Despite sustaining their high distribution yield of 8.54% throughout the turmoil of 2020, Magellan Midstream Partners (NYSE:MMP) still see their biggest challenge yet coming in 2022 and 2023 as they try to maintain their earnings despite consecutive years of barebones investments, as my previous article discussed. Apart from reviewing their subsequently released results for the first quarter of 2022, this article also expands the discussion to the case of their missing billion dollars of free cash flow that has arisen since the beginning of 2020 when management began highlighting their ability to produce free cash flow.
Since many readers are likely short on time, the table below provides a very brief executive summary and ratings for the primary criteria that were assessed. This Google Document provides a list of all my equivalent ratings as well as more information regarding my rating system. The following section provides a detailed analysis for those readers who are wishing to dig deeper into their situation.
*Instead of simply assessing distribution coverage through distributable cash flow, I prefer to utilize free cash flow since it provides the toughest criteria and also best captures the true impact upon their financial position.
Thanks to operating conditions recovering throughout 2021, their cash flow performance followed in tandem but disappointingly, this did not continue into the first quarter of 2022, despite the booming operating conditions within the refining industry and thus by extension, their refined products. Their operating cash flow of $100.4m during the first quarter of 2022 was down more than half year-on-year versus its previous result of $240.4m during the first quarter of 2021. Even if removing their relatively very large working capital build from the first quarter of 2022, their underlying result of $246m was still down 17.45% year-on-year versus their previous equivalent result of $298m during 2021. This was also mirrored elsewhere by their operating income of $220m during the first quarter of 2022, which is down 18.82% year-on-year versus their previous result of $271m during the first quarter of 2021. Despite not being ideal, thankfully it appears this weak start to the year should only prove to be a one-off issue, as per the commentary from management included below.
“At a high level, the year-over-year decline primarily resulted from mark-to-market adjustments on commodity hedges in the current period as well as from the favorable impact of winter storms on our 2021 results.”
-Magellan Midstream Partners Q1 2022 Conference Call.
Unfortunately, their income statement does not explicitly state the magnitude of these mark-to-market adjustments on commodity hedges nor does their cash flow statement reflect the impact on their operating cash flow. Although considering their margin deposits as listed within their current assets increased to $130.8m by the end of the first quarter of 2022 versus only $46.3m at the end of 2021, it indicates there was likely a sizeable cash flow drain incurred. Thankfully, these should only be temporary, whilst the unfavorable comparison against their Texas Winter Storm-boosted results of 2021 is obviously a one-off issue and thus it seems too fast to blame their weak start to the year upon their barebones investments during 2020 and 2021. Whilst this will require monitoring in future quarters, the manner in which they present their free cash flow caught my eye, as per the commentary from management included below, which I feel warrants investigation and explanation to my readers.
“Free cash flow for the quarter was $240 million, resulting in free cash flow after distributions of about $19 million. A detailed description of quarter-over-quarter variances is available in the earnings release we issued this morning.”
-Magellan Midstream Partners Q1 2022 Conference Call (previously linked).
It can be seen that management states their free cash flow for the first quarter of 2022 to be $240m but if looking at their actual cash flow statements, as portrayed within my graph included above, their operating cash flow was only $100.4m and thus cannot possibly provide more than twice its amount of free cash flow, at least from a purely cash-based approach. Since their capital expenditure was $45.7m, even if utilizing their underlying operating cash flow of $246m that excludes their working capital build, it still only sees an underlying free cash flow of $200.3m. They also state their excess free cash flow after distribution payments was $19m during the first quarter of 2022, which obviously also remains well above their purely cash-based results that actually saw their distribution payments exceed their free cash flow by $174.8m. Upon further inspection, this discrepancy was also evident back during both 2020 and 2021 after management began highlighting their ability to produce free cash flow, as the table included below displays.
It can clearly and easily be seen that management states their free cash flow after distribution payments was $97.9m during 2020 and $409.6m during 2021. Once again, this far exceeds the actual cash they generated with 2020 seeing their distribution payments of $927.1m actually outstrip their free cash flow of $528.6m by a sizeable $398.5m. Meanwhile, 2021 saw their free cash of $1.036b only exceed their distribution payments of $906.4m by a relatively minor $129.6m, thereby meaning that across 2020 and 2021, they actually saw their distribution payments exceed their free cash flow by a total of $528.1m. Whilst their results are not technically incorrect given these are non-GAAP metrics that can be calculated differently, they are materially different from the actual cash they generated and as a result, see a total difference of $1.036b or put another way, effectively see a missing billion dollars of free cash flow during 2020 and 2021.
There are two reasons for this significant difference, the first and most noteworthy of which stems from their results including the proceeds from their divestitures, which were $334.9m and $270.7m during 2020 and 2021, respectively. Since they obviously cannot sell the same asset twice, I feel this does not provide a true insight into their ability to generate cash and thus should be excluded from free cash flow. Furthermore, these actually exceeded the combination of both their maintenance and growth capital expenditure during 2021, which were of $77.6m and $73m respectively and thus the inclusion of their divestiture is tantamount to saying 2021 saw negative capital expenditure, which is logically invalid, at least in my mind.
Even if their combined divestitures of $605.6m are excluded from their missing $1.036b of free cash flow, it still leaves a further $430.4m remaining, which relates to the second reason. When looking back at the table included above, it can be seen that they calculate their free cash flow from their accrual-based adjusted EBITDA and not based upon the actual cash flow movements their partnership saw. Whilst other investors are entitled to their own views, I personally feel this defeats the purpose of utilizing what obviously otherwise would be a cash-based metric and thus, despite the additional work and occasional volatility, examining their actual cash flow statements is far more useful for reviewing the moving parts of their financial performance. Before moving onwards to finish reviewing their first quarter of 2022 results, to be clear, I am not implying that management has done anything illegal nor underhanded but rather pointing out that simply scanning their results as stated does not necessarily tell the whole story.
Following the first quarter of 2022, they saw their net debt jump to $5.313b versus its previous level of $5.087b at the end of 2021, thereby representing a relatively sizeable increase of 4.44% for such a short length of time. Thankfully, this increase mostly relates to their relatively very large working capital build and thus as this reverses in the coming quarters, it should help reverse this higher net debt to see it end 2022 around where it ended 2021, thereby broadly in line with the expectations within my previous analysis.
Due to seeing a bumpy start to 2022, it sent their leverage higher with their net debt-to-EBITDA increasing to 4.78 versus its previous result of 3.81 at the end of 2021, whilst their net debt-to-operating cash flow increased to 5.30 versus its previous result of 4.25. Even though these represent sizeable increases, especially in the case of the latter that now resides above the threshold of 5.01 for the very high territory, it would be prudent not to read too much into the results for merely one quarter, especially since their financial performance was apparently soft due to what should only prove to be a one-off issue, as previously discussed.
It would be positive to see their liquidity improve following the first quarter of 2022 with their current ratio now sitting at 1.06 versus its previous result of 0.82 where it ended 2021. Whilst certainly not perfect, this helps keep it adequate and builds upon the improvement their previous results had already seen versus their result of 0.78 following the end of the third quarter of 2021, as per my earlier article. If not for their large operational size, their almost non-existent cash balance may have been concerning but thankfully, this advantage should ensure that they can access debt markets as required to provide liquidity and refinance debt maturities even if central banks tighten monetary policy, as evidenced by the $1b remaining available under their credit facility.
Despite seeing a weak and bumpy start to 2022, their distributions remain safe and worry-free but at the same time, this will be worthwhile to monitor in future quarters. Since metrics like free cash flow are non-GAAP, they can be calculated however management or an investor wishes, although it firmly remains my view that calculating free cash flow with an accrual-based approach defeats the purpose of utilizing a cash metric, especially when there is consistently a material difference. Even though the tone of this article may sound rather bearish, I nevertheless still believe that a buy rating is appropriate for their high distribution yield, despite the missing $1b of free cash flow.
Notes: Unless specified otherwise, all figures in this article were taken from Magellan Midstream Partners’ SEC filings, all calculated figures were performed by the author.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.