Magellan Midstream: Moat Largely Intact, Sell-Off An Over-Reaction

Summary

• Magellan Midstream was sold off following its 2019 result reporting.
• However, its core business - transportation and terminals - continues to grow steadily.
• Its pricing power in refined products transportation - the core of core of its business - seems to be intact and robust although crude oil transportation may face continued uncertainties.
• I believe the sell-off has created an opportunity for long-term investors.
• I do much more than just articles at The Natural Resources Hub: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

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Since Magellan Midstream Partners, L.P. (NYSE:MMP) reported the 4Q2019 and full-year 2019 results, the stock had been sold off by some 8%. Although it beat Wall Street EPS estimate, the company missed the annual revenue estimate by nearly $100 million (see here and here).

Fig. 1. The revenue, gross profit, operating income, and net income of Magellan Midstream, by year (upper) and by quarter (lower). Sourced from TIKR.com.

The critical questions to me are these: Is the pricing power of the company still intact? Going forward, will it resume top-line growth?

Below, let's try to find the answers.

Why did revenue drop in 2019?

The decrease in revenue from 2018 to 2019 occurred in product sales, which has traditionally been more volatile than transportation and terminals - the core business of Magellan. Revenue from transportation and terminals actually increased by 4.9% year-over-year and has been consistently rising at a CAGR of 6.2% since 2014 (Fig. 2). So, there is nothing to be concerned about here.

Fig. 2. Annual revenue by sources. Source: Laurentian Research based on Magellan annual reports.

Operations

Volume shipped. The total volume of refined product shipments increased by 1.0% from 2018 to 2019 and at a CAGR of 4.4% since 2007.

The total volume of crude oil shipments experienced faster growth than refined products in the last few years, driven by the shale revolution. The throughput via Magellan 100%-owned pipelines rose 30.6% from 2018 to 2019 and at a CAGR of 40.7% since 2010. Magellan sold a 20% interest in the BigTex pipeline, causing its share of the 2019 volume to have dropped by 24.4%. The throughput via the Saddlehorn, another partially-owned asset, more than doubled. Combined, crude oil throughput increased by 22.4% from 2018 to 2019 and at a CAGR of 43.8% since 2010, when it launched crude oil transportation.

Going forward, the heady growth of crude oil transportation may face increasing uncertainties as various shale plays mature and as shale producers slash CapEx.

Fig. 3. Annual volume shipped of refined products and crude oil by asset types. Note BigTex was owned 50% by Magellan through September 28, 2018, and 30% thereafter, while Saddlehorn is owned 40% by us and began operations in September 2016. Source: Laurentian Research based on Magellan annual reports.

On February 4, 2020, Magellan announced that Saddlehorn Pipeline Company, LLC, the operating entity, has sold to Noble Midstream Partners LP (NBLX) a 20% membership interest in Saddlehorn, which runs from the DJ and Powder River basins to storage facilities in Cushing, Oklahoma, for $155 million effective February 1, 2020. The partners are working on increasing the total capacity by 100 Mbo/d to approximately 290 Mb/d by late 2020 (see here). Once the pipeline expansion is completed, Magellan's share of the capacity will actually increase from 76 Mbo/d to 87 Mbo/d; so the impact of the sale of a 10% interest in Saddlehorn will be transient.

Terminal utilization. While marine terminal utilization has plateaued since Magellan entered the space in 2011, crude oil terminal average utilization has been rising rapidly. From 2018 to 2019, crude oil terminal average utilization increased by 20.9%; since 2011, it has increased at a CAGR of 10.5% (Fig. 4).

Fig. 4. Average utilization of crude oil terminals and marine terminals. Source: Laurentian Research based on Magellan annual reports.

On January 21, 2020, Magellan sold three marine terminals to Buckeye Partners, L.P. (BPL) for $250 million, which are located in New Haven, Connecticut, Wilmington, Delaware and Marrero, Louisiana. These three terminals contributed less than $20 million of cash flow on a combined basis in 2019 (see here).

Pricing

Magellan was able to continually raise the prices for each barrel transported through its refined products pipelines. In 2019, the company charged 3.9% more for each barrel of refined products moved than in the previous year. Since 2007, the revenue per barrel of refined products shipped has increased at a CAGR of 2.9%.

It follows that the strong pricing power commanded by Magellan in refined product transportation, as I previously discussed in detail, is intact.

Fig. 5. Revenue per barrel shipped for refined products and crude oil moved through Magellan wholly-owned pipelines. Source: Laurentian Research based on Magellan annual reports.

Without the protection of barriers to entry, the rapid increase in crude oil transportation (Fig. 3) has attracted a lot of investment. Consequently, the revenue per barrel of crude oil shipped crashed in the last couple of years; from 2018 to 2019, it decreased by 22.3% (Fig. 5).

Investor takeaways

Two segments. From the above analysis, it can be concluded that the core business of Magellan, i.e., refined product transportation, is strong as ever. The total volume of refined products shipped continues to increase. The pricing power of Magellan in this segment is intact.

However, the risk associated with crude oil transportation may have risen. On the one hand, in the medium term, financial constraints on shale investment add to the uncertainty of further shipment volume growth. On the other hand, as additional crude export capacity from the Permian Basin comes onstream, the tariffs charged on crude oil shipped are expected to face further pressure.

Fortunately, the refined products segment still pulls in the vast majority of Magellan's revenue (69%); so investors can still rely on the company to outperform in the foreseeable future. Meanwhile, the share of revenue contribution from the crude oil segment continues to rise, from 20% in 2017 to 24% in 2019 (Table 1), implying the sustainable competitive advantage commanded by Magellan in refined products has been slowly diluted by its crude oil business, in which it has no competitive edge to speak of.

Table 1. A comparison of the crude oil (upper) and refined products (lower) segments of Magellan. Source.

2020 outlook. For 2020, Magellan guided toward $1.2 billion of distributable cash flow (or DCF), lower than the $1.3 billion DCF of 2019. However, the 2019 DCF benefited from (1) "significantly more crude transportation revenues than expected due to the favorable Permian differential for most of the year", with significant amount of high-margin spot shipments, (2) "more favorable butane blending margins than expected", and (3) "material one-time insurance recoveries in a one-time gain on the sale of [its] ownership in the discontinued Wink to Crane pipeline project" (see here).

Magellan decides to raise annual distributions by 3% for 2020, lower than the historical 5%. With DCF of $1.2 billion and 3% annual distribution growth targeted for 2020, it expects to generate distribution coverage of 1.25x, which results in more than $240 million of excess cash flow.

Because it expects to enter "a lower capital spending environment over the next few years", Magellan plans to return the excess cash flow to investors through repurchase programs or special distributions. To that end, the board of directors has authorized the opportunistic repurchase of up to $750 million of units over the next three years. A special distribution is viewed by the management as a very tax-efficient way of returning cash to investors.

Technically speaking, the market may have over-reacted to the 4Q2019 and full-year 2019 results and to the 2020 guidance. Considering its competitive advantage and able and unit-holder friendly management, I believe that Magellan will continue to reward investors in search of relatively reliable cash distribution in the long run (Fig. 6).

Fig. 6. Stock chart of Magellan. Source.

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.