Image Source: Business Insider
As an investor and an individual, Warren Buffett is one of my idols as I suspect he is to millions of fellow investors and individuals around the globe.
Beyond his quotes about investing, many of his quotes offer sage advice that can be applied to just about every aspect of life.
One of my favorites is "it is not necessary to do extraordinary things to get extraordinary results."
The reason why this quote resonates with me is that as a dividend growth investor, the financial media oftentimes tries to convince us that investing has to be more difficult than it really is, and that we have to perfectly time our investments, and obsess over every small development pertaining to the companies in our portfolio.
As an investor with a long-term mindset and a focus on eventually generating enough dividend/distribution income to support myself, I emphasize simplicity.
Aside from my initial screening before investing in a company where I examine the dividend safety/growth profile of a company, its operating fundamentals and risks, and the valuation aspect of an investment in such company, I monitor my investments once to twice a year.
Because I have already done much of the legwork upfront, there's very little to worry about as long as the operating fundamentals of a company remain intact, and no major risks appear likely to manifest themselves in the years ahead.
One example of a company within my portfolio that displays an ideal blend of distribution safety/growth and solid operating fundamentals at a reasonable valuation is Magellan Midstream Partners (hereafter referred to as Magellan) (MMP).
Today, I'll be re-examining the company's distribution safety/growth profile, operating fundamentals and risks, as well as the valuation component of an investment in Magellan to ascertain whether the company remains a great investment candidate compared to when we last discussed it in April.
I'll then conclude with my estimate of annual total return potential from the current price over the next decade.
The Distribution Remains Safe, And Steady Growth Continues
I will be briefly revisiting Magellan's DCF payout ratio in order to establish whether Magellan's distribution remains safe and well covered or if it is at risk.
In its previous fiscal year as stated in the company's Q4 2018 results, Magellan generated total DCF of $1,109.7 million, which covered the distribution 1.26 times.
As of its Q3 2019 results, Magellan is guiding for $1.26 billion in DCF, which is enough to cover the distribution 1.35 times over to pay projected cash distributions for 2019.
In other words, while Magellan's distribution isn't as well covered as the likes of Enterprise Products Partners' (EPD) distribution or Energy Transfer's (ET) distribution, Magellan's coverage ratios are going in the right direction as the company continues to grow its DCF at impressive rates.
When combined with the fact that Magellan's balance sheet is among the strongest in the industry along with EPD's, I rate Magellan's distribution as reasonably safe for the foreseeable future just as I did in the previous article.
Image Source: Simply Safe Dividends
Given our analysis above, it should come as no surprise that Magellan's distribution is as safe as it was 8 months ago when I wrote about the company, and that Simply Safe Dividends and I agree that the company's distribution remains safe.
Now that I've been able to verify that Magellan's distribution remains safe going forward, we'll next estimate the growth potential of Magellan's distribution in the years ahead.
Image Source: Simply Safe Dividends
While we won't know management's intentions for distribution growth in 2020 until the company reports its Q4 2019 operating results early next year, I believe it's realistic for us to conclude that Magellan will stick with mid-single digit distribution growth next year just as it targeted this year.
Given that Magellan is rather consistently delivering at least high-single digit DCF growth the past few years, I don't envision mid-single digit DCF growth as being that difficult for the company to attain as long as our thesis of the American energy boom continues to play out over the next decade and counting.
Now that I have reexamined Magellan's distribution safety and growth potential, I will be delving into the operating fundamentals of Magellan, which will ultimately be supporting the underlying distribution and growth of Magellan's distribution.
Operating Fundamentals Remain Stable, And The Balance Sheet Remains A Source Of Strength
Magellan once again delivered solid operating results in Q3 2019, managing to grow its DCF by 8.9% YOY compared to Q3 2018, from $281.8 million to $306.8 million.
Breaking this performance down further, the Refined Products segment generated $240.1 million in operating margin, which was an increase of $25.4 million over the 2018 period.
Transportation and terminal revenue increased $10.4 million for the Refined Products segment, which was mostly driven by higher volumes and slightly higher average rates. Rates in the quarter were positively impacted by the tariff increase of 4.3% that was implemented in July, and partially offset by the impact of higher short-haul movements.
Moving to the Crude operating segment, Magellan was able to grow its operating margin from $153.9 million in Q3 2018 to $154.4 million in Q3 2019.
Crude oil transportation and terminals revenue increased by $5.8 million, which was a result of new tanks at Cushing and Corpus Christi, in addition to higher storage and dock fees with the company's Seabrook joint venture terminal, following the implementation of export capabilities at the terminal in August 2018.
Transitioning to the Marine operating segment, Magellan grew segment operating margins from $29.0 million in Q3 2018 to $32.4 million in Q3 2019.
Revenues were $2.4 million higher compared to Q4 2018, which came as a result of more tankage being available for contract storage due to the timing of maintenance work.
It was this strong performance that led Magellan to increase its DCF guidance for the year from $1.22 billion to $1.26 billion, which will leave over $300 million in DCF retained for growth projects. This leads us into our next point about Magellan's growth prospects going forward.
Image Source: Magellan Midstream Partners RBC Capital Markets Midstream Conference Presentation
Over the last decade, Magellan has invested $5.8 billion in expansion projects, which has allowed the company to deliver strong DCF growth since 2009, nearly doubling its DCF during that time.
As Magellan has increased in size and scale over the past 10 years, one would expect that to maintain this mid to high-single digit DCF growth, the company would need to increase its spending on expansion projects in the years ahead.
Fortunately, Magellan intends to spend $1.4 billion (quite a significant amount for a company with a market cap of ~$13.3 billion) on '19-'20 construction projects that are currently underway primarily related to the transportation and storage of refined petroleum products, which are in some way involved in nearly every aspect of our modern economy.
Magellan is also expecting these projects to be highly accretive, at 6-8 EBITDA multiples.
Image Source: Magellan Midstream Partners RBC Capital Markets Midstream Conference Presentation
Aside from Magellan's solid operating fundamentals and significant spending on future growth projects, the company's balance sheet is arguably its greatest strength. Magellan's 2.8 leverage ratio at the end of Q3 2019 is well below the target maximum leverage ratio of 4 and means the company is in no immediate danger of a rating downgrade from the major rating agencies.
Magellan's credit ratings of BBB+ and Baa1 are investment grade and among the highest in the industry, which affords the company a low cost of capital as a source to fund future growth projects, along with retained DCF.
When I take into consideration Magellan's operating fundamentals, future growth projects, and the strength of its balance sheet, it is quite apparent that Magellan could be a great investment at the right price for those that are comfortable with its risk profile.
Risks To Consider
While Magellan is what I consider to be one of the very best midstream MLPs around, that doesn't mean the company is a risk free investment (no equity is by definition, risk free).
Because Magellan doesn't highlight any additional risks in its most recent 10-Q that it is aware of at this time, we will be briefly revisiting Magellan's key risks as indicated in its most recent 10-K.
The first piece of information that I'll be discussing is less of a risk to Magellan and more so a reminder of what distribution growth will be going forward.
While Magellan's 5-year and 10-year distribution growth rates are very impressive at 12% and 11%, respectively, it's important to remember that these growth rates were delivered before the mostly industry wide transition to the self-funding model that Magellan pioneered.
Because Magellan is dedicated to the self-funding model, it is imperative that the company retain more DCF now than in the past to fund future growth projects.
This will lead to distribution increases more in the realm of mid-single digits than the low-double digits of the past to lessen Magellan's reliance on the issuance of equity (which it has not relied on as a source of funding since 2010 when it bought out its general partner's IDRs), as well as debt (as evidenced by Magellan's deleveraging over the past few years).
Magellan offers a 7% yield, so I would suspect the investor community is more or less aware of this by now, but I thought it would be useful to recalibrate any expectations that some may hold toward the company based upon only examining its past distribution growth.
The first real risk is from an operational standpoint, which is the possibility that Magellan may eventually experience the consequences of a capacity overbuild in some of the markets that it operates in (pages 20-21 of Magellan's most recent 10-K).
Should the American energy boom end sooner than expected, this could result in decreased volumes being transported by the midstream industry.
Decreased volumes would have a detrimental impact to Magellan's financial results in that not only would Magellan's facilities potentially be underutilized, but the company would also be forced to lower the rates that it charges for services to remain competitive with its peers.
Although America's energy boom is expected to continue at least well into next decade, we need to remember that even the experts that predict the future of energy do so with a great degree of uncertainty.
I would encourage energy investors to refer to McKinsey & Company's dialogue between Senior Partner Namit Sharma, Simon London, and Christer Tryggestad as exhibit A in demonstrating this point.
While Mr. Sharma expects oil demand to peak around 2033, he points out that in the year prior, he was expecting peak oil in 2047. This highlights the imprecise nature of these estimates and how drastically they can change from one year to the next as the world and its energy consumption needs evolve.
Another key risk to Magellan is that, as a midstream company, Magellan's operations are subject to extensive environmental, health, and safety regulations that impose significant costs, requirements, and liabilities on the company (pages 29-31 of Magellan's most recent 10-K).
It's important to note that although energy will be demanded in the immediate future and Magellan plays a clear role in supplying that energy to the economy, the aftermath of the 2020 elections could potentially result in more stringent regulations governing Magellan and the industry should Democrats prevail.
Just as President Trump has undone some of President Obama's energy industry regulations, a Democratic president could undo President Trump's executive orders and make it more costly and difficult to bring new energy projects online.
In an industry that is already rife with cost overruns and delays in bringing projects online, such as recent examples of the Atlantic Coast Pipeline and the Mountain Valley Pipeline, this would at least somewhat damper Magellan's ability to generate DCF growth going forward (although it would increase the value of Magellan's assets due an increased difficulty in bringing new projects online).
While I have covered what I believe to be the key risks associated with an investment in Magellan, the risks outlined above are far from a comprehensive discussion of the risks facing Magellan.
For a more complete discussion of the risks associated with an investment in Magellan, I would refer interested readers to pages 17-38 of Magellan's most recent 10-K, page 55 of Magellan's most recent 10-Q, and my previous article on Magellan.
Magellan Is A High-Quality Company In A Deeply Undervalued And Despised Industry
Now that I have established Magellan is among the very best midstream MLPs in the industry, I'll be revisiting the valuation aspect of an investment in the company to determine if it is as attractive of an investment as it was when I initiated my coverage.
Image Source: I Prefer Income
The first valuation metric I will use to arrive at a fair value for units of Magellan is the 10-year median yield.
According to I Prefer Income, Magellan's current yield of 7.00% is well above its 10-year median yield of 4.77%.
For more recent context, Magellan's current yield of 7.00% is once again elevated well beyond its 5-year average yield of 4.98%, per Simply Safe Dividends.
Even if we ignore that Magellan's fundamentals remain as strong as they ever have been and assume a reversion to a yield of 6.00% and fair value of $68.00/unit, units of Magellan are trading at a 14.3% discount to fair value and offer 16.7% upside from the current price of $58.26 a unit (as of November 30, 2019).
The next valuation metric I'll use to determine the fair value for units of Magellan is the 5-year average forward price to DCF ratio.
As indicated by Simply Safe Dividends, Magellan's current price to DCF ratio of 10.6 is well below its 5-year average of 15.3.
Although Magellan's price to DCF ratio is well above the energy sector's average of 6.8, it's important for us to keep in mind that Magellan is among the best in its industry, which I believe justifies this premium.
This point is further reinforced by IPI's ranking feature as illustrated above, where Magellan is ranked comfortably in the top third of midstream MLPs, and the company is roughly on par with fellow large caps, ET, EPD, and Phillips 66 Partners (PSXP).
Assuming a reversion to a price to DCF ratio approximately down the middle at 13.0 and a fair value of $71.45 a unit, Magellan is trading at an 18.5% discount to fair value and offers 22.6% upside from the current price.
Image Source: Investopedia
The final valuation model that I will be using to assign a fair value to units of Magellan is the dividend/distribution discount model or DDM.
The first input into the DDM is the expected dividend per share, or in this case, the annualized distribution per unit. Magellan's annualized distribution per unit is currently $4.08.
The next input into the DDM is the cost of capital equity, which is another term for an investor's required rate of return. In my case, I believe a 10% rate of return adequately rewards me for the time and effort that I dedicate to researching and monitoring investments.
The third and final input into the DDM is the dividend/distribution growth rate or the long-term DGR.
This is obviously the most difficult input into the DDM because unlike the annualized distribution per unit and the required rate of return, the long-term DGR involves a number of considerations to accurately forecast that extend beyond a simple internet search of a company's annualized distribution or the preference of a rate of return. These considerations include a company's payout ratios (and whether it is likely to remain the same, expand, or contract over time), industry fundamentals, the strength of a company's balance sheet, and a company's operating fundamentals.
When I take into account that Magellan's DCF payout ratios will likely remain the same or contract a bit to ensure more retained DCF to fund growth projects, I believe that distribution growth will roughly mirror whatever DCF growth Magellan is able to deliver over the long term.
As long as the American energy boom thesis remains intact, I believe Magellan will have no difficulty delivering at least mid-single digit DCF growth to fuel 4% increases over the long term.
When I plug this into the DDM, I arrive at a fair value again of $68.00 a unit.
This implies that units of Magellan are trading at a 14.3% discount to fair value and offer 16.7% upside from the current price.
Upon averaging the three fair values above, I come to a fair value per unit of $69.15. This means that units of Magellan are priced at a 15.7% discount to fair value and offer 18.7% upside from the current price.
Summary: Magellan Offers An Attractive Risk/Reward Ratio Given Its Quality
Magellan's tendencies of fiscal conservatism and predicting the future of the midstream MLP industry have allowed the company to reward investors with distribution increases for the past 70 consecutive quarters. When we factor in Magellan's operating fundamentals and strong balance sheet, there is little reason to believe that Magellan will be unable to continue to deliver distribution increases for many quarters to come.
Magellan's management team has proven prescient as the first MLP in the United States to adopt the self-funding model, and one of the first MLPs to eliminate incentive distribution rights or IDRs.
DCF continues to increase at a mid-single digit to high-single digit clip, the balance sheet remains among the strongest in the industry, and Magellan's coverage ratios continue to gradually improve, which suggests all the meaningful metrics that we consider are trending in the right direction.
Adding to the case for an investment in Magellan is the fact that the company is trading at a 16% discount to fair value.
While this certainly isn't the largest discount in the industry, it still remains an attractive entry point because of the company's positioning as one of the very best midstream MLPs around.
Between the 7.0% yield, 3.0-4.0% annual DCF growth, and 1.7% annual valuation multiple expansion, units of Magellan offer 11.7-12.7% annual total return potential over the next decade.
For the foregoing reasons, I recently increased my position in Magellan from 3 units to 7 units, making it my 6th largest position in terms of distribution/dividend income in my dividend stock portfolio, accounting for 4.3% of the portfolio's income (excluding the mutual fund holding in my employer sponsored retirement account).
This article was written by
Kody's Dividends
8.46K
Follower
s
Hi, my name is Kody. Aside from my articles here on Seeking Alpha, I am also a contributor to Dividend Kings and iREIT on Alpha. I have been investing since September 2017 and interested in dividend investing since about 2009.Since July 2018, I have ran Kody's Dividends. This is a blog that is documenting my journey towards financial independence using dividend growth investing as the means to transform the dream of financial independence into a reality. It's also the inspiration of my pseudonym here on Seeking Alpha.By God's grace, I owe everything to my blog for introducing me to the Seeking Alpha community as an analyst. That's my story and I hope you enjoy my work examining dividend growth stocks and the occasional growth stock!
Analyst’s Disclosure: I am/we are long MMP, EPD, ET, CAIBX. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
