Magellan Midstream: 8% return with buybacks and low leverage (NYSE:MMP)

Robert Boslego profile picture

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Magellan Mid-Partners (New York Stock Exchange: MMP) has been trading at high yield for so long that it can be easy to overlook that it is one of the few stocks still trading near 52-week highs. The midstream pipeline company has committed in an aggressive unit buyback program, highly unusual for the industry, funded by sizable asset sales. While I expect unit buybacks to slow considerably going forward, management appears to have shown a commitment to limit growth capital expenditures in the coming years. It seems unlikely to me that the units will continue to return more than 8% if the company commits to generating free cash flow and buying back units. I continue to find MMP highly affordable here.

Note: MMP issues a K-1 tax form and may complicate your tax filing process; consider the tax ramifications before investing.

MMP Stock Price

While the MMP remains well below 2015 highs, the stock is one of the best performers this year.

Frame
Data by YGraphics

The last time I covered MMP was in July, where I explained why I turned bullish with selected middle traders. MMP has increased slightly since then, but arguably not enough.

Key MMP Stock Metrics

MMP is best known for having the longest refined petroleum products pipeline system in the country.

refined products pipeline

Presentation August

While MMP is technically in the energy business, its profits are typically much more stable than traditional power producers because, as the “owner” of the pipelines, MMP earns 85% of its margin from tariffs.

Operating margin

Presentation August

Within the midstream sector, I consider MMP to be one of the lower risk names. That may surprise some investors considering the low distribution coverage ratio of 1.25x DCF, but in my opinion, leverage and track record are the most important risk factors. MMP maintained a debt to EBITDA ratio of 3.7x as of last quarter and has kept leverage below 4x for decades.

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take advantage of

Presentation August

In terms of track record, MMP has the highest historical ROIC, meaning it has generated the strongest returns on its growth projects.

ROIC

Presentation August

With that in mind, it may surprise some investors to see MMP prioritizing unit buybacks over growth projects this year.

capital returns

Presentation August

MMP spent $138 million on buybacks in the quarter, bringing its total YTD to $377 million or 3.5% of units outstanding, and that’s after spending heavily on buybacks in 2021. These unit buybacks were made possible primarily due to to a reduction in growth capital spending as well as the sale of assets. Despite those asset sales, MMP still increased distributable cash flow (DCF) to $290 million from $277 million. Free cash flow was $273 million versus $252 million. I note that excluding asset sales, free cash flow after YTD distributions was $140 million vs. $65.5 million in 2021.

Management also raised guidance on the conference call, now expecting $1.1 billion in DCF for the full year. Even after deducting the projected $90 million in growth capital this year, free cash flow would comfortably cover the roughly $858 million in distributions for the full year, and that’s without factoring in asset sales.

MMP has not yet provided guidance for 2023, but reiterated guidance for at least 1.2x annual distribution coverage for the foreseeable future.

Is MMP Stock Buy, Sell, or Hold?

Although MMP is trading near 52-week highs, its distribution yield remains high compared to historical levels.

performance history

looking for alpha

That may surprise some readers considering that MMP has increased its distribution for more than 20 years in a row.

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dividend growth history

Presentation August

Management has indicated that annual growth capex will be around $100 million annually going forward, noting that it has already budgeted $100 million in 2023 and $40 million in 2024. see growth capex above $100 million as they budget for additional projects.

I’m pleased to see growth capital ambitions scaled back, but keep in mind that its strong track record means investors shouldn’t necessarily worry if management eventually goes back to old ways.

MMP remains a slow growth company with consensus estimates calling for minimal earnings growth.

consensus estimates

looking for alpha

MMP has already slowed its distribution growth significantly in recent years.

recent dividend growth

looking for alpha

That explains the context behind the high 8% yield: that valuation seems understandable considering minimal future growth. However, this is a company that trades at about 10.5 times free cash flow (I have not included any profit from asset sales). That valuation is too conservative considering the strong balance sheet and high payout from unitholders. Over time I could see the units appreciate at a 6.5% yield, implying another 19% upside potential just from the multiple expansion. Add the 8% yield, 1-2% growth and MMP should be able to generate double-digit total returns for years to come.

What are the key risks? I still have nagging doubts that the current sluggish growth will eventually turn into negative growth, but that seems unlikely given the heightened scrutiny of new pipeline projects and strong commodity prices. I also suspect the valuation may be artificially inflated as some investors mistakenly thought aggressive buybacks are sustainable. I expect the pace of buybacks to slow as asset sales slow. Much of the buybacks have simply offset the dilution of asset sales.

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I rate MMP as a buy as a lower risk name to consider in the midstream sector.

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