Magellan Gains Confidence in Distribution Coverage as Fuel Demand Tracks Expectations

Speaking at an investor conference on September 9, Magellan CEO Mike Mears reiterated his confidence in the firm's guidance and distribution safety.

Mr. Mears said demand for gasoline, diesel, and jet fuel tracked Magellan's projections in July and August, keeping the partnership on track to meet its full-year financial targets.

Magellan said gasoline demand was down around 8% to 10% in July, with some improvement towards the end of the month.

Management's guidance assumes gasoline demand remains down 6% for the rest of the year on average, reflecting a modest pace of recovery.

Meanwhile, jet fuel demand on Magellan's system plunged 40% in July and is at a level consistent with management's projections for the rest of the year.

Assuming these trends hold, Magellan expects a full-year distribution coverage ratio between 1.1x and 1.14x (i.e. a payout ratio near 90%). That would mark Magellan's lowest distribution coverage in at least a decade.

As we discussed in April, the firm's ability to return to management's target distribution of at least 1.2x (i.e. a payout ratio below 83%) hinges on the trajectory of fuel demand.

Transporting and storing refined petroleum products such as gasoline generates around 60% of Magellan's operating profits. (The other 40% consists of oil pipelines primarily backed by long-term take-or-pay commitments.)

This part of the business does not have protection in the form of minimum purchase commitments from customers; volumes are a function of demand for transportation fuel.

As a result, Magellan estimates that every 10% change in monthly gasoline demand impacts distributable cash flow by $4.5 million, or about 5%.

Assuming strict lockdown measures don't return, current trends in fuel demand seem unlikely to push Magellan's payout ratio above 100%.

Magellan also doesn't have any pressing financial obligations, taking some pressure off of its elevated payout ratio.

The partnership does not need to issue any equity to finish its $400 million of growth projects this year, and just $40 million of expansion capital spending is planned for 2021.

For context, Magellan this year expects to generate excess cash of $75 million to $125 million after paying distributions.

In other words, if management doesn't find more expansion projects for 2021, the firm's current level of cash flow generation remains sufficient to support all of the firm's spending commitments without requiring any debt or equity funding.

Cash flow does not need to be retained to improve Magellan's investment-grade balance sheet either. At the end of June, the firm's leverage ratio for compliance purposes was 3x, well below management's target maximum of 4x.

Magellan's next bond maturity is also not until 2025, reducing refinancing risk, and the firm has over $800 million of capacity available under its credit facility for additional flexibility.

As long as fuel demand keeps stabilizing and oil customers do not default on their contracts (close to 60% of revenue is from investment grade customers), Magellan's distribution remains deserving of its Safe Dividend Safety Score.

However, the market continues shunning nearly all MLPs, including Magellan. Some investors wonder what actions management might take if MLPs become an abandoned asset class, keeping Magellan's valuation depressed.

The most obvious options are to take the company private or convert to a corporation, which other MLPs are mulling over given the potential for tax consequences and distribution reductions.
 
For now, Magellan continues taking a wait-and-see approach, most recently on September 9 stating it was not evaluating the option of going private.

Unitholders need to be comfortable with this unique risk facing the MLP industry, as well as the long-term trajectory of demand for gasoline and oil. We will continue monitoring these issues as Magellan's business hopefully continues stabilizing in the near term.