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The website explains how distributable cash flow (DCF) is defined and why it is important to analyze it and derive a sustainable measure of DCF. Results reported by master limited partnerships (MLPs) are analyzed. comparisons of reported DCF to sustainable DCF are generated, and various coverage ratios and reports analyzing performance are generated. Simplified sources and uses of funds statements are presented to focus readers' attention on key cash flow items. The website also features general articles about MLPs and about other topics of interest to yield-focused investors.

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What to look for in Magellan Midstream Partners' results for 2Q17

 

 

 

Author: Ron Hiram

Published: July 24, 2017

Summary:

  • The 19% increase in 1Q17 operating margin vs. 1Q16 primarily reflects the impact of mark-to-market gains on futures contracts in the recent quarter vs. losses in the prior year’s quarter.
  • Overall, despite the high level of product margin in 1Q17, MMP’s reliance on commodity-related activities has been diminishing when measured on a trailing twelve months basis.
  • Look not only to what extent operating income increases in 2Q17, but also how much of that increase is driven by commodity-related activities.
  • 2Q17 results will also indicate whether distribution growth continues to outpace DCF growth, as was the case in 7 of the last 9 quarters, leading to lower coverage ratios.
  • Excess cash generated declined in the TTM periods ending 3/31/17, 12/31/16, 9/30/16, 6/30/16 and 3/31/16. Look to see whether this trend continues for the TTM ending 6/30/17.

Based on some of the key facts and trends identified in reviewing 1Q17 results reported by Magellan Midstream Partners L.P. (MMP), this article points to several variables investors should monitor when MMP reports results for 2Q17

MMP is engaged in the transportation, storage and distribution of refined petroleum products and crude oil. Its 3 operating segments are:

  1. 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;
  2. 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
  3. 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.

Comparing 1Q17 to 1Q16, Refined Products’ total volume shipped increased by 6.3%, revenue per barrel shipped increased by 3.2%, and operating margin increased by 29.2% ($50.2 million). The segment reported a 7.6% increase in revenue while operating expenses increased by 9%. The impact of mark-to-market gains on futures contracts in the recent quarter vs. losses in the prior year’s quarter accounts for $41.7 million of the $50.2 million increase in the segment’s operating margin. The futures contracts are used to hedge exposure to commodity price fluctuations.

Comparing 1Q17 to 1Q16, the Crude Oil segment’s operating margin was flat on a 5.5% decline in volumes (mainly on MMP’s Houston distribution system) and a 6.6% increase in revenue per barrel (resulting from deficiency revenue for volume committed but not moved). Higher storage revenue due to additional leased storage contracts also contributed to results in 1Q17.

The $6.6 million increase in operating margin at the Marine segment in 1Q17 vs. 1Q16 reflected placing new storage tanks into service and lower operating expenses due to favorable product overages in the current period.

Of the $359 million total operating margin in 1Q17, $73 million is derived from product margin, i.e., commodity-related activities. The margin earned from these activities fluctuates with changes in petroleum prices. The commodity-related activities primarily consist of butane blending and transmix fractionation. Butane blending involves purchasing butane and blending it into gasoline, which creates additional gasoline available for sale. The blending margin is a function of the differential between the cost of butane and the price of gasoline. MMP also operates three fractionators that separate transmix, an unusable mixture of various refined products, into its original components. In addition to fractionating the transmix that results from its pipeline operations, MMP also purchases and fractionates transmix from third parties and sell the resulting separated refined products. MMP utilizes futures contracts to hedge against changes in the price of petroleum products it expects to sell in future periods, as well as to hedge against changes in the price of butane it expects to purchase.

Commodity-related activities can cause large fluctuations in total operating margins. Examples of that can be seen in Table 1 (e.g., total operating margin increased 19% in 1Q17 and dropped 14% in 3Q16). The fluctuations reflect changes in unrealized profits or losses on hedged positions. Overall, despite the high level of product margin in 1Q17, MMP’s reliance on commodity-related activities has been diminishing when measured on a trailing twelve months (“TTM”) basis, 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.

Investors should monitor not only to what extent operating income increases in 2Q17, but also how much of that is driven by commodity-related activities.

Earnings before interest, depreciation & amortization and income taxes (EBITDA) increased by $29 million, while Adjusted EBITDA increased by $18 million in 1Q17 vs. 1Q16:

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. Adjusted EBITDA in 1Q16 excluded a $26.9 million noncash gain related to the transfer of MMP’s 50% interest in Osage Pipe Line Company and a $21.7 million derivative loss on commodity transactions. In 1Q17, it excluded a $20 million derivative gain 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.

2Q17 results will indicate whether distribution growth continues to outpace DCF growth, comparing each quarter to its prior year counterpart. As shown in Table 4, this was the case in 7 of the last 9 quarters, resulting in lower coverage ratios. Hopefully it will be the other way round, as was the case in 1Q17 and 3Q15. 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.

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.

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 $174 million and $304 million in the TTM ended 3/31/17 and 3/31/16, respectively. MMP is not using cash raised from issuance of debt or equity to fund distributions. On the contrary, the excess cash MMP generates is a significant source of capital and enables it to reduce reliance on the issuance of additional partnership units or debt to fund growth projects. However, as shown in Table 7, the excess cash generated in the latest TTM period ending 3/31/17 declined vs. the corresponding prior year period. This has also been he case for the TTM periods ending 12/31/16, 9/30/16, 6/30/16 and 3/31/16.

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 sole customer for the $300 million splitter, an affiliate of Trafigura, AG, had given notice to terminate its contract. Magellan believed this notice to be in breach of the agreement and initiated legal action. On March 21, 2017, MMP announced a new fee-based, take-or-pay agreement with Trafigura Trading LLC for the exclusive use of the condensate splitter. “Based on the new agreement, Magellan expects to begin commercial operation of the splitter during late second quarter” (MMP Form 8-K 3/21/17).

A comparison of 2017 guidance to 2016 actual results 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 similar goals for 2018: increasing distributions by 8% while maintaining 1.2x coverage.

The initial guidance for 2017 was provided on February 2 and “assumed no revenue generated from the splitter, commodity margins have recently contracted, resulting in management’s reaffirmed guidance” (MMP press release dated 3/21/17). The current guidance for 2017 (issued May 3) remains unchanged despite settlement of the dispute with Trafigura.

Expansion capital spending totaled a record $736 million in 2016 and MMP expects to spend $600 million in 2017 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. Contributions from new projects commencing operations could also help reverse the negative trend discussed in the context of Table 4.

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. It therefore filed a shelf registration statement for the issuance units totaling up to $750 million as part of an at-the-market equity program. No units have yet been issued pursuant to this filing.

MMP has a disciplined management team, an outstanding track record, superior distribution coverage, lower leverage, an ability to generate significant excess cash from operations, and good growth prospects. I continue to hold MMP.

 

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