As the S&P 500 Index nears a return to its record highs, in combination with near-zero interest rates, income investors are in a bind. Finding suitable levels of income has become harder with each passing month, as rates continue to plunge. The S&P 500 Index on average yields less than 2% right now, while fixed income securities like bonds aren’t much better. One solution to this conundrum is buying high-yield stocks.
While high dividend stocks are appealing for income investors on the surface, more thorough research needs to be done before buying, so the investor can make sure the dividend payout is sustainable. With this in mind, we believe Magellan Midstream Partners (NYSE:MMP) is a top high-yield stock with a 10% yield, a secure payout, and a long history of distribution growth.
Magellan Midstream Partners is a Master Limited Partnership, or MLP, operating in the midstream segment. This means it owns and operates transportation and storage assets, including pipelines and storage terminals. The midstream business model is relatively attractive in times of weak commodity prices, in comparison to exploration and production companies which are much more reliant on high oil and gas prices. Rather, Magellan makes money based on the volumes transported through its network of assets.
In this way, Magellan operates similarly to a toll road. While it is not completely immune from falling commodity prices, it is not nearly as exposed as upstream producers. In fact, the company estimates approximately 85% of its operating income is derived from fee-based activities which are not exposed to fluctuations in commodity pricing.
With that said, the pipeline industry has come under environmental pressure. The industry is far from a socially responsible investment, but it does provide a necessary service. Namely, the efficient transportation of oil and gas over land.
Magellan has two major operating segments–refined products, which represents 62% of annual operating income, and crude oil which generates the remaining 38%. The company’s refined products system consists of the longest refined petroleum products pipeline system in the United States, with 9800 miles of pipeline, 54 terminals and 46 million barrels of storage capacity. The size and scale of Magellan’s asset network is a major competitive advantage, as it provides for steady growth through tariff increases–the average tariff increased by 4.3% in 2019 and by 3.5% in July 2020. Furthermore, its crude oil segment includes 2,200 miles of crude oil pipelines, with 37 million barrels of total crude oil storage.
Diversified Business Pumping Out Cash Flow
The coronavirus pandemic has resulted in a steep decline in demand for fossil fuels, in conjunction with a severe economic downturn. This is a massive challenge for the energy sector more broadly, meaning investors need to be selective when it comes to buying energy stocks. Many high-profile energy stocks have cut their dividends in recent months to preserve cash, including Royal Dutch Shell (LON:RDSa) (RDS.B) and BP (NYSE:BP). But Magellan has maintained its hefty distribution, currently yielding near 10%, thanks to its resilient cash flow.
In the most recent quarter, Magellan’s distributable cash flow declined by 33%, reflecting suppressed demand for refined products caused by the coronavirus pandemic. However, the company has noted improved demand since then and kept guidance intact for distributable cash flow of $1.0 billion to $1.05 billion this year. Furthermore, Magellan intends to maintain its quarterly distribution constant for the rest of the year with a sufficient distribution coverage ratio of 1.10x to 1.14x.
Despite the coronavirus downturn, the company still has promising future growth catalysts in the form of new projects and expansions. For example, one of the most important projects in Magellan’s pipeline is an expansion of its Texas refined products pipeline system. Phase one of the project became operational in September 2019, adding 85,000 barrels per day of capacity. Phase two of the project began operations in July 2020 and added another 75,000 barrels per day.
Separately, Magellan’s Pasadena marine terminal joint venture represents a growth catalyst. This project is a 50-50 joint venture with Valero Energy (NYSE:VLO) that calls for 5 million barrels per day of storage capacity. Projects such as these will fuel Magellan’s future growth, providing cash flow that can be returned to investors through distributions.
Distribution Appears Secure
Another key factor that investors should analyze before buying an MLP is its balance sheet. Many MLPs are highly leveraged with too much debt. In a recession, these conditions can become disastrous, which is why so many MLPs have cut or eliminated their distributions in recent years. But Magellan is one of a select few MLPs that has maintained (and even raised) its distribution over the past several years, thanks in large part to its conservative financial position.
Magellan has a high investment-grade credit rating of BBB+, which is rare for an MLP. It also has a leverage ratio (generally defined as net-debt-to-adjusted-EBITDA) of 3.0x, which is below the level of many other MLPs. It also has comfortable short-term liquidity with a $1 billion credit facility, while the company does not face any significant debt maturities until 2025.
The company is also appealing because it has no incentive distribution rights, otherwise known as IDRs. And, the stock has an impressive distribution history. Before the coronavirus pandemic, Magellan had increased its distribution for 70 consecutive quarters. Magellan froze its distribution increases with the onset of the coronavirus pandemic, but the distribution appears secure, with room for future raises once the pandemic ends.
When it comes to the energy sector, investors need to tread carefully. The steep downturn in commodity prices and demand for oil and gas has been a major challenge for the energy sector this year. Master Limited Partnerships are no exception, and investors should not be swayed only by their high yields. But in the case of Magellan Midstream Partners, the distribution is not only attractive at nearly 10%, but also appears secure due to the company’s quality assets and strong balance sheet. As a result, we view Magellan as an attractive high-yield pick for income investors.