(Bloomberg Opinion) -- There’s a lot to be said for being a big fish in a small pond. But what if you’re a big fish in a small pond that has a sewage problem and is drying up by the year?
Which brings us to master limited partnerships and one of the largest, most respected companies in that corner of the capital markets: Magellan Midstream Partners LP. Magellan, which operates 12,000 miles of refined product and crude oil pipelines, has been one of the better MLP bets over the past decade.
Other than Magellan’s outperformance of the MLPs over the past decade, you’ll notice two other things. First, Magellan’s past five years have been more in line with the index, as in not so hot. Second, the S&P 500 trounced both.
Magellan stands out from many of its peers. It simplified its structure and ditched irksome incentive distribution rights more than a decade ago. Earnings and distributions grew steadily, even after the 2014 oil crash, until Covid-19 struck. Likewise, free cash flow has been positive in every quarter for the past eight years. The lackluster total return of the back half of the 2010s doesn’t reflect weak financial performance. It’s a classic derating.
Just before the 2014 oil crash got underway, Magellan’s dividend yield was about 4.3%, lower than for the Alerian MLP Index and a 3.4 percentage point spread to the S&P 500’s dividend yield. Today, despite its distributions having risen by almost 70%, Magellan yields more than 10%, the same as the MLP index and an 8.6 point spread to the S&P 500.
The problem here is that the MLP model, and moniker, has a certain stink about it. The unusual structure, twinned with fiddly tax-reporting requirements, have always made it an acquired taste. Compounding that, poor financial management and weak governance with profits and power skewed to insiders bred hubris, debt and distribution cuts. Magellan wasn’t guilty of these offences. But as investment dollars have flowed away from MLPs, so the company finds itself swimming in a shrinking, murky pool. More and more of its pipeline-owning peers have ditched the MLP structure to become regular C-Corps, taking a hit on taxes but gaining access to a wider pool of mutual funds and other investors.
This all came to a head of sorts on Magellan’s latest earnings call. Having laid out its reasoning for sticking with the partnership model, management then got into a testy exchange with representatives of Energy Income Partners LLC, one of Magellan’s top 10 investors.
EIP questioned the $2.3 billion tax hit from conversion — equivalent to a quarter of the market cap — that Magellan had calculated. First, that number was heavily weighted to the back end. Using Magellan’s assumptions, perhaps only a third of it accrues by 2035, in present value terms. It is highly unlikely investors are basing their decisions on discounted tax payments more than 15 years out, especially with an energy transition lurking out there. Second, Magellan’s corporate-level calculation left out tax implications for individual investors, essentially ignoring potentially large offsetting benefits from C-Corp. conversion.
Perhaps most puzzling was Magellan’s analysis of the potential value of being rerated as C-Corp. The latter, enjoying a wider pool of capital, tend to trade at a premium to MLPs — unless, that is, you only value them on metrics that are used by the dwindling band of MLP investors. This is what Magellan did, comparing itself on price to distributable cash flow. What’s that, you may well ask. It’s a calculation of cash available for payouts that is not well understood by outsiders and contains such eye-of-the-beholder elements as “maintenance capex”. On that basis, Magellan demonstrates its C-Corp peers trade at a discount to itself on average.
Just as one doesn’t make peace by talking to one’s friends but rather to one’s enemies, so Magellan’s valuation isn’t likely to get a bump by preaching to its existing believers. “The investors that hold you are through funds that are getting liquidated every day,” is how EIP’s chief executive Jim Murchie put it on the earnings call, adding those “who buy and sell things on P/E and growth rates and earnings stability are the people that would change your valuation.”
Looked at on the P/E multiples used outside of MLP-land, Magellan looks seriously undervalued.
Put Magellan on the median C-Corp. multiple, and the implied uplift to its market cap is around $4.5 billion. Magellan could of course argue such simplistic calculations may not pan out exactly like that in real life. Plus there are considerations around what the new administration in Washington portends for tax rates. These are worthy topics of debate. Against that theoretical tax burden calculation Magellan made of $2.3 billion, though, surely a theoretical gain of almost double the amount demands serious consideration. Being the best house on a bad block carries some cachet, but it won’t persuade many to move there.
This assumes corporate cash tax paymentsbegin in 2027 with a payment of $75 million and payments of $0.83and $1.47 per unit in 2030 and 2035, respectively, with units outstanding remaining constant at 223.7 million. Payments increase linearly between these points.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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