Magellan Midstream Partners (NYSE:MMP) and Enterprise Products Partners (NYSE:EPD) both offer mouthwatering distributions, yielding 11.5% and 10.8%, respectively, at current share prices. Before you jump into either stock, however, you need to understand why those yields are so high. The answer to that question will help you determine which looks like the better option for long-term dividend investors.
A tough time in energy
Magellan and Enterprise both own midstream facilities that help to move oil and natural gas around the world. This is a fairly conservative segment of the broader energy sector, as it's primarily built around fee-based assets. Essentially, midstream players collect tolls for the use of the pipelines, storage, processing, and transportation infrastructure they own and operate. The prices of the commodities traveling through their systems aren't all that important to either master limited partnership's bottom line. Enterprise and Magellan each generate more than 85% of their revenues from fees, usually from long-term contractual relationships.
The key factor for these midstream companies is demand. With the U.S. onshore energy sector growing materially for many years demand for the services provided by midstream companies had been huge, and the industry was in growth mode. Both Enterprise and Magellan had been building new assets to grow their businesses. However, COVID-19 has upended the industry -- the economic shutdowns and social distancing measures taken to slow the spread of the pandemic have materially reduced demand for oil and natural gas.
Worse, when demand fell sharply earlier in 2020, excess supply wound up in storage. That excess will likely have to be worked through before fossil fuel prices can rise again, which will keep a lid on drilling. So there doesn't appear to be a quick fix to the global supply/demand imbalance hitting the energy sector. And it's having a notable impact on the midstream space, which has seen a drop in demand for the assets that currently exist in key markets. Further, construction plans are in flux, as weak demand means there's little immediate need to keep building new pipelines. This ugly backdrop helps explain the massive yields on offer from Magellan and Enterprise. It's also worth noting that some of their peers have already resorted to distribution cuts.
Indeed, where once investors focused on a midstream player's ability to grow its disbursement, now they are focused on whether or not those distributions will survive. This is the factor that differentiates Magellan and Enterprise.
Looking at the two partnerships' financial foundations, they are on fairly equal footing. Enterprise's financial-debt-to-EBITDA ratio, the typical way that leverage is measured in the midstream space, is roughly 3.7. For Magellan, that metric is 3.2, and while its balance sheet looks a little cleaner, both have ratios that are actually toward the low end for the industry. In addition, both solidly cover their trailing interest expenses, with Enterprise at 4.8 times and Magellan at 5.6 times. As far as financial strength goes, these two partnerships are roughly in the same place. And, most important, both look strong enough to get through this difficult period in one piece.
Where things start to meaningfully differ between the two, however, is distribution coverage. Magellan only covered its distribution by around 1.1 times in the second quarter. Management pledged to hold steady on the distribution through the end of the year, but that statement hasn't instilled much confidence among investors. Magellan is clearly leaving the door open to a distribution cut if industry conditions don't improve. That helps explain its higher yield.
Enterprise is in a comparatively better position, with distribution coverage in the second quarter of 1.6 times. Before taking solace in that figure, however, it's important to note that Enterprise stopped raising its distribution each quarter this year. The decision to break that multiyear trend was a statement about how tough the current environment is for midstream companies. It has much more leeway to continue its shareholder disbursements at their current levels, but management is obviously looking to take a cautious approach with regard to the future.
First and foremost, there's no material reason to panic about either Enterprise or Magellan. In fact, Enterprise has been laying out a compelling case for strong long-term demand in the energy patch that will, assuming the outlook proves correct, benefit both partnerships. However, given the difficult environment today and Magellan's relatively weak distribution coverage, Enterprise appears to be a better option for income-focused investors right now. There's no way to guarantee that Enterprise's distribution will hold, but it certainly looks safer than Magellan's.