In theory midstream players such as Magellan Midstream Partners (NYSE: MMP) should be great for conservative minded folks seeking income. You typically get ownership of a bunch of transport and storage assets that charge fees based on the volume of commodities like crude oil, natural gas and refined products such as gasoline. The cash flow is stable and, in theory, less reliant on the price of the underlying commodity.
In practice, however, a number of things have gone wrong recently. Firstly, a bunch of them chased growth way too aggressively. Now, if said growth is funded from cash flow then it isn’t the end of the world. However if you are reliant on selling equity – i.e. the price of your own units – as well as debt, then things can get very tricky when the market heads south. Secondly, many of them don’t actually sport particularly attractive returns on capital (they are rather asset intensive after all). Finally, as an asset class we were looking at terrible overvaluation in the last oil price boom. All-in-all it was a toxic mix for supposedly conservative assets.
That said there is a handful that are worth a closer look for folks who care most about earnings quality. I’ve spoken positively of one of the newer ones – Shell Midstream Partners – in the past, and Kinder Morgan too if you can get it at the right price. Today I want to go over the best in class option: Magellan Midstream Partners.
A Brief Introduction To Magellan Midstream Partners
Let’s start with a brief overview of Magellan’s assets, which we can break down into three very broad operating segments. Firstly, we have the Refined Products segment. This consists of a wide range of pipeline and storage assets covering products like gasoline, aviation fuel and ammonia. As it stands, the segment accounts for around 60% of group operating profit. Next up is the Crude Oil segment, which consists of thousands of miles of oil pipelines linking supply with demand, as well as millions of barrels in terminal storage space. The segment makes up around a third of total group operating profit. Finally, we have the Marine Storage segment. This consists of a series of coastal terminals that provide longer term storage solutions for refined products and chemicals. Marine Storage accounts for just under 10% of total group operating profit.
(Source: Magellan Midstream Partners 2018 Summary Flyer)
So, why do I say that Magellan is best in class? Well, three things standout in particular. Firstly, most of its activity is fee based and high margin, particularly the Refined Products segment. Over the last five years the group has generated just under $13 billion in cumulative revenue and $4.3 billion in cumulative net profit. Secondly, Magellan ‘self funds’ quite a lot of its growth. It does use debt as well but a big chunk comes from its own cash generation. Sporting a conservative balance sheet helps to keep the cost of fresh capital fairly low. Thirdly, Magellan generates solid returns on capital; a good sign that they, and management, are high quality.
If we put all that together we get what a midstream stock should look like: cash generative and defensive. You will struggle to find a name in this sector that has posted the positive free cash flow ratios that Magellan has, even after accounting for the growth portion of capital expenditure. Oh and the distribution history here is a thing of beauty. Between 2001 and last year it grew from $0.56 per annum to $3.59 per annum – equivalent to a compound annual growth rate of around 11.5%. Bear in mind that the distribution yield averaged around 6.75% over that time frame. Add those two numbers together and it becomes pretty easy to see why investors like the units so much. If you are interested in conservative investments in the domestic energy sector then I’d have this one on the watchlist.
Is It A Buy?
So that was a very brief introduction to Magellan’s operations. But are the partnership units a buy right now? As it stands they currently trade at around seventy bucks each. If Magellan earns four dollars in net profit per unit as analysts expect it to then we get a price-to-earnings ratio of 17.5. Let’s convert that to an earnings yield of 5.7% – most of which will be paid out as distributions. It’s a shame I didn’t pen this piece three months ago when the units offered a 7% earnings yield, but we are where we are.
Can Magellan scratch out, say, mid-single digit growth to top off that 5.7% current earnings yield? It doesn’t seem to be that much of a stretch to assume so. US crude oil production, for instance, has grown by about 3.5 million barrels a day over the past five years. Much of that is down to rising production in the prolific Permian Basin in Texas, where there is now a well documented issue with takeaway capacity. Magellan has plans to construct a new pipeline in the region and to upgrade its existing capacity in the region. That’s on top of a couple of planned expansions to its Texan marine terminals. Throw in rising domestic production, rising consumption of refined products and rising US exports into the mix and there might just be enough to keep things ticking over nicely here.
N.B. I may, on occasion, refer to MLPs as companies and partnership units as shares of stock. However, readers should make themselves aware of the differences between MLP units and common stock, particularly in regards to tax treatment. This is especially true for foreign (i.e. non-US) investors.