Master Limited Partnerships (MLPs) have become some of the most popular high dividend stocks over the past decade.
In an age of record low interest rates, midstream (i.e. energy gathering, storage, and transportation infrastructure) MLPs’ tollbooth-like business models are especially appealing for investors living off dividends in retirement.
These partnerships typically generate a high percentage of revenue under long-term, fixed fee contracts, allowing these pass-through stocks to pay extremely generous distributions (a tax-deferred form of dividend).
However, the worst oil crash in over 50 years has revealed that this industry is more cyclical than many dividend investors thought, and unit prices can be extremely volatile.
That’s especially true if an MLP has a highly leveraged balance sheet that can force it to slash its payout and send its price crashing.
In other words, conservative investors considering investing in MLPs need to be highly selective and only consider the highest-quality names in the industry.
Let’s take a look at Magellan Midstream Partners, which has proven itself to be one most dependable MLPs in America.
Magellan Midstream Partners is America’s largest MLP, specializing in refined petroleum products. Magellan’s pipeline systems primarily transport products from refineries such as gasoline and diesel fuel, helping them eventually reach gasoline stations, truck stops, airports, and other end users.
The partnership’s 9,700 miles of pipelines and 53 storage terminals (42 million barrels of capacity) supply it with extremely steady distributable cash flow, or DCF (MLP equivalent of free cash flow), courtesy of the long-term contracts it has that are insensitive to commodity prices.
In fact, only 13% of Magellan’s operating margin in 2016 had any commodity exposure at all, and management uses hedging to reduce that risk even further.
In addition, because 68% of Magellan’s business is in refined products and marine storage, two sectors that do relatively well when oil prices are low (due to higher demand), the partnership’s business model is one of the most resilient MLPs in a low energy price environment.
Operating pipelines is an attractive business for several reasons. First, few companies have the financial capital and industry relationships to compete.
Building a new pipeline can cost billions of dollars while taking years to complete. Without connections to oil & gas producers, refineries, and regulators, it’s not possible to run a successful pipeline system either.
Each region can only support so many pipelines (the refined products market is quite mature), which has resulted in a fairly consolidated market.
Additionally, there are few substitutes for pipelines thanks to their cost-efficiency and safety, as well as geographical constraints. Most of the products moved by Magellan’s pipelines are also non-discretionary in nature, resulting in predictable demand patterns and stable cash flow.
Despite its tollbooth-like business model, like all energy stocks, Magellan’s sales are cyclical, rising and falling with the price of oil.
That means that revenues will naturally decline when oil prices crash, as they did in 2008-2009 and 2015.
However, what investors need to focus on is that because of the way Magellan’s contracts are structured, its margins and returns on invested capital are far less volatile.
Perhaps most importantly, unlike many MLPs that are struggling with falling DCF per unit, Magellan’s stable business model and lack of need for equity growth capital (which is dilutive to existing investors) means that its DCF per unit, (which funds, secures, and grows the payout) has been very stable over time.
Magellan’s stable DCF is possible in part because of the MLP’s buyout of its general partner back in 2009, at the height of the financial crisis.
That was a brilliant move because it allowed management to acquire its sponsor at fire-sale prices, and it means that Magellan Midstream is one of the few midstream MLPs that doesn’t have incentive distribution rights, or IDRs.
IDRs give the general partner (the manager and sponsor of the MLP) an increasing percentage of marginal DCF, up to 50% once the distribution climbs high enough.
IDRs provide the sponsor with an incentive to drop down (i.e. sell) assets to the MLP in order to grow its DCF, and thus the payout, quickly.
However, the downside of IDRs is that it increases an MLP’s cost of capital, since only 50% of a new project’s DCF ends up going to investors.
That higher cost of capital means that finding profitable enough growth opportunities, in which DCF per unit grows, becomes harder over time. That’s especially true in a rising interest rate environment, which we are now facing.
Equally important is Magellan’s very disciplined growth strategy. Specifically, management has chosen to specialize in refined product pipelines because they are a much higher returning business than regular natural gas and oil pipelines.
|MLP||Operating Margin||Net Margin||DCF Margin||Return On Assets||Return On Equity|
|Magellan Midstream Partners||42.4%||36.4%||43.0%||12.5%||39.0%|
Combined with smart diversification into other specialty refining segments, such as natural gas liquid (NGL) fractionation, Magellan is able to achieve very high EBITDA yields on its new projects between 12.5% and 16.7%.
As a result, Magellan Midstream Partners has achieved phenomenal DCF margins, which, combined with a conservative distribution coverage policy (retaining extra DCF to create a strong payout buffer), has allowed Magellan to achieve one of the best long-term distribution growth track records in the industry.
Best of all? Magellan’s growth runway remains long, with a total growth pipeline (projects scheduled to be completed within the next two to three years) in excess of $1 billion.
While that’s certainly not as impressive as some of its larger MLP rivals, such as Enterprise Product Partners’ (EPD) $6.7 billion growth backlog through 2019, you need to keep two important things in mind.
First, Magellan’s relatively small size means that it doesn’t need a large number of new projects to grow DCF and its payout quickly and sustainably.
Second, unlike some other MLPs, Magellan’s management likes to keep its growth plans close it its vest, only announcing a new project once it has ensured there is enough profitable demand and very little volume risk.
Given that America’s shale revolution seems likely to continue, courtesy of shale producers becoming incredibly efficient and reducing the breakeven price of production, U.S. oil production could continue to soar in the coming years.
In fact, even at just $55 per barrel, America’s shale formations are still capable of generating sufficiently high internal rates of returns that U.S. production is expected to hit a new record in 2018 and continue rising through 2025.
Since $55 per barrel oil is low enough to lower the price of refined petroleum products (and thus increase their demand), Magellan should see plenty of profitable growth opportunities over the next decade.
There are two major risks that apply to all MLPs, even those with a pedigree as wonderful as Magellan Midstream.
For one thing, MLPs are highly interest rate sensitive, for two main reasons.
The first is obvious. Because of the highly capital-intensive nature of the midstream industry, as well as the fact that MLPs payout the majority of DCF to investors, all MLPs need to take on a relatively large amount of debt.
You can see that Magellan Midstream carries over $4 billion in debt but has less than $20 million in cash on hand, for example.
Rising interest rates will increase the cost of future debt, as well as the cost of refinancing older bonds that currently enjoy relatively low interest rates.
In addition, MLPs will periodically sell new units to raise equity growth capital, which dilutes existing investors.
Now of course, great management teams make sure that any projects they invest this capital into are profitable enough that DCF per unit continues to grow, despite the rising unit count.
In addition, Magellan has historically retained a higher-than-average amount of DCF to fund much of its growth internally, reducing its dependence on external capital markets.
That being said, Magellan’s long-term distribution growth target of 8%, with a distribution coverage ratio (DCF/distributions paid) of 1.1 to 1.2 times, means that, while the payout will likely remain highly secure, its growth will remain sensitive to the whims of fickle debt and equity markets.
Here’s why that matters. While Magellan’s DCF is not very sensitive to oil & gas prices, its unit price (and that of all MLPs) is.
Which means that should oil prices crash again or the broader stock market experience a correction or bear market (which it eventually will), Magellan’s unit price could fall low enough to make large scale, accretive growth much harder to achieve. That in turn could slow the pace of DCF growth, as well as that of the distribution.
And we can’t forget that during the past decade, record low interest rates have been a major growth catalyst for all MLPs.
That’s not just because low rates resulted in very low borrowing costs, but also because yield-starved investors were forced to hunt for high-quality bond alternatives.
Magellan, as one of the “best-in-breed” partnerships in the midstream industry, was a major beneficiary of this abundance of cheap capital.
However, the Federal Reserve now projects that interest rates will rise to 3% by 2019 or 2020. That means that risk-free yields, such as U.S. Treasury bonds, will become far more appealing. That’s especially true if the Treasury decides to sell 50- to 100-year bonds, in order to lock in interest rates before they rise too high.
U.S. Treasury Secretary Steven Mnuchin has said that he is looking into doing this, which means that in the future Magellan might have to compete with longer-term Treasury bonds yielding as much as 5% or 6%.
Magellan Midstream Partners’ Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Magellan Midstream Partners’ Dividend Safety Score of 75, making it one of the safest distributions of any MLP.
You can see this from the MLP’s impressive track record of 16 consecutive years of payout increases, which makes Magellan a dividend achiever and just eight years away from joining the ranks of the dividend aristocrats.
The key to Magellan’s strong payout security is twofold. First, management has remained disciplined in its approach to raising the payout.
That means allowing DCF growth to outpace distribution growth and thus maintain a highly secure distribution coverage ratio, or DCR.
A relatively high DCR provides a strong safety buffer to secure the current payout and allows for steady growth even during times of economic or industry turmoil.
The other important protective factor is Magellan’s long-term commitment to a strong balance sheet. In fact, management’s policy is to never allow the leverage ratio (Debt / EBITDA) to go above 4.0.
|MLP||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
|Magellan Midstream Partners||3.55||6.9||66%||0.77||BBB+|
This ensures a very high interest coverage ratio and is why Magellan is tied with Enterprise Products Partners for the highest credit rating in the MLP industry.
As a result, Magellan’s borrowing costs are relatively low for an MLP, and the partnership is likely to continue enjoying plenty of access to low cost capital it can use to grow its DCF and distribution over time.
Magellan Midstream Partners’ Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Magellan Midstream Partners’ Dividend Growth Score is 70, meaning that dividend lovers can likely continue to expect better than average payout growth going forward.
That shouldn’t come as a surprise to long time investors who have enjoyed some of the industry’s best distribution growth since Magellan’s 2001 IPO. As you can see, the company’s distribution has increased by 11% annually over the last decade and by 15.8% per year over the last five years.
Of course, as Magellan grows, future payout growth will naturally decrease a bit because growing DCF from a larger base is harder.
That’s especially true when management has a wise long-term strategy of disciplined growth, refusing to go after projects that fail to meet its high profit standards.
However, with management currently guiding for 8% distribution growth in 2017 and 2018, while maintaining a reasonable 1.1 to 1.2 DCR (it was 1.25 in 2016), Magellan is likely to remain one of the most conservative MLP choices.
Magellan’s strong history of profitable joint ventures with other MLPs and oil companies, combined with the strong growth potential of U.S. oil production, means that Magellan seems likely to be able to achieve long-term distribution growth in the mid- to upper single-digits.
Because of the high depreciation that comes with this industry, GAAP earnings, EPS, and the P/E ratio aren’t the best way to review an MLP’s valuation.
Instead, many investors prefer to look at an MLP’s enterprise value (market cap + net debt) / EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or EV / EBITDA.
As you can see, Magellan Midstream’s high-quality and consistent growth record has the market currently pricing in a significant premium relative to its peers.
In fact, Magellan’s current EV / EBITDA ratio is higher than 87% of global midstream MLPs.
Similarly, MMP’s yield is trading at a premium to its historical norm and is much lower than most MLPs.
|MLP||EV / EBITDA||13-Year Median EV / EBITDA||Dividend Yield||13-Year Median Yield|
|Magellan Midstream Partners||18.5||15.2||4.5%||4.9%|
Magellan Midstream Partners’ current yield (4.5%) and long-term DCF growth rate (6-8%) suggest the stock has annual total return potential of 10-12% (4.5% yield + 6-8% DCF growth).
However a stock price under $70 (currently $76) would put MMP’s yield closer to 5% and seems like a more appealing entry point given today’s valuation multiples relative to history.
Concluding Thoughts on Magellan Midstream Partners
Magellan Midstream Partners has one of the highest price premiums in the MLP industry for very good reason.
The partnership’s long-term focused management team, industry-leading balance sheet, impressive payout security, and solid growth prospects make it a compelling MLP for investors willing to accept the unique business structure risks of the sector.
However, the stock’s relatively high valuation today means that Magellan might be better off on your watch list for now.