Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Magellan Midstream Partners is pricey -- which is actually a good thing.

The master limited partnership slightly missed analysts' consensus earnings estimate when it reported fourth-quarter results on Thursday.

But that is beside the point. The real numbers worth focusing on are 4.5 percent and 9.8 percent -- the dividend yields for Magellan and the Alerian MLP Index, respectively.

The Bottom Line
Magellan's dividend yield has risen, but it has become more expensive compared with the sector over the past year.
Source: Bloomberg

Ordinarily, investors would prefer owning something that pays a higher dividend yield. But this logic has been turned upside down in the MLP sector as of late. When more than half of the Alerian's 50 constituents sport yields of 10 percent or more, it's a sign that dividends have become generous to a fault, as I explained earlier here and  here. Kinder Morgan's massive dividend cut -- Kinder is no longer an MLP but has continued to pursue a very similar model -- and the resort to more unusual sources of funding by the likes of Plains All American Pipeline indicate the stress the industry has come under.

It isn't that the MLP model is broken altogether. Rather, with capital constrained and the oil downturn proving more lasting and damaging than previously expected, having a good balance sheet and realistic targets are a distinct advantage. Magellan's lower dividend yield may make it look expensive, but the flip side is an implicitly wider and cheaper set of funding options.

Magellan's latest results show that it isn't immune to the commodity cycle. Its core business is operating pipelines and terminals to store and ship refined products and crude oil, which are more exposed to decreases in volume than, say, interstate natural gas pipelines. Operating profit in the biggest business, refined products, fell by almost a fifth in the fourth quarter compared with figures in the period a year earlier because of losses on hedges and lower volumes as both drillers and refiners have pulled back.

So goes most of the midstream sector. What sets Magellan apart is its flexibility in coping with these swings.

The company finished 2015 with net debt of just 2.9 times Ebitda. It projects Ebitda to be $1.15 billion this year, a slight decrease from 2015. Take off about $250 million to cover interest costs and maintenance spending on its existing assets, and that leaves $900 million. This provides dividend coverage of 1.2 times despite the company's intention to raise the payout by 10 percent.

Now factor in expenditures for acquisitions and capital improvements, which is where the high cost of raising new debt or equity really complicates things for MLPs. Guidance of $650 million this year leaves an implied funding gap of roughly $500 million for Magellan. But even if it borrowed all of that, its net debt by the end of the year would rise to less than 3.4 times Ebitda.

In a recent report, Andrew DeVries of CreditSights stress-tested 13 midstream companies by cutting their 2016 consensus Ebitda estimates by 15 percent. Magellan was the only one projected to end the year with net debt of less than 4 times.

On a slightly different tack, take Magellan's own Ebitda guidance for 2016 but then hold it flat through 2017 -- a scenario no MLP is contemplating in public right now. Even then, Magellan could afford to bump its dividend by 8 percent -- as guided -- spend $500 million on expansion capex and still end 2017 with net debt of only 3.7 times Ebitda. Right now, 60 percent of the Alerian index's constituents have net debt of 4 times or more, based on their latest filing, according to data compiled by Bloomberg.

Magellan's assumptions provide further support. Besides projecting lower Ebitda this year, the company factors in an average oil price of $35 a barrel -- in line with the current futures curve and well below the $47.50 that Plains uses, for example.

None of this makes Magellan immune to further pain in the energy sector, but it is clearly better prepared for the current environment than many of its peers. Notice how its units have largely held their ground since the sector's big sell-off in September.

Pipe Splitter
Indexed price performance
Source: Bloomberg

Besides the comfort this should provide investors, it has an added bonus: acquisitions firepower.

With rivals seeking to sell assets to fund cash-flow shortfalls, Magellan should be able to capitalize. Besides its better balance sheet, Magellan's relatively cheap cost of equity, epitomized in that low dividend yield, gives it a better chance of a favorable reception if it decides to issue more units to fund a specific deal. As a bonus, it doesn't have the incentive distribution rights model that can drive up the cost of new equity for some MLP rivals with listed general partners.

It has become rarer over the past year to find MLPs that can credibly balance higher payouts and expansion spending with sound balance sheets. Rarer still are those that can potentially use their more "expensive" equity to actually take advantage of the downturn.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net