Magellan Midstream: Profitability And Capital Efficiency

Summary

• Magellan Midstream had a strong uptrend in operating and net margins until the recent industry recession.
• What could have caused such a softening of margins? Is there anything to be concerned about?
• In this article, I take an under-the-hood look at the profitability and capital efficiency of the company to find answers to these critical questions.
• Anyone interested in Magellan Midstream or its peers in the midstream sector may benefit from the gleanings derived from this research.
• This idea was discussed in more depth with members of my private investing community, The Natural Resources Hub. Start your free trial today »

Previously, I stated the following after an in-depth examination of the business model of Magellan Midstream Partners, L.P. (NYSE:MMP),

"I believe Magellan commands a considerable sustainable competitive advantage in its core business of the transportation, storage, and distribution of refined petroleum products. Its segments of crude oil and marine storage also have some competitive advantage, but the recent investment spurs in these areas may cause medium-term oversupply."

I concluded that article by saying, "To draw a definitive conclusion, we still have to examine its profitability and capital efficiency." In this article, I will do just that, and I will also derive the implications of my findings in these articles to the investors in Magellan in specific and other midstream players (AMLP) in general.

Margins

The operating margin and net margin improved from 2010 through 2015 and then softened in 2016 before entering a holding pattern, which lasted until this day. Such a pattern is especially pronounced after the 2016-2018 years are adjusted for gains made on asset dispositions (Fig. 1).

Fig. 1. The operating and net margins of Magellan, shown with the net margin adjusted for gains on the disposition of assets for 2016, 2017, and 2018. Source: Laurentian Research.

What could have caused such a softening of margins?

Magellan's pricing power in refined products transportation seems to be intact, while the crude oil transportation revenue per barrel has not started to soften until 2018 (Fig. 2). So, the real cause for the decrease in margins in the last few years has to be found in the services ancillary to transportation, including product sales and affiliate management fees. Among the ancillary services, product sales dominate over affiliate management fees with a 33% contribution to total revenue to less than 1%.

Fig. 2. Operating margin per barrel of refined products (upper) or crude oil shipped (lower), reduced into components of transportation sourced and of ancillary services including storage and so on. Source: Laurentian Research.

The ancillary services to crude oil transportation have demonstrably strengthened since 2014, ruling out them being the cause of the margin softening. That leaves the ancillary services to refined products transportation as the probable culprit (Fig. 2). Indeed, the operating margin of product sales decreased considerably from 2015 to 2018 (Fig. 3).

Fig. 3. Operating margin of product sales. Source: Laurentian Research.

Here are the gleanings from this analysis so far:

• Firstly, Magellan's pricing power in the transportation of refined products was unaffected during the recent industry downturn, underlining its secular nature. On the other hand, product sales, condemned to the perdition of commodity volatility, are inherently cyclical. Exactly due to the cyclical nature of product sales, however, one can expect the operating margin in product sales to recover as the industry enters an upcycle.
• Secondly, the pricing power in crude oil transportation has seen the first sign of weakening in 2018, most likely due to over-investment spur to solve the once serious problem of egress from the Permian Basin and the ensuing hyper-competition in that market. I am pleased to see that the management has decided to sell a minority (35%) stake in the Longhorn crude pipeline (see here) and to scrap a proposed pipeline from the Permian Basin to Gulf Coast (see here); these strategic moves are doubly commendable, considering the management had previously made a timely call to enter the crude transportation market just as crude production was taking off (Fig. 4).
• Lastly, ancillary services to crude transportation remain as strong as ever. That is perhaps why the company allocates a lot of capital to marine storage (Fig. 4).

Fig. 4. Historic strategic investments of Magellan. Source.

Overall, the company's sustainable competitive advantage appears to be largely intact, thanks to its reliance on fee-based, low-risk business activities. There is a rising risk in crude transportation, but the management seems to be making the right strategic moves to address it.

DuPont analysis

Asset turnover seems to have slowed down to some extent from 2016 to date. Meanwhile, leverage was up moderately during the same time (Table 1). Consequently, the return on equity (or ROE) only dropped slightly during the recent industry downturn and is still significantly higher than the average.

Table 1. DuPont analysis of Magellan from 2009 to 1Q2019. For 2016-2018, the net margin, ROA, and ROE adjusted for gains on the disposition of assets are given above the unadjusted results. WANOLPUD, the weighted average number of limited partner units outstanding, diluted. Source: Laurentian Research.

As for leverage, it is worth noting that Magellan has refrained from tapping into the equity market, sparing unitholders of equity dilution. In spite of some $5.8 billion of capital spending over the last 10 years, the company only issued $260 million of equity back in 2010. From 2011 to date, the diluted outstanding limited partner units only increased by 2.8%. The company has used debt, at an average effective interest rate of 4.5%, and retained profit to fund its growth (Fig. 5). Going forward, the management does not anticipate to fund growth projects currently underway or in foreseeable future with equity issuance.

Fig. 5. The financing mix by year for Magellan. Source.

ROIC vs. WACC

From 2009 to 2014, Magellan posted continuous improvement in return on invested capital (or ROIC). That uptrend was truncated by the oil downturn started in 2015, but as discussed above, much of the decrease in profitability resulted from cyclical segments of its business.

As of 1Q2019, the company returned 13.7% on invested capital; adjusted for gains on the disposition of assets, it still achieved an ROIC of 12.5%, substantially higher than the Weighted Average Cost of Capital (aka, WACC) of 6.07% for the same time (Fig. 6). The 6.4% spread between the adjusted ROIC and WACC strongly supports the proposition that Magellan commands a significant sustainable competitive advantage.

Fig. 6. The ROIC versus WACC for Magellan, shown with the ROIC adjusted for gains on the disposition of assets. Source: Laurentian Research.

Investor takeaways

Multiple lines of evidence presented above show that Magellan is a wide-moat business and that its competitive advantage survived the assault of the recent industry recession and emerged relatively unharmed. Importantly, the pricing power of its core business - refined products transportation - was as strong as ever even during the industry downturn.

Although the overall margins had softened during the industry downturn, they are shown to have resulted from cyclical fluctuations experienced by the product sales segment. They are, therefore, expected to recover as the industry gets stronger. Generally speaking, there is nothing to be concerned about here.

Inchoate signs of risk do arise as to the crude oil transportation business, thanks to rising competition in crude oil transportation out of the Permian Basin. However, I found the management had started to address that problem by partially monetizing existing crude oil pipelines and by walking away from a proposed crude oil pipeline project.

A falling leaf tells the arrival of autumn. Much of what we learned from this examination of Magellan Midstream can be projected onto the rest of the midstream energy industry (MLPX).

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.