Good things come to those who wait, and the recent market volatility may just provide the opening that patient value investors have been waiting for. In practice, buying above-average companies at below-average prices is a winning strategy that many successful investors have employed. That’s why it pays to tune out the market noise and focus on high-quality players whose long-term growth theses are intact.
This brings me to Magellan Midstream Partners (NYSE:MMP), which is a high-quality player in the midstream space that’s known for paying a reliable and growing distribution. I highlight what makes MMP an even more attractive buy after the recent drop, so let’s get started.
Magellan Midstream Partners is an MLP (note: issues schedule K-1) that operates pipelines and storage terminals across the Central and Eastern regions of the U.S. Its asset base includes America’s longest petroleum products pipeline system, covering 9,800 miles, 54 terminals, and 47 million barrels of storage capacity.
Notably, MMP can tap into nearly 50% of the nation’s refining capacity. Refined products make 71% of its operating margin, with crude oil making up the rest. What makes MMP’s income stream particularly durable is the primarily fee-based nature of its business. As seen below, just 9% of MMP’s operating margin is sensitive to commodity prices.
(Source: Investor Presentation)
Morningstar assigns MMP a wide moat rating considering the aforementioned attributes, and the fact that MMP’s producers and end customers have few alternatives, as noted in its latest analyst report:
“We expect Magellan will benefit from a particularly strong efficient scale moat source, given the lack of alternatives for its refined product pipelines (it provides more than 40% of refined products to 7 of the 15 states it serves), and with stable demand forecast, there's zero incentive for new competing pipelines to be built. We forecast returns on invested capital to remain well ahead of Magellan's cost of capital because of the minimal reinvestment needs of the refined product business.
Even if we assume refined product pricing declines by 50%--an extremely unlikely scenario, given that pricing generally only moves a few percentage points annually-- Magellan's ROICs are around 11% (versus 13% in our base case), demonstrating the strength of the business. ROICs are also supported by strong capital allocation as well as the elimination of its incentive distribution rights in 2010, which lowered its cost of capital.” - Morningstar
As noted above, Morningstar sees MMP as still having a low-teens return on invested capital even in a worst case and highly unlikely commodity pricing scenario. In a more likely scenario, MMP should be able to continue delivering ROIC in the mid-teens, given its strong business position. As seen below, MMP has achieved a 16% historical average ROIC, putting it ahead of Holly Energy Partners (HEP) and Enterprise Products Partners (EPD).
(Source: Investor Presentation)
MMP continues to perform well, with distributable cash flow growing by 7% YoY, to $277 million in the third quarter. This was driven by increased refined products transportation volumes, including continued strong distillate demand across MMP’s entire pipeline system, as well as lower than expected expenses due in part to management’s continued cost optimization efforts.
What sets MMP apart from its larger peer, Enterprise Products Partners, is its aggressive capital returns program. Last year, MMP returned nearly $1.2B of value to unitholders through cash distributions and equity repurchases, and management expects to return $1.4B this year, including $750M worth of unit repurchases so far this year (through end of Q3).
Looking forward, I see continued robust capital returns, as management recently expanded its repurchase program by an additional $750M. At the current equity market capitalization of $10.14B, this would be enough to retire an impressive 7.4% of MMP’s outstanding units. Management also expects to spend $80M and $20M in 2021 and 2022, respectively, and anticipates a healthy 6-8x invested capital to EBITDA ratio (the lower the ratio, the better).
Risks to MMP include the nature of its transported products as they relate to environmental and worker safety. The transition to renewable energy is also a risk, but MMP’s pipeline network can be adjusted to handle cleaner energy, as it has been a provider of ethanol and biodiesel services for many years. Last but not least, cost inflation introduces margin uncertainty, and management noted the potential for higher power costs next year during the recent conference call:
The component of our cost that is most likely to be impacted going forward is power, which represents about 10% of our total cost. Most of the power cost increases this year have been mitigated by our ongoing optimization effort. But it is likely that we'll see marginally higher power costs as we move into 2022, and that will be incorporated into our 2022 guidance, we will announce next year.
Meanwhile, MMP maintains a strong BBB+ rated balance sheet, with a debt-to-EBITDA ratio of 3.75x, sitting below the 4.0x threshold that I use for high-quality MLPs. Management also has a long-standing target maximum leverage ratio of the same 4.0x.
This lends support to the 8.7% distribution yield, which is more than fully covered at a 1.2x distribution coverage ratio. It’s worth noting that MMP has 20 years of distribution growth under its belt, with a 5-year dividend CAGR of 4.9%.
I see value in MMP, especially after the recent drop from the $51-level, at the current price of $47.52. As seen below, MMP appears to be undervalued based on historical valuations with an EV/EBITDA of 13.2, sitting well below its 15-20x range in the 2017 through early 2020 (pre-pandemic) timeframe. Morningstar has a fair value estimate of $52, and analysts have an average price target of $53.15, implying a potential 21% one-year total return including distributions.
(Source: Seeking Alpha)
Magellan Midstream Partners has a moat-worthy business with the largest petroleum and refined products pipeline system in the U.S. It’s seeing operating margin growth, driven by volume growth and effective cost optimization across its network.
Looking forward, MMP should be able to continue its track record of earning high ROIC and management is committed to strong capital returns. Meanwhile, MMP maintains a strong balance sheet and pays a well-covered distribution. I see the recent price weakness as presenting a buying opportunity on this high-quality MLP.
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This article was written by
I'm a U.S. based financial writer with an MBA in Finance. I have over 14 years of investment experience, and generally focus on stocks that are more defensive in nature, with a medium to long-term horizon. My goal is to share useful and insightful knowledge and analysis with readers. Contributing author for Hoya Capital Income Builder.
Disclosure: I/we have a beneficial long position in the shares of MMP either through stock ownership, options, or other derivatives. 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.
Additional disclosure: This article is for informational purposes and does not constitute as financial advice. Readers are encouraged and expected to perform due diligence and draw their own conclusions prior to making any investment decisions.