Magellan Midstream and Enterprise Products: Keep Calm and Collect High Returns (NYSE: EPD)

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Stocks are crashing right now as historically high valuation multiples, soaring interest rates, runaway inflation and rising expectations of a recession combine to form the perfect storm for public markets. The S&P 500 (SPY) is firmly in bearish territory, as are REITs (VNQ). The Nasdaq (QQQ) is hit even harder and high-growth technology (ARKK) was completely slaughtered:

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Even highly defensive utilities (XLUs) are hurt as rising interest rates erode the value of what were generally considered bond proxies. Only the midstream (AMLP) sector has managed to keep its head above water so far this year thanks to a combination of deals at historically low valuations, improving sector balance sheets and cash flow generation. available cash, and a spike in energy prices:

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However, despite these positive impacts, over the past ten days the midstream has taken it on the chin, even sending out blue chips with impressive multi-decade distribution growth streaks like Magellan Midstream (NYSE: MMP) and enterprise products (NYSE:EPD) free fall :

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In this article, we’ll discuss both of these companies and explain why we think the downside is the perfect time to add these low-risk high yields to your portfolio to help you keep your cool and collect dividends.

MMP: High Yield Inflation Hedge

MMP is without a doubt one of the most annoying midstream companies out there today. Its growth capital expenditure budget is certainly one of the lowest compared to its current size, despite being one of the smallest investment-grade mid-market companies with a market capitalization of $10.73 billion. . Management said in its latest earnings call:

We now expect to spend approximately $70 million in 2022 in expansion capital

However, this amount could increase a bit if they identify additional growth projects. Either way, growth spending is expected to be less than 1% of its current market cap and possibly even less than 0.5% of its enterprise value this year. No matter how you look at it, this is a very small capital budget.

However, management’s long-term returns on invested capital have been the best in the industry, so its ultra-conservative approach to investing in new projects is commendable, and it has proven to be very generous in returning excess cash flow to unitholders.

At a recent investor conference, management said it plans to continue this practice in the future:

We have increased our annual dividend for 20 consecutive years. Obviously some years are higher and some years we are lower. We have already announced that we expect distribution growth, similar in 2022 to what we did in 2021. We have not announced when or how this will work. But to give investors an idea, it’s probably going to look about the same.

On top of that, MMP has been quite aggressive with unit buybacks and said that in 2022 they expect any excess cash flow to be directed to additional unit buybacks.

Meanwhile, the business model is quite defensive, with the vast majority of cash flow (85%+) coming from priced contracts that are resilient to commodity prices. This means that MMP’s cash profile is remarkably stable. Combined with a rock-solid balance sheet that boasts an industry-leading BBB+ credit rating, MMP offers investors a low risk profile.

MMP is also remarkably well positioned to take advantage of inflation and even recently received analyst upgrades from JP Morgan (JPM) and Goldman Sachs (GS) for this very reason.

MMP is benefiting from tariff changes linked to the Producer Price Index as well as market factors, resulting in an expected average tariff increase of 6% next month. GS analyst Michael Lapides also pointed out that with the PPI at around 14% year-to-date, the MMP is also on course to see a major price hike in 2023.

Management also highlighted at the aforementioned recent investor conference the enduring competitive advantage it has in the refined products industry that should enable it to benefit from strong tariff increases for years to come:

There is a big difference between the crude oil industry and the refined products industry. I think we have to start there to understand why our refined products business is different, and in some cases has more franchise value, overall. And it’s on the refined side, it’s a demand pull system. If you look at the areas of the country that we serve from Houston, as far north as Fargo, North Dakota, technically as far west as El Paso, and pretty much everywhere in between, if you look at those areas of the country, the demand for refined products is the demand for refined products.

So whether it’s 1 million barrels, 8 million barrels, whatever the demand, we’re the cheapest, safest, and cleanest way to get those fuels to those markets. So that demand creates stability or franchise value for our refined products business. Combine that with the fact that we are connected to 50% of the refining capacity in the United States. So if you take this stretch of supply that we have and look at this network of pipelines that we have, it’s not a point-A-to-point-B pipeline. You can put barrels in Tulsa, Oklahoma, and 20 minutes later, out of the barrels in Florida, and Fargo, North Dakota…

When you put it all together it really means that it has a lot of value for our customers in terms of optionality what they can do with our system… A competitor may come along and want to build a pipe from point A to point B. But if he really wants to try to reduce the volume of our system, he must be able to get to point A, B, C, D, E and F, because that’s what we offer. We offer it all, not just from point A to point B.

So it’s just a higher barrier to entry that we have. We are much more differentiated. We think that differentiator basically translates to the ability, as long as we provide value to our customers, to increase prices because or if product declines occur over time, which I don’t know if one of you all saw analyst day, we think the future is a lot longer than most people probably realize. But if that happens and we go into that secular mode of decline, we don’t think it turns into a knife fight, because we’re differentiated. As long as we remain focused on value for our customers, which I believe is still quite high, we should be able to increase our prices with inflation and compensate for this drop in volume so that our financial performance is really stable, and potentially getting better.

All of this, combined with the 8.8% payout yield which is well covered by distributable cash flow, provides a compelling combination of a very attractive current yield, a conservative business model and balance sheet and strong protection against inflation.

EPD: the complete package

EPD – similar to MMP – has an excellent BBB+ credit rating which jointly leads the sector with Enbridge (ENB). It also has an excellent track record of growing the cast which will soon place it in the Aristocrat category.

However, while it certainly benefits from a similar low-risk balance sheet profile with MMP, EPD still has more to offer investors.

First and foremost, its business model is more diversified, with significant exposure to NGLs and natural gas and even early exploration of renewable fuels and other renewable energy technologies. On top of that, EPD retains considerably more cash flow than MMP and has more opportunities to deploy it into opportunistic growth projects. As a result, its current payout yield is around 90 basis points (7.9%) lower and it redeems far fewer units as a percentage of its market capitalization than MMP.

However, it recently acquired Navitas Midstream in a deal that is expected to be cash flow per unit accretive and deliver double-digit returns on invested capital, with considerable follow-on growth investment opportunities. Additionally, EPD just announced a new $5 billion steam cracker in Texas which is also expected to fuel further growth.

On top of that, the EPD is also fairly cheaply priced and has proven to be extremely effective in weathering economic storms. Its EV/EBITDA multiple is currently only 9.29x, well below its five-year average of 11.01x. Combined with its expected growth rate of 4.7% in distributable cash flow per unit through 2026 and a current distribution yield of 7.9%, EPD offers investors attractive value. Meanwhile, its EBITDA fell just 0.8% in 2020, reflecting how resilient its business model is to extremely adverse macro conditions.

Key takeaway for investors

Both MMP and EPD provide investors with extremely high current income that is very immune to the threat of a cut. As a result, income investors looking for a lucrative source of reliable income would be hard-pressed to find better investments today.

Moreover, both investments are good hedges against inflation – especially MMP – and EPD offers investors strong growth potential via investments in attractive growth projects. EPD – with its more diversified business model – is also better positioned to weather economic storms and the threats of energy transition to industry. Overall, we favor EPD here, but think there’s definitely a place for MMP in a conservative income-focused investor’s portfolio as well.

About Terry Simmons

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