Magellan Midstream & Enterprise Products: Best-Of-Breed MLPs
The energy sector has been through some serious challenges over the past half decade, including two oil price crashes and severe demand disruption from COVID-19. On top of that, the rapid ascendancy of the ESG movement in the investing, governmental, and corporate worlds has increasingly starved fossil fuel companies of capital and incremental demand.
As a result, equity multiples in the sector have compressed as capital has fled the space in favor of renewable energy stocks. This has put pressure on many of these companies to reduce shareholder capital returns in order to conserve increasingly costly equity capital and reduce debt to de-risk their business models. While less sensitive to demand and commodity price swings, the midstream sector has been no exception. In particular, midstream MLPs have been hit hard as their K1 tax forms and less-favorable corporate governance structures make it even less of an appeal space for investors to deploy capital than other fossil fuel places (or even into midstream C-Corps like Enbridge (ENB) and Kinder Morgan (KMI).
These challenges have emphasized the value of having a strong balance sheet as only the midstream MLPs with the strongest of balance sheets have seen their distribution growth streaks survive COVID-19 and related headwinds. Today, we are going to focus on the two MLPs with the very strongest balance sheets – Magellan Midstream Partners (NYSE:MMP) and Enterprise Products Partners (NYSE:EPD) – and determine which one is more attractively priced today.
MMP: Higher Yield & More Buybacks
First and foremost, MMP has a rock-solid balance sheet and business model. It owns a high quality refined products pipeline network that serves as an essential cog in the energy infrastructure chain by connecting refineries to end markets. The pipeline earns very stable cash flows for the business thanks to its long-term fee-based and inflation-linked contracts.
Management has also kept leverage low and the distribution marching steadily higher over time thanks to its extremely disciplined capital allocation practices. While this has kept the business smaller than giants like Energy Transfer (ET), it has also enabled it to focus on only the most profitable projects and thereby has achieved best-in-sector returns on invested capital. The remainder of the cash is then returned to unitholders via distributions and unit buybacks. This has led to strong long-term value creation for equity investors and an attractive risk-reward profile up to the present day given that the credit rating remains at a sector-best BBB+, the yield remains quite attractive at over 8.3%, and growth is picking up alongside inflation and recovering demand for energy.
In recent years, MMP has kept its balance sheet in pristine condition and sustained its distribution growth by slashing growth capital expenditures. On top of that, it was still generating excess free cash flow that it was largely allocating towards buying back its own units. This simpler and de-risked capital allocation policy has made it a very stable and reliable income investment.
Thus far, MMP has repurchased $800 million worth of its units and has $700 million still outstanding on its $1.5 billion repurchase program. Management has stated that it plans to use its expected $575 million in 2022 free cash flow for unit repurchases barring another compelling investment opportunity materializing. They also mentioned on their earnings call that they could potentially use debt to repurchase even more units if the price were to become meaningfully dislocated and leverage remains below target levels.
Overall, with the market cap under $10.5 billion, management expects to be able to repurchase ~5.5% of its outstanding units in 2022 with excess free cash flow beyond the distribution. Management has also signaled previously that as it reduces its outstanding units, it plans to continue growing its distribution as well to maintain ~1.2x distribution coverage. The conservative nature and simple approach to capital allocation at MMP these days is summarized well by management’s statement on its recent earnings call:
We’re not looking to really diversify outside of what we do right now. We don’t really feel like this is the time for us to make big bets on things outside of our space, especially since we have what we believe to be an attractive opportunity to buy back our equity.
Investors today can safely count on an ~8.5% yield and steady growth from buybacks and inflation-driven contract increases.
EPD: Stronger Balance Sheet, Greater Cash Flow & 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 MMP’s. This stems from its lower leverage level, better laddered debt maturity schedule, greater liquidity, and much greater diversification in its asset portfolio. In particular, EPD has significant exposure to natural gas and LNG whereas MMP has none. Given that natural gas is much cleaner than crude oil and coal, it is widely expected to play a key role in the coming decades as the global energy industry transitions away from “dirtier” energy sources towards cleaner energy sources. While not “renewable” like hydro, nuclear, solar, and wind, natural gas is still quite clean.
On top of that, EPD has a greater cash flow yield than MMP does. First of all, EPD has a lower EV/EBITDA and EV/EBIT than MMP does at 9.89x and 13.14x, respectively, compared to MMP’s EV/EBITDA and EV/EBIT of 11.13x and 14.14x, respectively. Furthermore, EPD’s 2022E DCF yield is 11.8% whereas MMP’s 2022E DCF yield is 10.4%. While the valuation gap is not as great here as it once was given EPD’s outperformance of MMP in recent months, EPD remains a better bargain according to these metrics.
Another major difference between EPD and MMP is that EPD is investing more aggressively in growth. MMP is slashing growth CapEx and selling non-core assets with a laser focus on free cash flow that is enabling it to buy back units. In contrast, EPD continues to only moderately grow its distribution and buy back a relatively small number of units while it continues to allocate capital aggressively towards growth opportunities.
The biggest recent example of this is its Navitas Midstream acquisition alongside a $1.5 billion growth CapEx budget in 2022. While buybacks have simplicity going for them, the Navitas Midstream acquisition is also expected to be highly accretive with a 14% DCF yield on investment projected from the deal. On top of that, it is supposed to provide high return, low risk incremental organic growth investment opportunities in the future. Given that EPD’s DCF yield is just 11.8% at present, the Navitas Midstream acquisition looks like it is a prudent allocation of capital.
MMP and EPD both boast rock solid balance sheets, lengthy distribution growth track records, attractive and safe current yields, high quality asset portfolios that have weathered several energy industry crises and headwinds admirably, and proven management teams with track records of allocating capital effectively.
Moving forward, the two businesses seem to be plotting different paths. MMP is focusing on its core businesses, selling non-core assets, and buying back units hand-over-fist while continuing to gradually grow its large distribution and maintain its strong balance sheet.
EPD is continuing to pursue growth opportunities across its diversified midstream platform, from which it aims to leverage its scale 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 returning opportunities in which to invest its excess cash flow, I favor EPD over MMP at the moment, though I think both make fine high yield low risk investments.
Note: both businesses issue K-1 tax forms. I encourage you to do your own due diligence on the tax ramifications before investing.