Magellan Midstream Partners: The Operating Fundamentals Remain Stable
Summary
- Magellan Midstream Partners delivered yet another distribution increase, marking the 71st consecutive quarterly distribution increase.
- Fueling Magellan Midstream Partners' continuation of steady distribution increases was a 2019 that saw a 17% surge in DCF compared to 2018.
- Magellan Midstream Partners is also trading at a 24% discount to fair value based upon valuation metrics sourced from I Prefer Income, as well as my inputs into the DDM.
- Magellan Midstream Partners' 7.9% yield and 3.0-4.0% annual DCF growth alone would be enough to meet my 10% annual total return requirement, without even considering the 2.8% annual valuation multiple expansion.
Image Source: I Prefer Income & I Prefer Income Filter
As recent and long-time readers of mine alike have noticed, a portion of my portfolio is allocated to the midstream industry.
Given that there are a number of well managed companies in this maligned industry trading at attractive valuations, this should come as no surprise.
Using I Prefer Income's filter above where I specify for a yield of greater than 7%, DCF growth of greater than 3%, distribution growth of greater than 3%, and a payout ratio of less than 80%, I was able to narrow the field of potential midstream investments from 66 to 4.
Since I recently reexamined Enterprise Products Partners (EPD), I will be focusing on its midstream blue-chip peer, Magellan Midstream Partners (NYSE:MMP). I last covered the company in December by reviewing the company's DCF payout ratios/distribution growth potential, discussing Magellan's operating fundamentals and risks, and comparing Magellan's fair value against its current stock price.
The Distribution Remains Safe With Long-Term Mid-Single Digit Growth Potential
As the investing expression goes, the safest dividend/distribution is the one that has just been raised. While I believe this is generally true and Magellan recently raised its quarterly distribution by 0.7% from $1.0200/unit to $1.0275/unit, I also think it's prudent for investors to look beyond recent distribution increases by examining a midstream company's DCF coverage ratios to determine whether a distribution is well covered and continued distribution increases are sustainable.
Magellan reported that it generated $1.297 billion in DCF during FY 2019 against $922 million in distributions paid during that time (according to page 68 of Magellan's 2019 Annual Report), for a relatively safe DCF coverage ratio of 1.41.
Although Magellan does expect DCF to decline a bit in FY 2020 as a result of an assumed less favorable commodity price environment in FY 2020 than that experienced in FY 2019, the company expects to cover its distribution at least 1.25 times while delivering 3% distribution growth during FY 2020.
This leads me to reiterate my belief that while Magellan's distribution isn't as well covered as EPDs, it is still quite safe for the foreseeable future.
Given that I am forecasting annual DCF growth of 3-4% over the long-term and that Magellan's distribution is in a reasonably safe range currently, I believe that a long-term distribution growth rate of 4% is a realistic expectation for the long-term.
The Operating Fundamentals Remain Stable And The Balance Sheet Remains Strong
Magellan reported reasonably strong financial results during FY 2019.
The encouraging news from an operational standpoint was that according to page 5 of Magellan's 2019 Annual Report, the company's total shipments increased 1.0% from 510.6 million barrels in FY 2018 to 515.9 million barrels in FY 2019.
While gasoline shipments declined 2.2% from 286.9 million barrels in FY 2018 to 280.5 million barrels in FY 2019 and LPG shipments dropped 11.8% from 11.0 million barrels in FY 2018 to 9.7 million barrels in FY 2019, this volume decline was more than offset by increases in distillates and aviation fuel shipments.
Distillates shipments increased 1.6% from the 181.7 million barrels in FY 2018 to 184.6 million barrels in FY 2019 and aviation fuel shipments surged 32.6% from 31.0 million barrels in FY 2018 to 41.1 million barrels in FY 2019.
Magellan's slight volume increases in shipments allowed the company to produce a record $1.581 billion in adjusted EBITDA in FY 2019, which was a 13.3% increase compared to the $1.396 billion generated in FY 2018.
In addition, Magellan was able to produce a record $1.297 billion of DCF in FY 2019, which represented an impressive 16.9% increase compared to the $1.110 billion in DCF generated in FY 2018.
It's worth mentioning that while Magellan was able to produce DCF in 2019 that blew its initial guidance of $1.14 billion out of the water, this was as a result of an especially favorable operating environment in 2019.
Due to this information, Magellan is guiding for a reduction in DCF to $1.2 billion for FY 2020, although this could prove to be higher if the Permian to Houston differential is better than what is suggested from the forward curve and if blending margins improve from where they are at now.
Image Source: Magellan Midstream Partners Wells Fargo Midstream Symposium Presentation
As I discussed in my previous article on Magellan, the company has invested $5.8 billion in expansion projects over the past decade, which has allowed the company to nearly double its DCF during that time.
While Magellan has done a masterful job at growing its DCF over the past 10 years, it will undoubtedly need to continue expansion project spending to drive DCF growth in the future.
Magellan spent $1 billion in FY 2019 and has $400 million in expansion projects currently scheduled for FY 2020 as indicated by Magellan CEO Michael Mears in the Q4 2019 earnings call, which comprises the $1.4 billion capital spend estimate for FY 2019-FY 2020.
While the company only has $400 million in definitive expansion project spending slated for 2020, it's worth mentioning that Magellan is evaluating over $500 million (over 4% of the company's $11.9 billion market cap) of potential organic growth projects that would create incremental value for unit holders and may begin construction at any point this year, should they meet or exceed Magellan's targeted 6-8 times EBITDA multiple threshold and offer sustainable cash flows.
Although Magellan will likely be in a lower spending environment over the next few years, the company appears well positioned to drive mid-single digit DCF growth in the years ahead as a result of relatively intact capital spending.
Image Source: Magellan Midstream Partners Wells Fargo Midstream Symposium Presentation
In addition to Magellan's stable operating fundamentals and continued capital spending to drive DCF growth, Magellan's balance sheet remains as strong as it was since I last covered the company.
As a result of Magellan's stable operating fundamentals and its leverage ratio of 2.8 times at the end of 2019, Magellan's balance sheet is investment grade with BBB+ and Baa1 ratings from S&P and Moody's, respectively.
And to reiterate the unlikelihood of Magellan needing to issue equity in the next couple years, CFO Jeffrey Holman indicated that the company allowed its shelf registration for its at-the-market-equity issuance program to expire.
Given the precipitous decline in Magellan's unit price over the past few days and the years long midstream bear market overall, Magellan's ability to fund its future projects solely with a combination of debt and retained DCF can't be understated.
When I factor in Magellan's relatively stable operating fundamentals, growth spending for 2020, and the stability of its investment-grade balance sheet, I still believe that Magellan is capable of being a great long-term investment at the right price for those that are able to tolerate its risks.
Risks To Consider:
Although Magellan is a blue-chip midstream MLP, that doesn't mean that the company comes without its fair share of key risks that potential and current unit holders would be wise to occasionally monitor.
The first risk facing Magellan is that as a midstream company, Magellan's financial results depend on the demand for the petroleum products that it transports, stores and distributes (pages 19-20 of Magellan's 2019 Annual Report).
The immediate threats facing Magellan on this front are two fold, with the first being the possibility of COVID-19 significantly reducing economic activity and consumer confidence, and with it, the demand for petroleum products.
An economic recession would further pressure oil prices to the point of potentially bankrupting some of Magellan's customers, which could adversely impact Magellan's financial results in at least the short-term.
The second immediate threat facing Magellan is the possibility that the market is flooded with a massive abundance in the global crude supply as a result of the Saudi plan to boost oil output next month to over 10 million barrels a day in response to the collapse of its OPEC+ alliance with Russia.
Just as reduced demand for petroleum products could lead to even more downward pressure on commodity prices, a significant surge in Saudi oil production could further pressure prices, once again resulting in the bankruptcy of some of Magellan's smaller E&P customers.
Magellan would then be faced with the task of both trying to recover as much of its lost revenues in the short-term from insolvent customers as possible and in the longer term, finding new customers to replace the lost volume and revenues.
Replacing lost revenue and volume stemming from smaller E&P bankruptcies could prove difficult until crude stabilizes and larger, more integrated energy companies boost production.
While on the subject of Magellan's immediate and long-term future being tied to the continued demand for petroleum products, it is important to note that capacity overbuild in key markets where Magellan operates is a major risk for the company (page 22 of Magellan's 2019 Annual Report).
Should energy infrastructure be overbuilt in regions where Magellan operates, this could lead to intense competition between Magellan and its peers to retain their customers and draw customers away from their competitors.
Such an event could lead to a "race to the bottom" on future contract renewals and less favorable terms for Magellan in efforts to remain competitive, which would harm the company's financial results.
Yet another risk to Magellan is that as a midstream company, the company's operations are subject to extensive environmental, health, and safety regulations that burden the company with significant compliance costs. The modification of any existing regulations governing Magellan's operations or the introduction of new regulations may result in Magellan needing to allocate more resources to compliance, which would weigh on the company's financial results (page 31 of Magellan's 2019 Annual Report).
On a similar note, it is also worth mentioning that in the event that Magellan is found to have not complied with any laws dictating its operations or is held responsible for an environmental accident, the company could face significant fines and penalties, as well as negative PR as a result of such an event. The fines and penalties in combination with potentially reduced demand for Magellan's services could have a materially adverse impact on the company's financial results.
The final risk to Magellan is from an environmental activism standpoint, which is a long-time risk that has faced the midstream industry for years that shows no signs of going away.
As I have mentioned in several articles in the past, EQM Midstream's (EQM) significant cost overruns and project delays on its Mountain Valley Pipeline serve as one among many reminders that environmental activism and drawn out court battles over the completion of pipelines are a threat to the growth prospects of the overall industry.
For context, MVP was initially expected to be in service in late 2018 at a cost of $3.5 billion when work began on the project in February 2018. Since that time, there have been numerous delays and cost overruns, pushing the estimated cost of MVP to $5.3-$5.5 billion and the completion date to late 2020.
Current and potential unit holders of Magellan and the industry in general must monitor the trends of environmental activism and their impact on the growth prospects of the industry.
While Magellan's distribution is safe at this point in time and annual mid-single digit growth appears realistic, unit holders will need to watch for delays and cost overruns in Magellan's key projects as such events could result in a decline in Magellan's growth prospects.
While I have covered several of what I believe to be key risks associated with an investment in Magellan, I haven't discussed all of the risks facing Magellan for the sake of conciseness.
For a more comprehensive discussion of the risks associated with an investment in Magellan, I would refer interested readers to my previous article on the company and pages 19-39 of Magellan's 2019 Annual Report.
A Blue-Chip Midstream Stock Trading At A Deep Discount To Fair Value
Even when I consider the fact that Magellan is a blue-chip midstream stock, that doesn't necessarily mean that an investor can pay any price for units of the company and still expect to do well over the long-term, which is why I'll be determining Magellan's fair value by using a couple valuation metrics and a valuation model.
Image Source: I Prefer Income
The first valuation metric that I'll be using to determine the fair value of Magellan's units is the yield to historical yield courtesy of I Prefer Income.
As anyone that has followed the midstream industry over the past several years has come to learn, even the blue-chip midstream companies are quite despised.
Magellan is no exception to this industry wide hatred, with its current yield of 7.90% being 65.7% higher than the historical yield of 4.77%.
Excluding the fact that Magellan's operating fundamentals remain stable, I believe that a reversion to a yield of 6.00% and a fair value of $68.50 is a realistic expectation of Magellan's fair value.
This implies that units of Magellan are trading at a 24.1% discount to fair value and offer 31.7% upside from the current unit price of $52.00 (as of March 7, 2020).
The next valuation metric that I will utilize to arrive at a fair value for units of Magellan is the current price to EBITDA to historical price to EBITDA.
As illustrated above, Magellan's current price to EBITDA is 37.9% below its historical price to EBITDA.
Building in a level of conservatism once again and splitting the difference down the middle at a fair value of $67.88 a unit, Magellan is priced at a 23.4% discount to fair value and offers 30.5% of capital appreciation from the current unit price.
Image Source: Investopedia
The valuation model that I'll be using to assign a fair value to units of Magellan is the dividend discount model or DDM.
The first input into the DDM is the expected dividend per share, or in this case, the annualized distribution per unit. In the case of Magellan, that amount is currently $4.11.
The second input into the DDM is the cost of capital equity, which is another term for the rate of return that an investor requires on their investment. Although this can vary tremendously from one investor to the next, I require a 10% rate of return on my investments because I believe this adequately rewards me for the time and effort that I spend researching and monitoring investments.
The third and final input into the DDM is the long-term dividend/distribution growth rate or DGR.
While the first two inputs into the DDM require little more than data retrieval and subjectivity, accurately forecasting the long-term DGR requires an investor to factor into consideration numerous variables, including a stock's payout ratios (and whether the payout ratios are positioned to expand, contract, or remain the same over the long-term), a realistic future DCF growth rate, industry fundamentals, and the strength of a stock's balance sheet.
When I consider that Magellan's DCF payout ratios are positioned to remain the same over the long-term and that Magellan appears set up to deliver 3-4% DCF growth over the long-term, I believe a 4% long-term DGR is a reasonable assumption given the company's investment-grade balance sheet.
Upon using the inputs above for the DDM, I am once again left with a fair value of $68.50 a unit, which suggests that units of Magellan are trading at a 24.1% discount to fair value and offer 31.7% upside from the current unit price.
When I average the 3 fair values above, I compute a fair value of $68.29 a unit.
This indicates that units of Magellan are priced at a 23.9% discount to fair value and offer 31.3% of capital appreciation from the current unit price.
Summary: Magellan Is Deeply Undervalued And Provides Strong, Reliable Immediate Income
Magellan delivered its 71st consecutive quarterly distribution increase in January and its distribution is reasonably well covered, which positions itself among the best of the best in the midstream industry along with EPD.
When I take into consideration Magellan's history of being ahead of the curve in terms of adopting the self-funding model and eliminating IDRs well before its peers, the company's stable operating fundamentals, and investment-grade balance sheet, I believe Magellan is well positioned to continue delivering mid-single digit distribution increases on an annualized basis for its unit holders.
Bolstering the case for consideration of an investment in Magellan is the fact that the company's units are trading at a 24% discount to fair value.
Magellan's 7.9% yield and 3.0-4.0% annual DCF growth potential alone are enough to meet my 10% annual total return requirement, without even factoring in the 2.8% average annual valuation multiple expansion that I expect over the next 10 years as a result of the company's deep undervaluation.
Because of the aforementioned reasons, Magellan is comfortably the 3rd largest midstream holding in my portfolio behind EPD and Energy Transfer (ET), and I am considering adding to my position in the days ahead.
This article was written by
Analyst’s Disclosure: I am/we are long EPD, MMP, ET, EQM. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (22)
And EPD at $13
And ET at $5.With yields above 13%. ET at 23%.23%. Is ET a junk bond about to default??
