Author: Ron Hiram
Published: February 22, 2017
- Crude Oil segment operating margins increased 17.9% in 4Q16; higher average rates, in part resulting from deficiency revenues, more than offset lower shipment volumes. Storage revenues also increased.
- Refined Products’ operating margin decreased 6.4 due to mark-to-market losses on hedges; but total volume shipped increased 5.9% and revenue per barrel shipped increased 2.2%.
- Distribution coverage ratios remain strong and well above industry peers, whether calculated on a sustainable basis or as reported.
- The condensate splitter dispute reflects a rare management stumble, but is not of a magnitude that affects MMP’s ability to achieve 8% distribution growth in 2017-2018 with solid coverage.
- Distribution growth has been outpacing DCF growth; consequently, coverage ratios, while still very robust, are declining.
This article analyses some of the key facts and trends revealed by 4Q16 results reported by Magellan Midstream Partners L.P. (MMP).
MMP is engaged in the transportation, storage and distribution of refined petroleum products and crude oil. Its 3 operating segments are:
- Refined Products: this segment primarily transports gasoline and diesel fuels and includes a 9,700-mile refined products pipeline system with 42 million barrels of storage capacity at 53 connected terminals, 27 independent terminals not connected to MMP’s pipeline system, as well as a 1,100-mile ammonia pipeline system;
- Crude Oil: this segment is comprised of ~2,200 miles of crude oil pipelines and storage facilities with an aggregate storage capacity of approximately 26 million barrels (of which 16 million are used for leased storage); and
- Marine Storage: this segment consists of 5 marine terminals located along coastal waterways with an aggregate storage capacity of ~26 million barrels, plus ~1 million barrels of storage jointly owned through the Texas Frontera, LLC joint venture.
Operating margin is a one of the key non-GAAP metrics used by management to evaluate performance of its business segments. It includes revenue from affiliates and external customers, operating expenses, cost of product sales and earnings of non-controlled entities. But unlike operating profit, it excludes depreciation and amortization expenses and general and administrative expenses.
The bulk of MMP’s operating margin is fee-based (i.e., derived from fees, tariffs, contractual commitments). Operating margin generated by MMP’s commodity-related activities (mostly within the Refined Products segment) includes butane blending and fractionation. It exhibits far more volatile swings on a quarter-to-quarter basis.
Operating margin by segment for recent quarters is presented in Table 1:
Table 1: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
The 17.9% increase in the Crude Oil segment’s operating margins in 4Q16 vs. 4Q15 reflects higher average rates, in part resulting from deficiency revenue for volume committed but not moved. This more than offset lower shipment volumes. Higher storage revenue also contributed to the increase. Overall, deficiency revenues remain small and not material.
Although total volume shipped increased by 5.9% and revenue per barrel shipped increased by 2.2%, Refined Products’ operating margin decreased by 6.4% in 4Q16 vs. 4Q15. This reflects the impact of mark-to-market losses on futures contracts in the recent quarter vs. gains in the prior year’s quarter. These contracts are used to hedge exposure to commodity price fluctuations.
Commodity-related activities can cause large fluctuations in total operating margins, as evidenced by the 14% drop in 3Q16 total operating margin seen in Table 1. The drop reflects a move from unrealized profits on hedged positions in 3Q15 to an unrealized loss on hedged positions in 3Q16. The good news is that fee-based gross margin has been increasing for at least 12 consecutive quarters, while MMP’s reliance on commodity-related activities has been diminishing, as shown in Table 2:
Table 2: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Fee-based activities generated 92% of total operating margin in the trailing twelve months (“TTM”) ending 12/31/16, up from 86% in 2015 and 78% in 2014.
Earnings before interest, depreciation & amortization and income taxes (EBITDA) increased by $18 million, while Adjusted EBITDA increased by $24 million in 4Q16 vs. 4Q15:
Table 3: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Adjusted EBITDA is another key non-GAAP metric used by management to evaluate its financial results. The adjustments include adding back equity based compensation and impairment charges, deducting derivative gains, and adding back derivative losses on commodity transactions.
Distributable Cash Flow (“DCF”) is one of the primary measures typically used by a midstream energy master limited partnership (“MLP”) to evaluate its operating results. Because there is no standard definition of DCF, each MLP can derive this metric as it sees fit: and because the definitions used indeed vary considerably, it is exceedingly difficult to compare across entities using this metric. Additionally, because the DCF definitions are usually complex, and because some of the items they typically include are non-sustainable, it is important (albeit quite difficult) to qualitatively assess DCF numbers reported by MLPs.
MMP derives DCF as follows:
Table 4: Figures in $ Millions (except ratios and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Comparing each quarter to its prior year counterpart, we see that coverage ratios, while still very robust, are declining vs. their prior year counterparts. This is because for 8 of the 9 quarters shown in Table 4, distribution growth has outpaced DCF growth. Still, MMP’s levels of distribution coverage are higher in comparison to other MLPs.
The generic reasons why DCF as reported by an MLP may differ from what I call sustainable DCF are reviewed in an article titled “Estimating sustainable DCF-why and how”. A comparison between the two is presented in Table 5. It indicates no material differences between reported and sustainable DCF for the TTM periods under review:
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
In calculating sustainable DCF, I ignore cash generated by liquidating working capital (because I do not consider it a sustainable source) but deduct funds consumed by working capital (because cash consumed is not available to be distributed). In contrast, reported DCF always excludes working capital changes, whether positive or negative. My sustainable DCF calculation also excludes cash flows related to risk management and “other” activities.
Fluctuations in working capital account and risk management activities are the major reason for the discrepancy shown in Table 5 between reported and sustainable DCF for the TTM and quarter ended 12/31/16.
Table 6 compares coverage ratios based on reported and sustainable DCF:
Table 6: Figures in $ Millions, except ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
When coverage is measured in terms of distributions declared (rather than actually made), coverage in 2016 stood at 1.25x vs. 1.38x in 2015.
Table 7 presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:
Table 7: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Net cash from operations, less maintenance capital expenditures, exceeded distributions by $121million in the TTM ended 12/31/16. MMP is not using cash raised from issuance of debt to fund distributions. On the contrary, the excess cash generated constitutes a significant source of capital for MMP and enables it to reduce reliance on the issuance of additional partnership units or debt to fund growth projects. The importance of this is magnified in the current environment that imposes a much higher cost of capital on all midstream energy MLPs. However, a comparison of 4Q16 and 2016 shows less excess cash was generated vs. he corresponding prior year periods
Management provided initial guidance for 2017. It is based on an average crude oil price of approximately $55 per barrel for the year, assumes no significant incremental throughput volumes on the system, excludes mark-to-market adjustments on commodity-related activities, and assumes MMP’s 50,000 barrel per day condensate splitter at Corpus Christi, Texas, will generate no revenues.
The $300 million splitter “is mechanically complete, and the unit has been operating and generating products meeting market specifications. However, the sole customer, an affiliate of Trafigura, AG, has recently given notice to terminate its contract. Magellan believes this notice is in breach of the agreement and has initiated legal action” (MMP Form 8-K, 2/2/17). However, in a prior filing (MMP From 10-Q, 3/11/16) MMP acknowledged delays in the construction and commissioning of the facility, noting they “could result in the termination by our customer of its commitment to us as early as first quarter 2017, which could materially reduce the revenues and profits we expect to realize from the project and the value of the splitter”.
A comparison of 2017 guidance to 2016 actual results, as well as the initial guidance for 2016 provided a year ago, is detailed in Table 8.
Table 8: Figures in $ Millions (except ratios and number of units). Source: company 10-Q, 10-K, 8-K filings and author estimates.
DCF coverage for 2017 is projected at 1.2x after factoring in 8% growth in distributions. Management also set an initial goal of increasing distributions by 10% in 2018 with coverage ranging from 1.1x to 1.2x.
Expansion capital spending totaled a record $736 million in 2016 (the $742 million in 2015 included acquisitions) and MMP expects to spend $550 million in 201 and $350 million 2018 to complete projects currently under construction. MMP expects its investments in expansion projects to average 7-9x EBITDA (12.5% unlevered return on capital at the midpoint). Based on that, EBITDA would increase by ~$112 million once projects currently under construction are placed into service. This is a 9.3% increase from the 2016 EBITDA level. The 8% distribution growth guidance for 2017 and 2018 therefore seems achievable.
But, as noted in the discussion of Table 4, in 9 of the last 11 quarters, distribution growth has been outpaced DCF growth when both are measured on a per unit basis and each quarter is compared to the corresponding prior-year quarter. This gap may threaten future coverage ratios unless the trend is reversed through improved operational results from existing assets and through contributions from additional projects that meet or exceed their EBITDA multiple projections.
MMP distinguishes itself from other MLPs by its superior distribution coverage and much lower leverage ratio (currently 3.4x Adjusted EBITDA on a TTM basis). It also has a track record of generating net income per unit that exceeds distributions per unit:
Table 9: Figures in $ per unit. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Further, in over four years (since 3Q 2010), MMP has not issued additional partnership units (excluding units issued in connection with compensation arrangements). This too is a significant accomplishment and rare achievement in the MLP universe. In its conference call discussing 3Q16 results, management indicated it may not be able to continue funding growth projects using only debt and internally generated excess funds. Following that, MMP filed a shelf registration statement for the issuance units totaling up to $750 million as part of an at-the-market equity program. In the conference call discussing 4Q16 results, management noted there is “not an immediate need to issue equity… until material new organic projects are announced”. But the filing provides a tool to help effectively manage MMP’s leverage ratio and to take advantage of opportunities to grow the business.
MMP has a disciplined management, outstanding track record, superior distribution coverage, lower leverage, an ability to generate significant excess cash from operations, and good growth prospects. For all these reasons, I continue to hold it.