Midstream master limited partnerships, or MLPs as they are more commonly known, are all the rage these days. Investor demand for these securities is sky-high, due mostly to their very high distribution yields.
Their huge yields are highly sought after by income investors, and many MLPs have seen their unit prices rally this year. One of them is Magellan Midstream Partners (NYSE:MMP), which has enjoyed a 35% rally year to date. This is far better performance than the S&P 500 Index, which is up a much more modest 12% in this time.
But while Magellan is a well-run business with strong cash flow, its units have rallied well ahead of the fundamentals. Its yield is now down well below the average yield of most others in its peer group, and its valuation is very high. As a result, investors should hold off on buying Magellan for now and wait for a decent pullback.
Magellan's growth comes at a steep price
These MLPs are involved in the storage, processing, and transportation of oil and gas through pipelines and terminals. They operate much like toll roads, and collect fees based on the volumes of oil and gas they handle. As such, they're not as vulnerable to volatile swings in commodity prices as upstream exploration and production companies. This structure allows for a much more stable and consistent stream of cash flows, which in turn allows midstream MLPs to pay very high distribution yields, often in excess of 5% annually. In addition, in exchange for a favorable tax classification, they are actually required to distribute the bulk of their cash flow through to investors.
This allows for steady growth and high yields across the asset class. For example, Magellan's third-quarter distributable cash flow jumped 30% year over year, due to the strength of its assets and growth in its refined products and crude oil businesses. Such strong growth is what has allowed Magellan to raise its distributions every quarter like clockwork. Its third-quarter distribution of $0.668 was 20% higher than the same distribution one year ago. Over the past five years, Magellan grew its distribution by 13% per year, compounded annually.
But Magellan's growth comes at a cost. Magellan's annualized $2.67 per unit distribution yields just 3%. The yield is so low because of Magellan's huge rally over the past year. Its yield is now well below the peer group. For instance, sector exchange-traded fund Alerian MLP ETF (NYSEMKT:AMLP), a basket of midstream MLPs, yields 6%. That's almost twice the yield that Magellan offers. A 3% yield is far below what investors should settle for from an energy MLP. This does not properly compensate investors for the risks involved, and there are indeed risks when buying these securities.
First and foremost is the potential rise in interest rates. MLPs like Magellan are highly capital-intensive businesses that need to raise capital frequently to fund maintenance and growth expenditures. As interest rates rise, so does the cost of capital when debt rolls over. This is already starting to happen, even though interest rates haven't increased much at all. Magellan's interest expense is expected to total $124 million this year, which would be an 8% increase versus the prior year. Once interest rates really start to rise significantly, this will weigh on future cash flow available for distributions.
Stay on the sidelines for now
Magellan management expects $865 million in distributable cash flow this year, and $3.81 in distributable cash flow per unit. At its current unit price, Magellan trades for 22 times this year's distributable cash flow. By comparison, this is significantly above where other midstream MLPs trade. Such a high valuation multiple and low distribution yield indicate that Magellan is mis-priced as an MLP. Even though Magellan is a growing company with a great management team, even great businesses can amount to poor investments if too high a price is paid.
There is certainly nothing wrong with Magellan from an operational standpoint. The reason why Fools should hold off from buying units at this price is its high valuation and low yield. It would be wise to let Magellan pull back somewhat, to closer to a 4% yield, before buying. That level would more appropriately compensate investors for the risks of buying an individual MLP.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Magellan Midstream Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.