Why I Added This MLP to my Retirement Account

Based on several media stories lately, I'm probably in the minority for saying this. I am a big fan of Master Limited Partnerships for my retirement account. Not because I need the income today -- I'm pretty sure I'm quite a few years away from retirement -- but instead I like the idea of reinvesting those high distribution payments over time. This is one of the reasons that I recently added Magellan Midstream Partners (NYSE: MMP  ) to my retirement account.

Source: US Fish & Wildlife Service

Of course, the simple fact that Magellan is a MLP isn't the only reason I bought this company. There are several factors that made me decide to select Magellan over many of its peers. Let's take a look at the reasons I decided to purchase this company -- perhaps they will give you some information about the company that will help guide you in your financial decisions.

The 3 factors influencing my decision
There are lots of things that make Magellan a compelling company to buy, and the best way to categorize them is into three parts: The business model, the potential, and the corporate culture/structure. 

The business model: Four of the largest master limited partnerships have specialties that gives them distinct competitive advantages: Enterprise Products Partners (NYSE: EPD  ) has natural gas liquids, Kinder Morgan Energy Partners (NYSE: KMP  ) has pure natural gas, Plains All American (NYSE: PAA  ) has crude oil, and Magellan Midstream has refined petroleum products. Each of them is the dominant American player in each respective space.

Like it or not, oil and gas will continue to be in demand for many years to come, and as long as that demand is there, we will need efficient infrastructure to deliver those products from the well to the pump. Over the several decades prior to the recent energy boom, the value chain for oil went something like this: Imported crude oil makes its way to coastal refineries where it is then transported as finished products across the U.S. This made Magellan Midstream an incredibly important factor in this value chain. It's near-10,000 miles of pipelines and storage terminals are designed to transport and store refined products from the Gulf Coast throughout the Midwest, Rocky Mountains, and Southeast United States.

Source: Magellan Midstream Partners Investor Presentation

Magellan's pipeline system and the major refineries in its network (Source: Magellan Midstream Partners Investor Relations)

But wait, we are in an oil production boom, and places like North Dakota are producing gobs of oil, Right? That is true, but the refining capacity in these parts of the country is much more limited. The Gulf Coast region of the U.S. has more than 50% of the nation's refining capacity. So unless there are some major investments to build new refineries across the United States -- not that likely considering costs and the highly technical term known as "not in my backyard" -- we will likely see much of that crude moved down to the Gulf Coast and then transported back to the rest of the country through refined product pipelines. Since Magellan has refined product pipeline connections to over 50% of the nation's refining capacity, it has a distinct competitive advantage in delivering oil and gas to gas pumps across the nation.

Also, since it is a Master Limited Partnership, investors should look for stable, predictable cash flows that won't be interrupted by things like changes in commodity prices. A majority of Magellan's revenue is based on volume pricing and fee based services -- approximately 85% of the company's operating income comes from activities that aren't based on commodity prices. So the biggest threat to the company's business would be a major downturn in gasoline demand. While this is certainly a long term threat, it will still take years before this actually happens. Magellan estimates that the total refined product demand in its serviced markets will decline by less than 0.5% within the next 10 years. 

The possibilities: Even though Magellan has one of the more complete refined products pipeline networks, the real growth in the pipeline business is on the other side of the refinery: crude oil. Shale oil formations such as the Permian and Eagle Ford are growing in leaps and bounds. Even though rail has been there to cover the shortage of takeaway capacity from these regions, long term pipelines are the cheaper method of transportation. This is why Magellan's decision to dedicate 80% of its near $1 billion 2014-2016 capital budget to crude oil pipelines is such a positive. Between its newly operational Longhorn, BridgeTex, and Double Eagle pipelines, the company will have almost 700,000 barrels per day of crude-carrying capacity coming online between now and the middle of 2015.

Source: Magellan Midstream Partners Investor Presentation

A key focus of Magellan's growth strategy is focused on moving crude oil, and it has identified a niche: moving oil from regions like the Permian & the Eagle Ford to the gulf coast. Not only are these pipelines in great need, but the capital to get them off the ground is rather modest since oil gathering and distribution networks are already in place. Plains All American has thousands of miles of gathering pipeline in the Permain, and Magellan already has a well established network of crude distribution pipelines in the Houston region. 

The corporate structure: Major financial media outlets such as Bloomberg have recently voiced their concerns over the master limited partnership space for two major reasons: the way they find growth and the complicated corporate structure. This is what makes Magellan and a very small set of Master Limited Partnerships unique.

Unlike most other MLPs, which are split into a general partner that manages the operations of the partnership and the limited partnership that owns the assets, Magellan doesn't have a managing general partner. Back in 2010 it bought out its general partner's stake. Not only does this make Magellan easier to understand as an investment because it is a stand-alone enterprise, but it isn't required to pay management fees -- also known as incentive distribution rights. There are multiple benefits to not having to pay these fees that go beyond just the cost of doing business, which are better explained here

The absence of these management fees and the pressure to pay out all of its distributable free cash at any cost gives it the ability to grow its business with some organic capital rather than entirely from debt and equity issuances. Over the past 3 years, Magellan has generated cash flow of at least 30% in excess of its distribution payments. This excess cash has allowed the company to increase both its share count and total debt issued by the lowest amount of its peers, all of which have translated into better stock performance for the company. Since its buyout of its general partner it has outpaced its closest peer, Enterprise Products Partners, by 88%, and has nearly quadrupled the S&P 500 on a total return basis.

MMP Total Return Price Chart

MMP Total Return Price data by YCharts

Of course, past performance doesn't predict future success, but the combination of a well integrated pipeline and storage network, strong growth opportunities, and a more transparent corporate structure make Magellan one of the top pipeline investments in my book.

What could concern me down the road
As I mentioned, a decline of total gasoline consumption thanks to increasing fuel efficiency and alternative fueling options are probably a long ways off, but it is still a legitimate threat that is worth watching. Disruption of gasoline-fueled transportation has been difficult to achieve, mostly because of the massive infrastructure required for any viable alternative. One thing that can never be underestimated, though, is the ability of technology to rapidly change course, so any major technological advancements that could have an immediate impact on transportation will be watched closely.

One other critical element I will be watching is whether management continues its rather conservative growth and distribution policies. If the company's distribution coverage ratio starts to get thinner because of overaggressive distribution increases without major business growth, than I may need to revisit this position. After all, this is for a retirement account, and I don't have plans to retire any time soon.

What a Fool believes
Magellan Midstream's distribution yield of 3.2% might not wow investors like Kinder Morgan Energy Partners' 7.1% or Plains' 4.4%. However, Magellan has grown its distribution 12% on an annualized basis for 12 years running, and on a total return basis it has been one of the best performing MLPs since its decision to go General Partner-free. For a long term investment, Magellan seems to be pulling all the right levers, and that is why I have decided to add it to my retirement account. Is Magellan right for you? I can't say. The needs of your retirement account could be wildly different than the needs of mine, but it is hard to argue with the fundamentals of the business.

If you like Magellan Midstream, then you will love these rock-solid dividend stocks
It's hard to find a company that has continually grows its dividend like Magellan does, and the smartest investors know that dividend stocks simply crush their non-dividend-paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. Find out if Magellan made the list of stocks in our special report, just click here now and we'll give you free access.

 


Read/Post Comments (8) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 05, 2014, at 2:52 PM, rizno wrote:

    The thing I wish this article addressed is why its a good idea to go with MMP in an IRA account because of the tax issues relating to the MLP's. What considerations need to be made in regards to making these investments within an IRA vs. a traditional portfolio?

  • Report this Comment On May 05, 2014, at 5:06 PM, gsbaird wrote:

    Also all MLPs have negative Unrelated Business Taxable Income (UBTI). The concern of including MLPs in IRAs is way overblown. In fact, it is much more convenient to own MLPs within an IRA because one doesn't have to worry about adjusting his or her cost basis every year.

    Stephen

  • Report this Comment On May 05, 2014, at 5:07 PM, gsbaird wrote:

    I meant to say 'almost all MLP's' rather than 'also all MLPs'.

    Stephen

  • Report this Comment On May 06, 2014, at 8:21 AM, TMFDirtyBird wrote:

    @rizno

    Here is an article I did a while back that covers MLPs and the tax implications they carry

    http://www.fool.com/investing/general/2013/03/18/an-investor...

    Hope this helps

  • Report this Comment On May 16, 2014, at 2:56 PM, MSWeaver wrote:

    The author makes some really interesting points, especially about investing options that are not well known or understood such as MLPs. I wish there was more discussion about different vehicles for investing in these types of entities. For example, self-directed IRAs can be a great way to use retirement funds for exactly this kind of investment option.

    Michael Weaver

    www.trustetc.com

  • Report this Comment On May 16, 2014, at 6:52 PM, BarrySta wrote:

    Having happily owned MMP for several years, I'm baffled by why MF rates it a "hold" (http://scorecard.fool.com/snapshots/mmp/?premium=1048).

    With total returns (with reinvested dividends) currently at

    1 Year +53.8%

    3 Year +202.0%

    5 Year +511.5%

    and a history of increasing distributions, this has been a real winner for me. I'd like to add to my position, but would feel more comfortable if I understood why it's a Hold.

  • Report this Comment On May 17, 2014, at 1:19 PM, kuzumel wrote:

    <I> I'd like to add to my position, but would feel more comfortable if I understood why it's a Hold.</i>

    If you look at the price chart, it is pretty much at its 52-week high. Which makes the current dividend yield not the most rewarding for the price - considering its a Unit Trust.

    So you can always go the Put options route until the price comes back down.

  • Report this Comment On May 20, 2014, at 5:42 PM, BarrySta wrote:

    @kuzumel But MMP keeps steadily climbing its price growth curve, and, having appreciated 28.5% so far this year, is maintaining its excellent total return. Or does the "Hold" status relate only to the dividend yield?

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