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.