Magellan Midstream And 3 Proven High-Yield Income Strategies

Summary

• In this article, I discuss three practical income strategies that are proven to deliver a stream of reliable yet expanding income.
• They are wide-moat stalwarts in a cyclical industry, wide-moat business in turnaround, and wide-moat, secularly-growing businesses bought during a recession or idiosyncratic crisis.
• I will then apply the principle to Magellan Midstream in greater detail.
• In conclusion, I believe for those who believe the death of fossil fuel is greatly exaggerated, Magellan is a high-yield wide-moat income opportunity.
• Looking for more investing ideas like this one? Get them exclusively at The Natural Resources Hub. Get started today »

In this article, I will use Magellan Midstream Partners, L.P. (NYSE:MMP) as an example to demonstrate the wide-moat cyclical income play, one of the three strategies we at The Natural Resources Hub use to generate a stable, high-yielding, and growing stream of dividends.

Three proven income strategies

Here are three practical income strategies that are proven to deliver a stream of reliable yet expanding income:

• Strategy 1: wide-moat stalwarts in a cyclical industry;
• Strategy 2: wide-moat business in turnaround; and
• Strategy 3: wide-moat, secularly-growing businesses, bought during a recession or idiosyncratic crisis.

My focus in this article will be on the first strategy, using Magellan as an example. Nonetheless, the other two strategies are included in Table 1 for comparison, the relevant examples being Altria Group, Inc. (MO) and Moody's Corporation (MCO).

Table 1. Three income investing strategies used at The Natural Resources Hub. Source: Laurentian Research.

Retirees are fond of measuring stocks by their dividend yields. For example, as of December 14, 2020, Magellan yields 9.02% and Altria 8.02%. Precisely speaking, those are dividend yields to the current share price, which is only meaningful at the time when you're considering an entry.

Suppose you bought Magellan back in late March 2020 at around $35. Your Magellan shares are actually yielding 11.74% (i.e., 9.02% X $45.57 / $35), relative to your cost basis ($35). Yield-to-cost is a great measure to use when you hold a stock for the long haul.

The concept of yield-to-cost is especially important when it comes to dividend growth investing (aka, DGI). Take Moody's, whose dividend yield to the current share price is at an apparently uninspiring 0.82%. However, if you purchased your shares between November 2008 and October 2010 as I did, your cost basis should be around $24, and your yield-to-cost is at 9.40% today (on top of the capital appreciation over the past ~11 years). Around the same time, I also bought Intercontinental Exchange (ICE), which currently yields some 16.62% to the split-adjusted cost.

Important questions to ask

As you can see, all three income strategies can work beautifully. However, the devil is in the details of the investing process.

There are some critical questions we must ask before the entry, so as to ascertain our investment goal (a stream of reliable, high-yielding, yet growing dividend income) is achieved.

• Is my principal going to be safe?
• Can business fundamentals turn sour under adverse economic conditions and force the management to cut dividends?
• How high will the yield-to-cost be by the time when I actually need the income?
• How consistent will the promised dividend raises be?

The best guarantee for principal safety is the presence of a sustainable competitive advantage or, in Warren Buffett parlance, wide moat. Businesses of durable competitive advantage are resilient at the time of recessions. They tend to be the last business standing so the likelihood for them to fold is extremely low; as a matter of fact, they may even benefit from the crisis as rivals go bankrupt.

Businesses with a sustainable competitive advantage usually have the wherewithal to continue paying dividends when industry peers cut distribution to avoid default. Our three examples, all protected by a wide economic moat, did not cut dividends during the economic crisis from which we are recovering (Table 1).

Once we are convinced a durable competitive advantage does exist, the rest is straightforward. Focus on these fortress-like businesses we identified, and ignore all the weaklings even though they may at times offer a higher dividend yield.

• I like wide-moat cyclical plays from, e.g., the oil patch or mining industry. I like them better when nobody wants to touch them with a 10-foot pole thanks to the downcycle. Extremely high-quality companies at give-away prices mean high yields can be had at very little risk. I like it the best when the yield-to-cost goes through the roof as the underlying commodity enters a roaring bull market. That's the beauty of strategy 1.
• Turnaround stories are slightly harder to invest in, because we, as outsiders, know little about the operational improvements inside the company. Moats may even have been damaged during the crisis. However, if the wide moat is confirmed to be intact, we are supposed to have the conviction to go for the high yield. The reward for such an apparently gutsy move comes in the form of a bigger and bigger dividend check as well as an appreciating share price as strategy 2 plays out.
• The greatest mistake a dividend growth investor can make is to chase dividend raises without insisting on the presence of a wide moat around the dividend-paying business. Without the protection of sustainable competitive advantage, eventually, dividends will get ahead of underpinning profits; when the business goes south, dividends will be cut. In the worst case, an investor may suffer from total loss of capital. To qualify for strategy 3, the company must also be in secular and profitable growth, pretty much free from the yoke of economic cycles. The best entry opportunities occur during a stock market crash (e.g., the global financial crisis) or on an idiosyncratic adverse event (e.g., when Verisk (VRSK) lost a case in court).

Below, let's apply the above-discussed principle to Magellan.

Magellan Midstream

The business

As I discussed in detail in previous pieces (see here, here, here, here, and here), Magellan chooses a business model that is primarily (>85% in terms of operating margin) focused on fee-based, low-risk activities of transporting and storing refined oil products (65%) and crude oil (35%). The company is the largest midstream player in refined oil products; it is also a significant operator of crude oil pipelines, which are substantially backed by long-term throughput commitments, and crude oil storage, strategically located in Houston and Cushing storage hubs (Fig. 1). To a large extent, Magellan benefits from a monopolistic to oligarchic market position.

Fig. 1. Crude oil (left) and refined product (right) infrastructure of Magellan. Source.

Magellan has consistently delivered >16% returns on invested capital (or ROIC) over the last 15 years (Fig. 2). It boasts one of the highest-rated midstream companies at BBB+ or Baa1. On the balance sheet, its Debt-to-EBITDA ratio was 3.2X as of the 3Q2020. It has a $1 billion credit facility, with the next bond maturity not until 2025. Clearly, it is a well-run, healthy business.

Fig. 2. A comparison of ROIC of 15 major midstream companies in the U.S. ROIC defined as trailing 12-month after-tax net operating profit, divided by average invested capital.

Profitability

The oil industry has been in a bear market since late 2014. Adding salt to the wound, the coronavirus pandemic decimated the demand for crude oil and oil products. In spite of the cyclical headwinds, from 2014 to date, Magellan was able to grow adjusted EBITDA at a CAGR of 5.71% and distributable cash flow at 5.52% (Fig. 3).

Fig. 3. The revenue, adjusted EBITDA, net income, and distributable cash flow of Magellan for 2004-3Q2020. Source: Laurentian Research based on financial releases by Magellan.

Shrewd capital allocation by the management has contributed the most to the anti-cyclical growth, aided to a moderate extent by repurchasing outstanding units. Magellan seems to have also used its pricing power to the fullest. On July 1, 2020, Magellan increased the average tariff on refined oil products by 3.5%, which should offset in part the weak throughput volume caused by the pandemic. This latest tariff increase came after a 4.3% tariff increase that became effective in mid-2019. The pricing power has certainly given Magellan exceptional resilience in the industry downturn.

Although refined oil product demand has been impacted by the coronavirus pandemic during 2020, Magellan expects that demand to return to historical levels as car traffic recovers along with the economic activity. The crude oil business segment benefits from long-term commitments from creditworthy counterparties, which mitigates the impact of a lower-for-longer crude oil price environment.

As of the 3Q2020, although the business has not recovered to the level of one year ago, inchoate sequential improvements in revenue, EBITDA, net income, and DCF have been very encouraging (Table 2).

Table 2. Key parameters of Magellan, Altria, and Moody's. FCF is for Altria and Moody's, while DCF is for Magellan. Magellan uses distributable cash flow, i.e., adjusted EBITDA minus net interest expense (excluding debt issuance cost amortization) and maintenance capital, to measure cash distribution coverage. Expansion capital expenditures, undertaken to construct new assets and organically grow business, are excluded in the calculation of DCF. Source: Compiled by Laurentian Research.

Magellan and the oil industry: generational opportunity or a value trap

For people interested in investing in Magellan that owns long-life midstream assets, the critical question is whether the oil industry is in another down cycle or in its terminal decline. If an upcycle is on the horizon, then Magellan may well be a generational entry opportunity; if oil, on the other hand, will face imminent existential oblivion, then Magellan is the quintessential value trap.

The difference in the ongoing oil downturn is the coincidental movement of greenhouse gas emission reduction and the rise of renewable energy. According to popular thoughts, electric vehicles are to replace ICE cars in short order; having seen its terminal lucidity back in the early 2010s, the end of the oil industry is nigh.

The reality is the EV industry still needs considerable time to substantially reduce costs and enhance recharge ubiquity to effectuate a massive replacement of ICE cars. In the foreseeable future, EVs are not expected to have a material impact on the market served by Magellan. The more distant future may even not belong to EVs. Environmentalists may wake up one day to the unintended environmental consequences of battery metal extraction. Technological advancement may lead us to, e.g., hydrogen fuel cells instead, in which case a window of opportunity may open for Magellan to parlay its midstream assets and expertise into hydrogen storage and transportation.

In my personal opinion, fossil fuel will remain an important part of human mobility in the medium term, and Magellan represents an investment opportunity for income investors.

Cash distribution

Thanks to its resilient business model, Magellan has been able to pay increasing cash distributions through business cycles since its IPO in 2001 (Fig. 4).

Fig. 4. The earnings, DCF, and cash distribution per unit of Magellan. Source: Laurentian Research based on financial releases and presentation of Magellan.

Amidst dividend cuts by peers, Magellan declared it would maintain the quarterly dividend at $1.0275 per unit. It expects to maintain the current level of quarterly distribution for the remainder of 2020 and 2021.

As of 3Q2020, cash payout was at 110% of net income and 74% of DCF. Cash distribution coverage by earnings is at least no worse than in 2008-2009. Because the company has latitude to put off expansion capital expenditures (indeed, Magellan expects the 2021 growth spending to be in the range of $100 million, much lower than in 2020), the cash distribution seems to be adequately covered. However, given the current ratio situation, it is unclear whether Magellan will carry out its $750 million unit repurchase program; year to date, it bought back $250 million of units.

• Due to the cyclical nature of the business, payout varies; but cumulatively from 2004 to date, cash payout was 91% of net income and 66% of DCF. Since 2010, cash payout averages 89 +/- 12% of net income and 75 +/- 5% of DCF (Fig. 5).

Fig. 5. The payout relative to earnings and DCF per unit. Source: Laurentian Research based on financial releases of Magellan.

Investor takeaways

The three practical income strategies we at The Natural Resources Hub use to generate a stream of reliable yet expanding income are underpinned by the presence of a wide economic moat around the business and opportunistic entry.

Magellan falls into the wide-moat cyclical income strategy. The company has survived the ongoing industry downturn fairly well so far, thanks to its wide moat and pricing power. Even in challenging 2Q2020, it was still profitable. The business has since turned the corner, with sequential improvement in the 3Q2020.

Unlike its midstream peers, Magellan did not cut cash distribution; it maintains the quarterly dividend at $1.0275 per unit. Unless the industry condition turns materially sour (which appears to be increasingly unlikely), such a level of cash distribution is adequately covered. That's why the management intends to keep it for the remainder of 2020 and 2021.

Going forward, as business improves further, the unitholders stand to reap even higher yield-to-cost in addition to unit price appreciation. Such a rich reward comes with the risk that a terminal decline of the industry may render the long-life assets of Magellan worthless. But for those who believe the death of fossil fuel is greatly exaggerated, Magellan is still the best wide-moat high-yield income play from the midstream sector.

Disclosure: I am/we are long MMP, MCO, ICE, MO, VRSK. 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.