This article was coproduced with Dividend Sensei.
It’s almost like we’re back in 1999 – perhaps even very early 2000 – where every tech possibility is automatically loved and the market responds accordingly.
Admittedly, the current tech selloff seems to negate that somewhat. Yet unprofitable tech company Snowflake (SNOW) went public this past week in the middle of that. And its price surged more than 100% on opening day to trade at 175x sales.
Leaving more intelligent investors worried about a potential market crash. A real one.
There’s a historic outcome to such rabid euphoria, after all. And it’s never pretty.
However, just because some stocks are outrageously overvalued doesn’t mean there aren’t also anti-bubble blue chips that are outrageously undervalued. In fact, it’s during markets like this that “slow-growing” stars are the most unloved.
And therefore trade at the deepest discounts.
Consider the actual tech bubble, when real estate investment trust Realty Income (O) was trading at 7x funds from operations (FFO). That was a 50% discount to historical fair value, complete with a very safe 11% yield.
This was one of the least favored blue chips on Wall Street. Nobody cared about it considering how Amazon (AMZN) had risen 30x in the last two years.
Better get in on that instead! Right?
Because of how little loved it was, many investors naturally assumed it would fall much more during any downturns. However, when valuations become so detached from reality, unlikely things can happen.
When the next “downturn” – also calculated as the fourth worst market crash in U.S. history – came about, Wall Street darlings fell as much as 93%. Yet Realty doubled in value when including dividends.
For that matter, it outperformed the S&P 500 by 4.4x over the next 15 years.
(Source: Portfolio Visualizer)
Today, it’s not anywhere close to being such a great bargain. Which is OK though.
We’ve got our eye on something very similar…
Meet Magellan Midstream Partners
At first glance, analysts can see some eerie similarities between Magellan Midstream Partners (MMP) and Realty’s valuations from yesteryear:
- Realty bottomed at 7x FFO. MMP is trading at 7.2x operating cash flow (OCF).
- Realty peaked at an 11% yield. MMP is yielding 11.1%.
- Realty became 50% undervalued. MMP is currently 52% undervalued.
Then there’s the yield similarities, since Magellan is trading just one tick above Realty’s was, at 11.1%. Is it similarly safe as well?
To figure that out, let’s turn to our usual favorite down below.
We don’t use every metric every time since they’re not each always relevant. But it’s a strong tool overall nonetheless in figuring out how stable a company’s dividend will be in a regular recession.
Since this isn’t a regular recession we’re experiencing, we take it a step further these days.
Here’s why Magellan scores a 4/5 above average on distribution safety today:
- 2020 consensus discounted cash flow payout ratio: 89% vs. 83% safe for self-funding midstreams
- Debt/capital: 66% vs. 60% or less safe
- Debt/EBITDA (earnings before interest, taxes, depreciation, and amortization): 3 vs. 5 or less safe
- Interest coverage: 5.6 vs. 2.5+ safe
- S&P credit rating: BBB+ stable outlook = 5% 30-year bankruptcy risk
- Moody’s credit rating: Baa1 (BBB+ equivalent) stable outlook = 5% 30-year bankruptcy risk
- F-score: 5/9 vs. 4+ safe, 7+ very safe = low short-term bankruptcy risk
- M-score: -3.11 vs. -2.22 or less safe = ultra-low accounting fraud risk
- Dividend growth streak: 18 years (every year since its IPO)
And Magellan would have a full-out 5/5 safety score if its payout ratio were at or under safety guidelines.
As is, it’s still covering the distribution though. And next year, analysts expect the DCF payout ratio to hit the safe 83% level and then 84% in 2022.
That shouldn’t be surprising considering how, back in March – when the pandemic and worst oil crash in history began – management actually reiterated its 2020 capital allocation guidance for a 3% distribution hike in 2020. Analysts don’t actually expect the payout to start growing again until 2022, but they also don’t expect it to be cut.
Moody’s writes that it has “relatively low business risk characterized by stable fee-based operations that account for most of the company’s cash flow.” It also lauds the midstream for maintaining “low financial leverage” and appreciates how:
“… to date, most of the markets Magellan serves have not experienced the level of the economic shutdown that other parts of the U.S. have… as a result, the loss of volume is not likely to have a material effect on the company’s overall credit profile.”
And there’s a lot more to love where that comes from.
(Source: MMP investor presentation)
As the chart above shows, 85% of cash flow is from fees, with minimal commodity price exposure.
Moreover, most of its customers are large, financially-strong companies, including Phillips 66 (PSX), Exxon (XOM), and Valero Energy (VLO). All three contribute to its refined products business, which represents two thirds of revenue.
In all, 61% of its crude oil contracts are with investment-grade oil producers. And overall, the company’s crude-based revenue is highly diversified in terms of client base.
We’ve already touched on Magellan’s low leverage, but what you may not know is that’s the norm.
Management’s policy is to never take debt/EBITDA above four. And it stuck to that even in the first oil crash.
As a result, today leverage is just 3 – literally the lowest of any large midstream operator. Even this year, MMP expects to retain $100 million in post-distribution cash flow, on top of an untapped $1 billion credit revolver and no debt maturing until 2025.
MMP literally has the strongest balance sheet in this industry, surpassing even the mighty Enterprise Products Partners (EPD).
For these reasons and more, MMP’s 11% yield is just as safe as Realty Income’s back in 2000.
One of the Highest-Quality Midstreams in the World
Magellan also boasts the oil and gas midstream industry’s best returns on invested capital (annual pre-tax profits/average invested capital) – another record it’s held since going public.
(Source: MMP investor presentation)
The key to its profitability is the nation’s largest refined product network. This consists of nearly 10,000 miles of pipes that deliver 40% of all gasoline, jet fuel, and diesel in seven of the 15 states it serves.
As Morningstar has noted, this gives Magellan “a wide economic moat,” though the MLP hardly takes that for granted.
It’s known for the past decade that its refined products aren’t a growth industry. That’s why it’s spent that time investing $6.8 billion into crude oil and marine storage.
Those categories combined now make up 32% of its cash flow.
All of this comes courtesy of one of the best management teams in the industry. These praises aren’t hyperbole. The company offers an 18-year distribution growth streak that’s rewarded income investors with 14.4% compound annual growth rate payout growth for nearly two decades.
Here’s just a sample of what Morningstar says about these leaders:
“We award an Exemplary stewardship rating to Magellan’s management, which is among the best in the industry.
“Management has consistently been ahead of the curve in its strategic vision and pragmatic approach to managing and deploying capital. Michael Mears, chairman of the board, president, and CEO of Magellan’s general partner, has been with the company for about three decades, serving in various management roles. Under his leadership, Magellan was among the first MLPs to simplify its capital structure when the LP bought out its general partner in an all-stock deal in 2009. In addition to a lower cost of capital, this streamlined structure better funnels the benefit of earnings growth to LP holders…
“In an industry fraught with dilutive equity issuances, we applaud management’s ability to deliver top-tier distribution growth without tapping equity markets since 2010.”
Again, that’s the short version. Suffice it to say that Morningstar very much recognizes and respects Mears and his similarly shrewd and experienced C-suite compatriots.
Put it all together and you have a:
- 4/5 dividend safety
- 3/3 business model
- 3/3 management quality/dividend culture
- 10/11 SWAN quality business.
And then there’s that valuation…
An Unlikely Future for Magellan
Let’s begin this segment by quoting Bank of America:
“We believe MMP deserves a premium to average midstream/MLP adjusted EV/EBITDA multiple of 9x, as we believe MMP’s balance sheet, liquidity, and defensive qualities are underappreciated at current levels.”
Right now, Magellan is trading at the average enterprise value, or EV, (net debt)/EBITDA ratio – despite clearly not being an average-quality MLP. What “typical” business steadily grows its fundamentals in the middle of an intense bear market?
Analysts certainly don’t consider MMP a dying company, as shown below.
The average S&P 500 company, meanwhile, is expected to see 20% earnings declines.
As for beyond, here’s MMP’s long-term growth profile:
- FactSet 2022 medium-term growth consensus (worst oil crash in history): -3.3% CAGR
- FactSet long-term growth consensus (looking beyond the oil crash): 3% CAGR
- Ycharts long-term growth consensus (looking beyond the oil crash): 4% CAGR
- Reuters’ five-year growth consensus (worst oil crash in history): -0.4% CAGR
- 20-year rolling growth rates: -2.5% to 16% CAGR.
For the record, Magellan has a great track record of beating growth estimates. Its analyst margin of error is -15% to the downside and +40% to the upside. And it missed two-year forecasts just once in the past decade.
That turns the 3%-4% CAGR long-term analyst growth consensus range into 2%-6%.
While that’s still slower than most of its historical growth rates, it doesn’t even come close to justifying the current 7.2x cash flow multiple. Magellan’s intrinsic value – which is, by definition, a function of distributions and cash flows that support them – has objectively and consistently gone up while the price falls.
Magellan Midstream: A Classic Anti-Bubble, Buffett Style “Fat Pitch” SWAN
As Ben Graham once said, the market almost is never wrong about a company’s intrinsic value over time. During the last 20 years, 91% of S&P 500 total returns can be explained by valuation and fundamentals.
Short term, of course, such considerations don’t always matter much. But we’re long-term minded, which is why we consider the following factors to estimate a company’s fair value:
- The multiples real investors risking real money have paid for dividends, earnings, and cash flow in the past
- Periods of similar growth rates, regulatory environments and, when applicable to the business model, interest rates
- Graham/Dodd fair-value estimated multiples or a companies historical multiples, whichever are lower (when growth rates are expected to be slower than historical growth rates)
During the past 20 years, outside of bear markets and bubbles, MMP has very consistently traded at 12x-14x operating cash flow. That includes during the last terrible, horrible, no good, very bad six years.
Yet it’s been growing its cash flow and distribution through this time period. Its intrinsic value has been rising, and its stock prices should eventually reflect that.
We estimate MMP is worth $66-$86 in 2021 with an average fair value of $77. That’s a 52% discount to next year’s consensus fundamentals.
Even if you want to use this year’s estimates, it’s still basically half off.
This makes Magellan an ultra-value, anti-bubble sleep well at night SWAN stock with incredible upside opportunity.
Fantastic Risk-Adjusted Return Potential
At its current price, Magellan will deliver about 13% CAGR total returns during the next five years. And that’s if all analysts, credit ratings, and members of management are wrong, and the company never grows again.
According to the Graham/Dodd fair-value formula, a company with stable cash flow but zero growth potential is still worth about 8.5x earnings or cash flow.
Yet, again, MMP is trading at a blended cash flow multiple of 7.4, with a 7.2x 2021 consensus. That prices in about -0.6% CAGR growth forever. More realistically:
- If the company grows at the low end of its expected growth range and trades at the low end of its historical fair value range in five years, investors could see 17% CAGR total returns.
- If MMP grows as analysts expect and returns to mid-range fair value by 2025, then 20% CAGR total returns are expected.
- If it grows at the high end of its expected growth range and trades at the high end of historical fair value, up to 28% CAGR total returns are possible.
Of course, there are no certainties on Wall Street, only probabilities, margins of safety, and sound risk management. And we actually “only” expect about 14% in the next five years – which is still more than quadruple what the broader market is likely to deliver.
Magellan Midstream Partners Investment Decision Score
As usual, its extreme potential and solid fundamentals don’t make it a perfect company or a perfect stock. Magellan Midstream isn’t right for everyone. And it does come with risks.
According to Morningstar:
“From a contract coverage perspective, we consider Magellan’s position to be weak. But the maturity and stability of the refined product market have lent itself to a niche where long-term contracts are less frequently used than in nearly all pipeline markets. Magellan only seeks long-term contracts when further investments are needed to ensure recovery of its capital, so only about 40% of its refined product shipments were subject to term commitments (usually involving reduced fees) with about three years until expiry…
“Without contract coverage, Magellan is exposed to lower volumes over time due to higher levels of fuel efficiency in the United States. Magellan’s major crude oil pipelines are largely contracted (75%-87%) under contracts that have an average remaining life of between four and seven years.”
Other midstream operators sometimes seek 15-25 year contracts on their assets. So Magellan has less contracted volumes and for shorter duration periods.
In addition, gas demand will probably begin to decline in a few years, and some 55% of Magellan’s operating margin comes from transporting refined products.
The company’s outlook here isn’t critical. And, as we’ve already said, it’s working hard to diversify. But analysts are keeping their eyes on the situation nonetheless.
Investors also should be aware of volatility risk, which is always possible for any company.
Despite what many investors may think, MMP isn’t typically volatile. Over the past 13 years, its annual volatility has been just 22.2% versus 27% for the average standalone companies.
It’s basically an energy utility. And, thanks to its cash flow stability, it captured just 61% of the market’s downside and 78% of its upside.
(Source: JPMorgan Asset Management)
Outside of the current bear market, this company tends to be extremely defensive. It fell just 30% at the peak of the financial crisis vs. 54% for the S&P 500. And during the 2011 correction, when stocks fell 19%, MMP was flat.
Only when the “double oil crash” began did MMP become more volatile.
(Source: JPMorgan Asset Management)
Magellan also has a habit of doing very well in market recoveries – rallying 100% vs. the S&P 500’s 84% after the financial crisis and 116% versus 55% in 2012.
Today, it’s up 82% off its March lows, beating even the high-flying Nasdaq and certain tech darlings.
MMP also outperforms the market, generally speaking, in falling interest-rate environments. Though, unlike bonds, it actually generated positive returns in three of the five latest rising-rate periods as well.
There always are unknowns out there, naturally. To name a few that JPMorgan economists have considered, there could be:
- A mini-financial crisis
- Continuing pandemic issues
- Policy changes at the government level
- China trade deal difficulties or failures
But if you follow sound investing guidelines – such as the ones below – you should be properly prepared to ride out almost anything that comes your way.
No individual company on its own makes a SWAN portfolio. Rather, it’s a collective effort between quality, income-producing assets that keeps your money working for you and your goals.
We can’t tell you when Magellan’s bear market will end, only that we do expect it to end eventually. Just as long as this solid management team delivers the expected 2%-6% CAGR long-term growth in its cash flow and distributions…
We expect good things up ahead.
Just like Realty Income back in early 2000, MMP represents the quintessential anti-bubble SWAN whose valuation is 100% disconnected from its fundamentals.
Let the gamblers and speculators chase their bubbles. Prudent long-term investors have always come out ahead in the past. And we don’t see that changing in the future.
That’s why we’re using the present to take advantage of the excellent opportunity that Magellan represents.
Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MMP over the next 72 hours. 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.