Magellan Midstream & Enterprise Products: Best MLPs
The energy sector has faced serious challenges over the past five years, including two oil price crashes and severe demand disruption due to COVID-19. Moreover, the rapid rise of the ESG movement in the The investment, government and corporate worlds have increasingly starved fossil fuel companies of additional capital and demand.
As a result, equity multiples in the sector compressed as capital fled space in favor of renewable energy stocks. This has caused many of these companies to reduce returns on equity to shareholders in order to retain increasingly expensive equity and reduce debt to reduce risk in their business models. Although less sensitive to fluctuations in commodity demand and prices, the midstream sector was no exception. In particular, mid-tier MLPs have been hit hard because their K1 tax forms and less supportive corporate governance structures make them an even less attractive space for investors to deploy capital than other fossil fuel venues (or even in intermediate C-Corps like Enbridge (ENB) and Kinder Morgan (KMI).
These challenges have underscored the importance of having a strong balance sheet, as only midstream MLPs with the strongest balance sheets have seen their distribution growth streaks survive COVID-19 and related headwinds. Today, we’ll focus on the two MLPs with the strongest balance sheets – Magellan Midstream Partners (NYSE: MMP) and Enterprise Product Partners (NYSE:EPD) – and determine which one is more attractive today.
MMP: higher yield and more redemptions
First and foremost, MMP has a rock solid balance sheet and business model. It has a network of high-quality refined product pipelines that serves as a vital cog in the energy infrastructure chain by connecting refineries to end markets. The pipeline generates very stable cash flow for the company through its long-term, fee-based, inflation-indexed contracts.
Management has also maintained low leverage and a steadily increasing distribution over time through its extremely disciplined capital allocation practices. While this has allowed the company to remain smaller than giants like Energy Transfer (ET), it has also allowed it to focus only on the most profitable projects and thus achieve the industry’s best returns on capital. invested. The remaining cash is then returned to unitholders through distributions and unit redemptions. This has led to strong long-term value creation for equity investors and an attractive risk-reward profile to date, as the credit rating remains at the industry’s best, BBB+, the yield remains quite attractive at over 8.3% and that growth is accelerating alongside inflation and the recovery in energy demand.
In recent years, MMP has kept its balance sheet in pristine condition and supported its distribution growth by significantly reducing its growth investments. On top of that, he was still generating excess free cash flow which he attributed largely to buying back his own shares. This simpler, risk-free capital allocation policy has made it a very stable and reliable income investment.
So far, MMP has repurchased $800 million of its shares and still has $700 million outstanding on its $1.5 billion buyout program. Management said it plans to use its projected free cash flow of $575 million in 2022 for unit buybacks unless another attractive investment opportunity materializes. They also mentioned on their earnings call that they could potentially use debt to buy back even more units if the price were to break down significantly and leverage remained below target levels.
Overall, with a market cap of less than $10.5 billion, management expects to be able to repurchase approximately 5.5% of its outstanding shares in 2022 with excess free cash flow beyond the distribution. Management has also previously reported that as it reduces its units in circulation, it also plans to continue to increase its distribution to maintain approximately 1.2x distribution coverage. The conservative nature and straightforward approach to capital allocation at MMP these days is well summed up by management’s statement on its recent earnings call:
We’re not really looking to branch out outside of what we’re doing now. We don’t really think now is the time for us to make big bets on things outside of our space, especially since we have what we think is an attractive opportunity to buy back our shares.
Today, investors can safely count on a return of around 8.5% and steady growth through redemptions and inflation-driven contract increases.
EPD: stronger balance sheet, stronger cash flow and more growth
Similar to MMP, EPD boasts an industry-leading BBB+ credit rating. However, its business model and balance sheet are arguably even stronger than those of MMP. This stems from its lower level of indebtedness, a more staggered debt maturity schedule, greater liquidity and a much greater diversification of its asset portfolio. In particular, EPD has significant exposure to natural gas and LNG while MMP has none. Since natural gas is much cleaner than crude oil and coal, it is expected to play a key role in the coming decades as the global energy industry shifts from sources of ‘dirtier’ energy to cleaner energy sources. Although not “renewable” like hydro, nuclear, solar and wind, natural gas is still fairly clean.
On top of that, EPD has a higher cash yield than MMP. First, EPD has lower EV/EBITDA and EV/EBIT than MMP at 9.89x and 13.14x, respectively, compared to MMP’s EV/EBITDA and EV/EBIT of 11.13x and 14 ,14x, respectively. In addition, the DCF 2022E efficiency of EPD is 11.8% while the DCF 2022E efficiency of MMP is 10.4%. While the valuation gap isn’t as big here as it once was, given EPD’s outperformance over MMP in recent months, EPD is still a better deal by these metrics.
Another major difference between EPD and MMP is that EPD invests more aggressively in growth. MMP is significantly reducing growth investments and selling non-core assets with a focus on free cash flow, allowing it to buy back units. In contrast, EPD continues to increase its distribution only moderately and repurchase a relatively small number of units while continuing to aggressively allocate capital to growth opportunities.
The biggest recent example of this is its acquisition of Navitas Midstream alongside a growing CapEx budget of $1.5 billion in 2022. While takeovers have the simplicity that suits them, the acquisition of Navitas Midstream is also expected to be highly accretive with a DCF yield of 14% on the expected investment from the agreement. In addition to this, it is expected to provide additional high-return, low-risk organic growth investment opportunities in the future. Given that EPD’s DCF yield is currently only 11.8%, the acquisition of Navitas Midstream appears to be a prudent capital allocation.
Key takeaway for investors
Both MMP and EPD have strong balance sheets, long track records of distribution growth, attractive and secure current yields, high quality asset portfolios that have weathered several energy sector crises and headwinds admirably. , and proven management teams with a track record of efficient capital allocation.
Going forward, the two companies appear to be charting different paths. MMP is focused on its core business, selling non-core assets and repurchasing units by hand while continuing to gradually expand its large retail business and maintain its strong balance sheet.
EPD continues to seek growth opportunities on its diversified midstream platform, from which it aims to leverage its size and diversified asset base to further strengthen its competitive position and unlock synergies for investors.
Given that EPD has a lower leverage ratio and stronger liquidity position, a cheaper valuation on both EV/EBITDA and P/DCF metrics, and higher return opportunities in which to invest its cash flow surplus, I prefer EPD to MMP at the moment, although I think both make good high return, low risk investments.
Note: Both companies issue K-1 tax forms. I encourage you to do your own due diligence on the tax ramifications before investing.