Magellan Midstream Partners: A Much Misunderstood Partnership (NYSE:MMP)

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(Note: This article appeared in the newsletter on June 26, 2022 and has been updated as necessary.)

Magelan Midstream Partners (NYSE: MMP) is a very sound partnership with one of the highest financial strength ratings in the industry. Like Enterprise Products Partners (EPD), this company is also rated investment grade. But unlike Enterprise Products Partners, this company transports refined products and does a lot of oil-related business. The market doesn’t make the connection with the green revolution here that it does with natural gas products. However, petroleum-based products find their way into our lives in so many ways that the future remains bright even if the demand for fuel disappears tomorrow.

Some of the more unexpected products made from the oil include aspirin, floss, crayons, lotion, and petroleum jelly. In fact, one would be surprised by all the beauty products (like lipstick) that are based on oil, coal and coal tar. Additionally, petroleum has the lighter carbon-hydrogen chemical bonds that are easier to break than the oxygen-hydrogen bonds in water. If the day ever comes when natural gas becomes too expensive to serve as a feedstock for the fast-growing hydrogen market, then oil would be another possible place to make hydrogen (though by far it’s not the only one). .

Meanwhile, oil, like natural gas, is slowly finding its way to the green revolution. This part of the industry has done much less to trumpet the progress made in helping the market find those green end products. However, dependence on non-renewable resources will first have to change before we can ever lose that dependence. This means changing an ingrained habit that is unlikely to be a quick process. Because of this, many still point to the need for future growth in oil as well as natural gas.

Magellan Midstream is mainly involved in the “first step”. This first step mainly involves getting the product to and from the refineries

Magellan Midstream refined product distribution and storage map

Magellan Midstream refined product distribution and storage map (Magellan Midstream August 2022, Corporate Presentation)

The company aims to be a “one-stop-shop” for its main customers. The whole business is mainly fee based. The ease of dealing with a large carrier of these types of goods is obvious. The partnership has competition “across the country” but has a competitive advantage simply because its large size allows its clients many convenient alternatives.

Magellan Midstream Fee-Based Business Composition

Magellan Midstream Fee-Based Business Composition (Magellan Midstream August 2022, Corporate Presentation)

The business is primarily a fee-based business and is further insulated from industry cycles by long-term take-or-pay contracts. This company will show something of a cyclical nature. But it won’t be anything close to the cyclical swings that investors see all the time.

However, Mr. Market does not like negative earnings comparisons that come with anything cyclical in nature. Despite the sustainability of this business and good financial strength, these units will often follow upstream companies whenever there is a cyclical downturn in the upstream. Whenever not, the cushion provided by financial strength usually makes this company a bargain whenever the upstream industry suffers from weak commodity prices.

Comparing Magellan Midstream's long-term profitability

Comparing Magellan Midstream’s long-term profitability (Magellan Midstream August 2022, Corporate Presentation)

Despite some cyclical trends in the business, management has kept partnership profitability well within an excellent range. Good profitability also provides some investment protection because the market respects decent earnings and the cash flow that comes with those earnings.

One of the side issues with many “history stocks” and “pioneers of new industries” is the tendency to report earnings without cash flow. This occurs when depreciation and other cost allocation methods are insufficient to actually record the amount of expenses necessary to cover the revenue.

Investors should remember that public accountants acquire new clients through a competitive process. This competitive process exerts pressure to “temper” their normal conservative tendencies. Public accountants are well known for adjusting cost allocation guidelines after an issue has become public headlines. This is due to that competitive pressure that limits the amount of revenue and thus the time spent to find the complete fraud, as well as the aggressive accounting that is likely to be disallowed in the future.

Investors can counter this public accounting trend by looking at cash flow from reported earnings. At some point, even growing companies will have cash flow from operating activities. Investors need to hold “management’s feet to the fire” to make sure the money gets through and deadlines aren’t pushed back.

Magellan Midstream Record Investor Return

Magellan Midstream Record Investor Return (Magellan Midstream August 2022, Investor Presentation)

Magellan Midstream has a long track record of returning excess cash to shareholders. The profitability shown above enables this record to be maintained while keeping leverage low. Note that in the early stages of the industry’s recovery, the medium capacity is still filling up from the previous downturn. So the need for much expansion just isn’t there.

Free cash flow will change as industry recovery accelerates and more midstream capacity is needed. The use of share repurchases has enabled this partnership to have an attractive track record of long-term distribution growth. Management has not wisely increased distributions rapidly during this time of record free cash flow. Some of this free cash flow will be needed as demand for more capacity increases cyclically as in the past.

Magellan's mid-term debt ratio history and financial strength rating

Magellan’s mid-term debt ratio history and financial strength rating (Magellan Midstream August 2022, Investor Presentation)

Magellan Midstream has maintained debt ratios at industry low levels for a large independent midstream company. The result is that rare investment grade rating for a mid-sized company. Management has the level of debt at a place to be able to fully finance future expansions with debt if that proposition is sufficiently profitable or if management chooses to increase the debt ratio.

Any investment grade company has more than adequate access to the debt markets at reasonable rates. Additionally, the company has long been self-funded, so there was no need for adjustment when the market squeezed competitors who raised capital to help fund future expansion projects. Here the periodic dilution of net capital was largely absent.

A well directed stream like this will give some appreciation combined with a generous spread. Total return should be in the teens. Units can be held by investors until the story changes or until the stock price becomes so incredibly high that it would take years of growth to justify the price. This is so unlikely in an industry that is not considered part of the green revolution that it is not worth worrying about. As a result, most investors can buy this in any pullback and will probably hold “forever” as long as there are no adverse management changes or changes in the “steady like you” story. This stock will attract a wide range of investors.

(Note: this company issues a K-1. Investors should be thoroughly familiar with all aspects of a K-1 before investing).

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