Transportation segment, which embodies all the aforementioned characteristics.

Source: Magellan Midstream Partners, Tulsa MLP & Midstream Conference presentation, December 13, 2018

Not only has Magellan avoided taking on incremental debt, issued shares instead of using internally generated cash flow, or reallocated CapEx to fund distributions, it's actually done the opposite. As shown above, the firm expects record CapEx spending in 2019 on top of the previously record spending in 2018. Also note that the full extent of anticipated expenditures is classified as organic growth rather than acquisitions, which can be less reliable in execution and sometimes require paying hefty premiums to a reasonable market value. It's also easier for management to make up excuses as to why acquisitions don't pan out.

As mentioned in the conclusion of the previous sections, these projects result in anticipated distributable cash flow ("DCF") increases of 5-8% annually over the next couple years, while maintaining today's healthy 1.2x DCF distribution coverage.

Dangers Of Indexing

Lazy ETF/Index investing can be very costly. MLPs, for instance, live and die by their cost of capital, scale, partnerships with large energy companies, and building sufficient asset diversification. This means smaller or poorly managed MLPs, particularly in cyclical downturns, suffer harsher fates than in many other sectors. Many of us likely remember what happened to the beloved Kinder Morgan (KMI) when management lost discipline and took on too much debt.

Let me give you a powerful demonstration of the pitfalls of indexing:

Source: Yahoo Finance

This chart includes Phillips 66 Partners (PSXP), Enterprise Products Partners (EPD), Magellan, and the Alerian MLP Index. On a capital gains basis, Phillips posted a remarkable 14%+ gain over the difficult five-year period, both Enterprise Products Partners and Magellan posted losses of approximately 14%, while the index lost a borderline cataclysmic 44%. All the results are 20-25% better including distributions. I didn't cherry-pick these MLPs; they are what we chose years ago for what became the Institutional Income Plus subscriber portfolio. They are also the three current components of its 7.5% allocation to MLPs, though they are not evenly weighted. The relative performance is nearly identical on a one-year, two-year, and YTD basis, with the exception of MMP performing more in line with index recently, which is why it is currently attractively priced.

The scary part, however, is that the index is composed of 10.04% EPD, 2.62% PSXP, and 9.98% MMP. Nearly a quarter of the index is, and has been, composed of these stocks, yet it massively underperformed them! This is not hyperbole. The average performance of the three MLPS on a strictly capital gains basis is a modest -5% (up ~24% in terms of total return) versus the index, being nearly cut in half over the same period. The Alerian MLP index included 39 companies as of its last reporting period, and many of them are not high-quality companies. Many don't have a competitive cost of capital, and many don't own infrastructure in areas with sufficiently favorable economics to weather a downturn in commodities. They aren't good investments, so think twice before blindly investing in them!

Quick Note on MLP Taxation

In general, firms structured as MLPs issue K-1s, and Magellan is no exception. It's a lot easier to obtain these documents than in the past (there is now a system that allows you get all your K-1s from participating companies, which is almost all of them, in one place), but they are still more cumbersome come tax time. Your cost basis is reduced by the amount of the distribution classified as "return of capital". On one hand, this is fantastic, as it allows tax-free income in a retail account. On the other hand, if the stock is sold years later, it is almost guaranteed that a capital gain will be generated, since the cost basis declines over time. The MLP position can be received by heirs with a step-up in cost basis, eliminating this negative attribute, but I generally assume I'll still be alive when an investment is sold.

Personally, it takes me about 10-20 minutes for each K-1 come tax time, but it can be longer if many transactions are involved. Taking distributions in cash can alleviate this problem significantly. To be 100% covered, you'd want to keep track of the amount of distributions classified as return of capital in a spreadsheet, so you'll know exactly what your basis is when it comes time to sell. Neither the MLP nor your online broker is responsible for maintaining this information - you are. The threshold for generating taxable revenue in a retirement account is high, in my experience, but this is another item to be cognizant of that I can't go into much detail on in a public article. For subscribers, I will share my personal experience tax-wise with any K-1s included within the Institutional Income Plus portfolio. Note that nothing stated in this article should be construed or taken as tax advice.

Summary and Valuation

• Magellan owns and operates arguably the largest and most important petroleum infrastructure network in the country.
• The firm's business model is stable and much more favorably structured than that of most of its peers. This means no general partner incentive distributions or reliance on equity to raise capital at the expense of investors.
• The 12% CAGR of its distribution since the early 2000s, represented by the 64 consecutive increases, is remarkable and not by chance.
• While forecasted distribution growth is not quite at the level of the past, it is still sufficient to generate reliable 5-8% increases in the distribution annually.
• Financially, the firm has one of the highest credit ratings in the business, thanks to a conservative and disciplined management team.
• Like all MLPs, Magellan is structured as a partnership, not a corporation, and issues a K-1.
• K-1s have to be entered manually come tax time, and if the position is large enough, could result in taxes even if held within an IRA. This applies to the distribution only and not capital gains. In my 15+ years actively investing in this sector, the position has to be worth >$25,000 to generate taxes in an IRA, but that is an average observation and not a definitive one.

Magellan is approximately 20% off its 52-week highs despite its consistently strong financial performance. We thank the market for this opportunity. Specific entry prices and the associated real-time alerts are reserved for subscribers, but Magellan is currently attractively priced, in our opinion, though buying on a dip is preferable. As always, thanks for reading, and please "Follow" for two more MLP articles currently in process.

Analyst’s Disclosure: I am/we are long VLO, KMI, MMP, PSXP, EPD. 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.