Magellan Midstream Partners (MMP) has long operated in a conservative manner, prioritizing its ability to distribute cash to its unitholders. That hasn't changed, but the pandemic's impact on the energy sector has upended the model here, with the shift toward clean energy alternatives increasingly complicating this master limited partnership's (or MLP's) life. Here's why investors shouldn't take Magellan's distribution, which yields 8.5%, for granted.
The last time?
Magellan last increased its distribution in the fourth quarter of 2019, offering a roughly-3% year-over-year increase. Not huge, but in line with the long-term historical growth rate of inflation. The master limited partnership has a long history of being conservative, so there was no particular reason to worry here. And then the worldwide efforts to slow the spread of the coronavirus pandemic led to a massive drop in demand for oil, natural gas, and the products they get turned into.
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Magellan chose not to increase its distribution in 2020. Given the backdrop, that's a reasonable (and conservative) stance, and not out of line with what one might expect. However, as 2021 has gotten under way, Magellan has stated that it plans to hold the line of the distribution again this year. That suggests no increase, and an end to the partnership's two-decade-long streak of annual hikes. Because the last increase was in 2019, 2020's distribution was technically higher than 2019, so it counted as another year in the streak despite the fact that there were no increases. Without an increase in 2021, however, the distribution will have remained flat for two years running.
Often one of the first signs of trouble for a longtime dividend increaser is when the dividend stops growing. Magellan's stance here is also important, as it isn't providing any guidance beyond 2021. The expected distribution coverage ratio in 2021 is 1.17 times, but the partnership's long-term target is 1.2 times. At first glance it doesn't appear like that's much of a risk, but there's more here than meets the eye.
Reading between the lines
It isn't unusual for Magellan's coverage ratio to fall below that 1.2-times target, but there's a wrinkle to consider. Historically the company has grown through investments in new assets, often building from the ground up. The coverage ratio would drop in years of heavy spending, with the cash flow from new investments coming online bringing the number back up into a healthier range in subsequent years. But weak demand in 2020 and increasing headwinds to construction on the environmental front have left Magellan's capital spending budget at a tiny $75 million in 2021. It only has $15 million scheduled for 2022 at this point. For comparison, it spent $355 million in 2020, and nearly $1 billion in 2019.
Put simply, Magellan's growth looks like it has ground to halt, suggesting that the old playbook isn't working right now. That's a worrying sign. Add to this the fact that the partnership has a focus on oil and refined products (like gasoline), and there are long-term headwinds to consider as well. Automobiles are expensive to replace and have significant longevity, so it is unlikely that there's going to be an overnight change in demand once the pandemic hit passes. However, if Magellan can't find a way to grow its business, the distribution's safety is hardly assured.
That said, Magellan is conservatively managed. Its balance sheet, with a financial-debt-to-EBITDA ratio of about 3.9 times, is one of the strongest in the midstream space. Thus, the partnership's ability to survive really isn't at issue, and with ample room for leverage it could end up being a consolidator should acquisitions become a major industry growth engine. And yet, as leverage goes up, distribution safety goes down. So this isn't exactly a panacea either.
With a strong balance sheet and a market cap of around $11 billion, meanwhile, Magellan could also find that one of the industry's larger names makes an acquisition offer it can't refuse. If Magellan gets bought out, there's no telling what happens to unitholder distributions. If a deal were to materialize, there's likely to be a premium involved, so perhaps a quick payday would appease most investors. But income-oriented types may be left looking for a high-yield replacement.
No easy distribution answers
At the end of the day, Magellan's business is under pressure, but it isn't going away anytime soon. The bigger question is what happens to the partnership in the years ahead and what impact that will have on the distribution. Right now, there's virtually no growth spending built into management's plan. Holding the line on the distribution seems like the best one can expect. Beyond that, a lot will depend on the direction the industry takes, including on the consolidation front. But even there, it's hard to make a call, since Magellan is small enough that it could end up being bought out.
If you own this midstream partnership, you probably shouldn't be worrying about a distribution cut right now -- but you'll want to keep a close eye on what management says as the year progresses. Distribution risk is definitely higher than it has been in a very long time, and extremely conservative income investors may want to start looking at larger and more diversified alternatives in the sector -- even if that means accepting a lower, but more certain, yield.
