I recently launched my new Deep Value Dividend Growth Portfolio or DVDGP. This represents the culmination of 23 years of investing experience and over four years of professional knowledge I've gleaned while being an analyst/investment writer. The portfolio is designed to answer the burning question that readers have been asking me in recent weeks and months, "where is the best place to put new money today?".
The portfolio is specifically tailored to all investors, both conservative retirees, as well as younger investors still building their long-term wealth. DVDGP is 100% focused on low-risk sleep well at night or SWAN stocks, that are designed to provide safe and growing income, no matter what the economy, industry conditions, or interest rates are doing.
Our strategy is focused on three time-tested and proven investing strategies:
I literally couldn't have launched this portfolio at a better time, because we just experienced the worst correction since the Great Recession. As a result, almost all sectors are undervalued, and even Grade A blue chips are trading at some of their best valuations in years.
That includes blue chip MLPs like Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), and MPLX (MPLX), all of which I recently bought for the DVDGP. Let's take a look at why Wall Street has once again turned hyper-bearish on these great high-yield income growth stocks, and why the market is almost certainly wrong.
More importantly, learn why these three blue chips in particular, from today's great valuations (16% to 33% discount to fair value), are likely to deliver not just generous, safe and growing income in the coming years, but likely also market-beating total returns of about 15% to 17%. Or to put another way, thanks to the market's latest irrational short-term freakout, all three of these high-yield blue chips are very strong buys for your diversified income growth portfolio.
There are three reasons a stock can crash, general market weakness, an industry bear market, and fundamental problems at the company/MLP level.
Thanks to a perfect storm of negative factors including political chaos in DC, fears over the Fed hiking us into a recession, and trade uncertainties, the overall stock market just had one of its weakest quarters ever.
As a result, almost every sector went from historically overvalued a year ago, to historically undervalued. Energy, in particular, has been the hardest hit in recent weeks and become the most undervalued source of quality bargain hunting you can find today.
That's thanks to worries over a global oil glut in 2019 causing one of the fastest oil crashes in decades, a shocking 45% decline in just two months.
This has been especially rough on MLPs because the last oil crash (mid-2014 to early 2016), was brutal enough to kick off an industry bear market that's now in its fifth year.
Part of the reason that MLP investors have been fleeing in droves is fear that a severe and prolonged oil crash will bankrupt many oil & gas producers, and thus potentially put at risk the long-term, volume committed contracts that underpin MLP distributable cash flow or DCF. DCF is the industry equivalent of free cash flow and what pays the distributions.
In recent weeks the combination of crashing oil prices and overall financial market fear has caused junk bond spreads (junk bond yield minus yield on investment-grade debt) to soar. If that were to continue then weaker oil & gas producers might indeed face much higher debt refinancing costs in the future which might cause some to go bankrupt.
But while these broader market and industry conditions are based on real risks (fears of slowing growth and energy industry bankruptcies), as usual, Wall Street is letting worries over worst-case scenarios cause it to irrationally price an industry that's not dying, but thriving.
First, let's address the broader market fear of slowing US economic growth, which is largely a function of Fed tightening and trade uncertainties.
It's certainly true that 2018's 3% GDP growth (as high as 4.2% in Q2 2018) isn't going to be repeated. However, it's important to remember that most economists expected slower but still positive growth in 2019 and 2020.
For 2019 estimates range from 2.3% (The Fed) to 2.7% (NYSE:IMF), with FactSet Research right in the middle at 2.5%. That's even with growth slowing by Q4 to just 2%, and even further into 2020 (1.8% growth forecast for that year).
That's expected to drive slower but still above historically average earnings growth in 2019 (as well as 2020). Note that in recent weeks earnings estimates, that have been steadily falling due to growth concerns (from 10.5% to 7.8%) have stabilized around 8% for the entire S&P 500.
But what about energy? Won't crashing oil prices cause energy earnings to be decimated and thus imperil MLP contracts, cash flows, and distributions?
In fact, even with US oil prices stabilizing around $45 (down from $76 in early October) energy earnings are expected to grow almost 10%, making it the third fastest growing sector next year.
What about the risk that oil prices crash even further and thus prove those estimates wrong? Well, for that to be true two things would have to happen.
First, the expected oil glut in 2019 would have to worsen, due to weaker oil demand growth caused by a global recession.
However, no major global economic forecasts call for a global recession in 2019 or 2020. In fact, no large economy is expected to fall into a recession, just suffer slower growth due to the risk factors that we're currently facing.
That's why the International Energy Administration's latest 2019 oil demand growth forecast is unchanged at 1.4 million bpd. And as for the oil glut, we can't forget that this was largely triggered by a temporary event, notably OPEC boosting oil production by 1.2 million bpd ahead of Iranian oil sanctions that US waivers have made unnecessary (those expire in four months).
OPEC and Russia recently agreed to cut production by 1.2 million in January to undo those previous increases. That is combining with Alberta's government ordering Canadian oil companies to cut production by 8.7% (over 300,000 bpd), to stabilize oil prices, which are no longer crashing. This highlights one of the biggest differences between this oil crash and the last one.
In 2015 OPEC tried to crash oil prices on purpose to bankrupt US shale. At the time US oil producers were highly leveraged, and breakeven prices were about $85 for most shale formations. The oil crash (which bankrupted about 100 companies out of 3,000 shale producers) caused the entire industry to deleverage rapidly and focus on growing production purely out of operating cash flow.
Thanks to much lower interest costs and new fracking 3.0 technology, breakeven prices have now plummetted to $30 or below for most major shale formations. OPEC now realizes it can't win a protracted price war with US shale thanks to the much stronger financial fundamentals of the industry.
That's why not just did OPEC + Russia agree to cut production, but Saudia Arabia has agreed to cut its production by an extra 20%, and the UAE oil minister recently told Reuters that OPEC is willing to call a special meeting to deepen and extend cuts even further.
“What if the 1.2 million barrels of cuts are not enough? I am telling you that if it is not, we will meet and see what is enough and we will do it...The plan (to cut oil production) is well studied but if it does not work, we always have the power in OPEC to call for an extraordinary meeting. If we are required to extend for (another) six months, we will do it... I can assure you an extension will not be a problem.” - Suhail al-Mazrouei, UAE oil minister
Essentially OPEC is now willing to do whatever it takes to stabilize oil prices because after the last oil crash devastated its member's financial reserves, most country's in the group simply can't afford to balance their budgets at low oil prices.
That stabilization via cuts is why the US EIA is forecast US oil to average $54 in 2019 and Brent to average $61. Note that most US oil producers (MLP customers) have now budgeted continued production growth at $40 to $50 US oil prices.
Combine much stronger US oil companies, with lower breakeven prices, and a modest recovery in crude expected this year, and analyst forecasts for continued earnings growth for oil stocks are indeed reasonable.
And let's not forget that MLPs are NOT a commodity sensitive industry, but a volume focused one. And when you combine all those facts with the strong individual business models and balance sheets of these three MLP blue chips, the result is a fantastic long-term buying opportunity.
IPOing in 1998 Enterprise is one of America's oldest and largest MLPs, with a massive and vertically integrated system of midstream assets that services nearly every major oil & gas formation, and every part of the fossil fuel value chain.
That system is the result of over $64 billion of well managed and executed capex and acquisitions over the past two decades. Enterprise's wide moat asset base is so essential to the energy industry that typically oil or gas will pass through at least six of the company's assets between being extracted and making its way to the end consumer.
And thanks to massive continued growth in US oil & gas (and natural gas liquid or NGL production) Enterprise's actual financial results in 2018 are setting new records.
That includes retained DCF (DCF minus distributions) of over $1.5 billion that puts the MLP on track to retain about $2.1 billion in 2018 to reinvest in future growth. And let's not forget that due to almost all its cash flow being under long-term (15+ for its NGL assets), and usually volume committed contracts (100% for NGL assets) EPD's cash flow has been extremely stable, even in the face of the second worst oil crash in over 50 years (76% plunge in crude between 2014-2016).
That has resulted in the MLP delivering remarkable distribution growth, including 20 consecutive years of increases and payout hikes for 57 consecutive quarters.
Now it's true that recently EPD has pulled back on the rate of its distribution hikes, to just 2.4%. That's part of management's long-term plan to de-risk the business model even further by switching to a self-funding business model.
That means that going forward Enterprise wants to retain enough cash flow to replace all of the equity issuances (other than DRIP) it has used to fund organic growth in the past. Or to put another way, Enterprise wants it enormous long-term growth potential to be 100% independent of its stock price. In the first 9 months of 2018 EPD funded 49% of its capex with retained cash flow, 37% with debt and 14% with its DRIP. The MLP's official target is to fund 50% of growth with retained cash flow and in Q3 it officially hit and surpassed that target.
Management (which owns 32% of its units), says that in 2020 the MLP will re-evaluate its capital allocation plans to either accelerate distribution growth, start repurchasing its undervalued units, or both.
As part of that plan (which is now about 1 year ahead of schedule) the company has focused on strengthening its balance sheet, already one of the safest in the industry, even further.
In 2016 when the average MLP had a leverage ratio of about 6.5, EPD's peaked at 4.4. Credit rating agencies and bond investors consider 5.0 or below a safe level, given the stable and commodity insensitive nature of MLP cash flow. Enterprise's leverage ratio recently hit 3.6 and management's new long-term goal is just 3.5. That's likely good enough to earn it an upgrade to an A- credit rating, which would be an industry first.
Further cementing its long-term payout safety is the fact that Enterprise has been refinancing its debt in recent years (in a rising rate environment) to focus on locking in low-interest rates for decades. That's why 99% of its debt is now fixed, and half of its bonds are for 30 years. Yet despite an average bond duration of almost 20 years (longer than the duration of its contracts), the MLP's average cost of debt is just 4.7% or roughly 1/3rd its returns on invested capital.
And thanks to one of the best management teams in the industry has been able to consistently grow while retaining stable and high ROIC over time. In fact, over the past decade, the MLP's unlevered ROIC has averaged 12%, among the highest in the industry.
That's what keeps its DCF/unit growth so steadily and makes it a high-yield income growth investor's dream stock.
Today Enterprise is working on over $6 billion in high margin growth projects. 82% of that is focused on NGLs and petrochemicals which are booming thanks to America's low-cost advantage courtesy of cheap natural gas fueling strong export demand to emerging markets. And the MLP continues to add new projects to its backlog, which is why CEO Jim Teague (over 40 years of industry experience) announced during the last conference call that Enterprise is doubling down on NGLs even more.
We announced two additional growth projects this morning...Including these projects, we currently have $6.6 billion of growth capital projects under construction that are scheduled to be completed and begin generating new sources of cash flow between now and 2020." - Jim Teague
Why is Enterprise betting so heavily on NGLs? Because they serve as the feedstock for high margin petrochemicals like ethylene and propylene. Demand for these chemicals is booming thanks to strong demand growth from all over the world, but especially China and India.
Enterprise has positioned itself to be a leading one stop shop for the NGL/petrochemical industry thanks to having so much of its gathering, processing, and transportation infrastructure located in Texas, specifically the booming Permian basin. 70% of future NGL growth is coming from Texas, and literally no MLP is better positioned to profit from this secular trend.
But being so large and diversified EPD isn't just betting on NGL and petrochemical exports. Rather Enterprise is also poised to help America become one of the world's largest energy exporters, including in oil, NGLs, and refined products.
Today Enterprise's total export capacity is 5 million bpd, but it plans to expand that by 60% in the coming years. That includes increasing its oil export capacity by 2 million bpd by 2021. That's to help serve America's oil export market which is what's allowing US shale production to grow at such a prodigious rate.
Between 2018 and 2025 US oil exports are expected to more than triple, and make America the second largest oil exporter in the world behind Saudi Arabia within just six years.
Because US oil is sweeter than what our own refineries can handle exports are the primary way that US shale production can grow (until our old refineries are converted to handle the low sulfur crude). But thanks to that export boom OPEC (hardly a fan of US shale) expects America's shale production to double by 2029, to a staggering 16 million bpd.
And thanks to the fact that natural gas and NGLs are produced alongside crude, that means that America's epic energy boom, expected to last for decades, is going to require massive infrastructure investments over the coming years.
The bottom line is that Enterprise's toll-booth business model, with its long-term and volume committed contracts, means rock steady cash flow no matter what commodity prices are doing. And with one of the strongest balance sheets in the industry (that keeps getting better over time), a large and growing backlog of growth projects, and a low-risk self-funding business model, Enterprise Products Partners is an exceptional high-yield SWAN stock that you can rely on in all market/economic/industry environments.
While Enterprise is the king of US NGLs, Magellan, which IPOd in 2001, is the king of refined product pipelines. The MLP owns 9,700 miles of refined product (gasoline, diesel, jet fuel) pipelines, 53 terminals and 44 million barrels of storage capacity, mostly focused on the Midwest. In half of its 15 state service base, Magellan's network provides 40% of all refined products used. In total Magellan's network connects to 50% of US refining capacity.
The reason the MLP began by focusing on refined products is the highly favorable economics of that industry. Specifically, US refined product demand is extremely stable, BUT also a slow/no growth industry. As a result, Magellan's network is very wide moat because rivals are not willing to invest billions to recreate it which gives it strong pricing power. Historically this allows Magellan to hike its pipeline tariffs by 2% to 3% per year, and sometimes (like in 2018) up to 4.4%, without losing market share.
But while refined products are a wide moat and highly lucrative business, Magellan needs other industries to grow its cash flow and distributions. This is why since 2010 the MLP has been focusing on serving the rapid growth of America's shale oil industry.
In the past eight years, Magellan has invested $5.4 billion into constructing 2,200 miles of crude pipelines and 33 million barrels of storage capacity. This is focused on critical geographic areas including Cushing, Oklahoma (where US oil is priced), and the Permian Basin.
The Permian, according to analyst firm Rystad Energy, could hold up to 250 billion barrels of recoverable remaining reserves, about half of which is profitable to extract at $40 crude prices or below ($45 current price).
Magellan's pipelines are focused on connecting the key Permian drilling sites to export terminals on the Texas Gulf Coast, primarily in Houston. The MLP also has pipelines connecting the prolific Eagle Ford basin to export capacity in Corpus Christi.
Thanks to its diversification efforts in oil and oil exports, today slow/no growth refined products account for just 54% of Magellan's cash flow.
Like with Enterprise (and most MLPs), Magellan's cash flow is nearly entirely insensitive to commodity prices. Just 7% of operating cash flow is exposed to volatile oil prices.
Its highly stable cash flow, plus aggressive investments over time have allowed Magellan to deliver 17 consecutive years of distribution growth including 66 consecutive quarterly payout hikes.
That fast and consistent distribution growth, made possible by Magellan being the first MLP in America to eliminate its IDRs (Enterprise and MPLX have as well) and adopt a self-funding business model, has made this MLP into a fantastic market-beating high-yield investment over time.
Such amazing performance is courtesy of stellar management led by CEO and chairman Michael Mears. Mears has been with Magellan for about 30 years, before it IPOd. It was his forward-looking leadership that allowed the MLP to eliminate its IDRs back during the Financial Crisis at low cost, and thus greatly lower the MLP's cost of capital, making future investment more profitable.
What's even more impressive is that Magellan has managed to master self-funding with the lowest coverage ratio in the industry (among self-funding peers). Historically the MLP's DCF has been 1.2, yet it's still managed to avoid issuing new equity since buying out its IDRs in 2010. For context, most self-funding MLPs maintain coverage ratios of 1.4 to 1.9.
Going forward Magellan expects to achieve 5% to 8% distribution growth via its laser-like focus on the most profitable projects, all while maintaining its historically safe 1.2 coverage ratio (in this industry 1.1 or above is low-risk).
At first glance, you might think that a $2.5 billion backlog, with another $500+ million in the shadow backlog (projects awaiting contracts), isn't much. And compared to EPD's $6.6 billion in ongoing growth efforts, it's indeed small. However, off Magellan's smaller asset base the MLP's most aggressive spending ever still managed to deliver 20% YOY DCF growth in Q3 2018.
Magellan's latest growth project is a 600-mile pipeline connecting the Permian to both its export terminal in Houston, as well as Energy Transfer (ET)'s Louisiana facility.
That $2 billion project ($500 million is MMP's share) is a joint venture between Magellan, Energy Transfer, MPLX and Delek Logistics Partners (DKL). The initial capacity is set at 1 million bpd but the consortium is conducting an open season to see if it can't obtain enough contracts to expand that significantly. The pipeline is expected to be fully operational by mid-2020.
Meanwhile Magellan's shadow backlog, which for years was listed as "over $500 million" is now "well over $500 million" and includes:
Magellan management is focused on only the highest margin projects, specifically targeting 12.5% to 16.7% EBITDA yields (vs industry average of 10% to 12.5%). Disciplined capital allocation is a key reason for Magellan's past success and what will continue to make this a good high-yield income stock in the future.
Even more impressive is that Magellan has managed to self-fund its growth while maintaining one of the lowest leverage ratios in the industry. Management's policy is to never exceed 4.0, and in Q3 the leverage ratio hit 2.3, one of its lowest levels ever.
Magellan Leverage Ratio Over Time
The MLP plans to raise that substantially in the future, by potentially tapping its $1 billion revolving credit facility, which has remained untouched for years. But even if the leverage ratio rises to management's self-imposed 4.0 limit that will still make for one of the strongest and safest balance sheets in the industry.
The point is that Magellan is a legendary MLP blue chip with an impressive track record of delivering generous, safe and fast payout growth no matter what the stock market, economy, or oil prices are doing. And thanks to its biggest growth backlog ever, and access to plenty of low-cost capital to execute on those growth plans, Magellan's future looks bright indeed.
MPLX was launched in 2013 by Marathon Petroleum (MPC), which is now America's largest independent refiner. Originally it was supposed to be a drop-down oriented MLP that just raised debt and equity capital from investors to buy Marathon's logistics infrastructure which included:
Those assets would come with five to 10-year volume committed contracts that would ensure stable cash flow to support MPLX's generous and fast growing distribution.
But while MPLX's logistics & storage business still accounts for 65% of cash flow, the MLP has set its sights on becoming the future EPD. That began with the 2015 $15.6 billion acquisition of MarkWest, the dominant natural gas and NGL MLP in the prolific Marcellus/Utica shale of Pennsylvania, Ohio, and West Virginia.
Thanks to MarkWest, as well as several years of organic growth to expand those assets, MPLX is now a dominant natural gas and NGL MLP as well with:
Note that not all of that gas/NGL capacity is just in the Marcellus/Utica. MPLX has since diversified into Oklahoma's SCOOP/STACK formation and is now starting to provide for the gas/NGL needs of the Permian as well.
Those gas/NGL contracts are for 10 to 15 years in duration and have allowed MPLX to achieve remarkable cash flow growth as well as a steadily rising distribution coverage ratio. And keep in mind that MPLX's DCR, which hit 1.47 in Q3, is despite growing its payout at 18% CAGR since its IPO.
Even during the 2014-2016 oil crash MPLX not just avoided a payout cut, but continued to grow its distribution at a fast and sustainable rate. In fact, it's now raised its payout for 23 consecutive quarters.
The MarkWest acquisition meant that MPLX had a toehold in two of America's three booming energy markets.
However, in order to become a fully integrated industry blue chip management needed to make two changes.
The first was buying out MPC's IDRs as well as the rest of its logistics infrastructure in 2017. That was part of an epic $12 billion acquisition year that left MPLX with permanently lower costs of capital as well as a self-funding business model.
Those massive acquisitions, combined with strong volume growth in its MarkWest assets, means that MPLX's DCF growth in the first nine months of 2018 was 79%, one of the fastest growth rates in the industry.
And thanks to its rising coverage ratio, MPLX is now on track to retain nearly $1 billion in annual cash flow to fund its growth. That growth includes the MLP's bigger focus on crude pipelines (of which it owns 4,500 miles worth as well as numerous joint venture stakes).
Like with Magellan, MPLX's crude pipelines are focused on the Permian, where production is expected to double over the next five years and where new takeaway capacity is in highest demand.
But in addition to serving the Permian's exploding oil takeaway needs, MPLX wants to become vertically integrated like Enterprise. That means it's also participating in joint ventures to serve that mega formation's natural gas and NGL needs via:
And starting in Q3 2018 MPLX, like EPD, also got into the energy export business.
That's when MPLX spent $450 million on the Mt. Airy export terminal which included 4 million barrels of storage capacity and 120,000 bpd of export capacity. Not just does management plan to increase that capacity to 10 million barrels of storage and 240,0000 bpd of export capacity in the future, but it's already secured the permits to do so. And Mt. Airy is just one of five export locations that MPLX plans to focus on in the future so that it can cash in on US exports of both NGLs and crude oil.
In total MPLX plans to spend $6.6 billion between 2018 and 2020 on organic growth projects, including $4.2 billion in 2019 and 2020.
That is expected to drive 8.2% annualized DCF growth over the next two years and management will be rewarding investors with quarterly $0.01 distribution hikes. That translates into about 6% distribution growth which is slightly below the growth rate of DCF/unit.
That should help the MLP boost its already safe coverage ratio from 1.47 to about 1.53 by 2020 (assuming the same distribution growth in 2020). Which in turn would mean MPLX will be retaining $1.2 billion per year in cash flow within two years.
That's enough to fund 57% of its growth spending plans (assuming $2.1 billion in long-term growth capex), which will help the MLP maintain one of the lowest leverage ratios among blue chip MLPS (3.8 in Q3 2018). That's a fortress-like balance sheet that is why MPLX has recently been able to sell new bonds at highly attractive rates.
The MLP also has $2.3 billion in liquidity under its revolving credit facilities to leverage its large amount of retained cash flow.
But keep in mind that this guidance doesn't include the potential future acquisition of Andeavor Logistics LP (ANDX). In May 2018, Marathon bought Andeavor (ANDV) in a $23 billion deal that left it the largest independent refiner in America. Andeavor's MLP ANDX happens to own substantial assets including:
In addition, ANDX is working on $3 billion in organic growth projects and additional drop-down opportunities of legacy ANDV assets. Andeavor Logistics' assets are concentrated in the Permian and North Dakota's Bakken, so purchasing ANDX (something management eventually plans to do) would further strengthen MPLX's goal of becoming the new EPD by diversifying into yet more hot shale formations.
The point is that MPLX has managed to evolve from a drop-down oriented refiner focused MLP into a true vertically integrated blue chip. One with its finger increasingly in every part of America's booming energy industry. That bodes well for its long-term growth prospects.
In fact, EPD, MMP, and MPLX all offer what I consider to be a near perfect combination of generous, safe and steadily growing income that should translate into some of the best total returns of any blue chip you can find today.
The most important part of any income investment is the payout profile which consists of three parts, yield, safety, and long-term growth potential. Combined with valuation this is what tends to drive total returns over time.
|MLP||Yield||Distribution Coverage Ratio||10-Year Expected DCF/Unit Growth (Analyst Consensus)||Expected Total Return (No Valuation Change)|
Valuation-Adjusted Total Return Potential
|Enterprise Products Partners||7.0%||1.7||5.9%||12.9%||14.7%|
|Magellan Midstream Partners||6.9%||1.25||6.0%||12.9%||17.0%|
|S&P 500||2.1%||3.0||6.4%||8.5%||5% to 9%|
(Sources: management guidance, earnings releases, Simply Safe Dividends, Gurufocus, Fast Graphs, Yardeni Research, Multipl.com, Morningstar, Vanguard, Gordon Dividend Growth Model, Dividend Yield Theory, Moneychimp)
All three MLPs are offering sensational yields, of three to four times that of the broader market. More importantly, those distributions are safe thanks to strong coverage ratios and highly stable, long-term contracted cash flow.
And looking at their balance sheets, we similarly see no reason for any of these stocks to be trading in the toilet.
|MLP||Debt/Adjusted EBITDA||Interest Coverage Ratio||S&P Credit Rating|
Average Interest Cost
|Enterprise Products Partners||3.6||6.6||BBB+||4.7%|
|Magellan Midstream Partners||2.3||6.8||BBB+||4.6%|
(Sources: earnings releases, conference calls, Morningstar, Gurufocus, FastGraphs)
All three MLPs have far below average leverage ratios, high interest coverage ratios, and strong investment grade credit ratings. This allows them each to borrow at low interest rates far below their returns on invested capital.
Over time distribution growth is likely to track DCF/unit growth and each MLP is expected to grow at 5% to 6% over the coming decade. I consider those to be reasonable growth estimates given the incredible industry tailwinds facing each MLP. That might not be the fastest rate in the industry, but it's still good enough to deliver 13% to 14% total returns, even with no valuation changes. For context, the S&P 500's historical CAGR total return is 9.2% and from today's valuations that likely what investors can expect (Vanguard expects just 5% to 8% from the S&P 500 in the coming years).
And when we factor in each MLP's rock-bottom valuation, then these blue chips become even better investments, with the potential to deliver 15% to 17% long-term total returns.
In recent weeks the combination of the worst correction since 2009 and the second oil crash has caused all three MLPs to plunge. But that merely creates a potentially great buying opportunity for high-yield income investors.
|MLP||Forward P/DCF||5-Year Average P/DCF||Long-Term Growth Rate Baked Into Price|
Actual Expected Long-Term Growth Rate
|Enterprise Products Partners||9.1||13.3||0.8%||5.9%|
|Magellan Midstream Partners||11.1||16.9||1.9%||6.0%|
(Sources: Simply Safe Dividends, Benjamin Graham, Fast Graphs)
The entire midstream industry is trading in the toilet with a forward P/DCF (industry equivalent of a PE ratio) of just 7.3. That prices in slightly negative growth despite the best industry growth tailwinds in its history (as well as the strongest collective industry balance sheet).
These three MLPs are trading at well-earned premiums to their peers, but still far below their five-year average forward P/DCFs. And keep in mind that the five-year average includes the worst bear market in the industry's history. This basically means EPD, MMP, and MPLX are priced for virtually zero long-term growth when in fact each is growing at a rapid pace and expected to deliver solid long-term cash flow and payout growth. This means investors can expect significant multiple expansion when the market calms down and stops ignoring these MLPs' objectively excellent and fast improving fundamentals.
How much of a valuation boost are we talking? For that, I turn to my favorite valuation method for blue chip income stocks, dividend yield theory or DYT. Since 1966 DYT has proven highly effective for stable business model companies, as proven by asset manager/newsletter publisher Investment Quality Trends
IQT has been exclusively using DYT on blue chip dividend stocks to deliver decades of market-beating total returns and with 10% less volatility to boot.
DYT simply compares a stock's yield to its historical yield, because over time yields tend to mean revert or return to a stable level that approximates fair value.
|MLP||Yield||5-year Average Yield|
Discount To Fair Value
|Enterprise Products Partners||7.0%||5.9%||16%|
|Magellan Midstream Partners||6.9%||4.6%||33%|
(Sources: Simply Safe Dividends, Dividend Yield Theory)
To be conservative, I'm using the five-year average yields, because this is almost exclusively the historical yield during the MLP bear market. That's to compensate for slower long-term growth rates than each MLP has enjoyed in the past.
However, as you can see each of these blue chip MLPs is still trading at a deep discount to fair value. That means strong upside potential that will significantly boost total returns when each stock finally trades on fundamentals and not irrational stock market sentiment.
|MLP||Upside To Fair Value||Valuation Boost (Over 10-Years)||Expected Total Return (No Valuation Change)|
Valuation-Adjusted Total Return Potential
|Enterprise Products Partners||19%||1.8%||12.9%||14.7%|
|Magellan Midstream Partners||50%||4.1%||12.9%||17.0%|
(Sources: Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model, Fast Graphs, Moneychimp)
MMP has the greatest upside to fair value and EPD the least. But all three stocks are likely to deliver fantastic total returns well in excess of the market's historical total returns in the coming years.
That kind of margin of safety means that all three are very strong buys for anyone comfortable with their risk profiles.
While all three of these stocks are low-risk from a payout safety perspective, that doesn't mean investors shouldn't be aware of several challenges they might face in the future.
Magellan and MPLX are both betting big on crude pipelines in the Permian and for good reason. However, with so many MLPs building pipelines as fast as possible takeaway capacity is going to rapidly increase starting in the second half of 2019. A lot more capacity means that market rates for pipelines are likely to decline.
For example, in Q3 Magellan renegotiated 50% of its Permian Longhorn pipeline capacity bringing total contracted capacity to 100%. However, that was at a rate of $1.75 per barrel compared to $2.25 on its remaining 50% capacity (eight-year average contract duration remaining). This means that this key pipeline now has an average remaining contract of five years at a lower market rate of $2 per barrel of oil transported.
This highlights that while long-term and volume committed contracts make for great cash flow stability, eventually contracts expire and then MLPs need to renegotiate them. While overcapacity is not a big risk to the industry (no projects begin construction without most capacity already contracted for), cash flow growth rates can face headwinds if future market rates are lower than expected.
And as for Enterprise, its biggest risk is betting so heavily on NGLs to drive its growth. While its NGL projects (specifically fractionators) are all 100% contracted for 15 years, future growth in NGLs is dependent on continued strong economic growth in emerging markets driving high import demands for petrochemicals.
However, China's economy, already slowing due to several secular trends, has been hit hard by the trade war with the US. As a result, Markit's latest manufacturing survey report came in at 49.7, down from 50.2 in November. 50 is neutral, and a reading below 50 indicates that China's manufacturing industry (a key user of petrochemicals) is now contracting.
That is confirmed by the latest Chinese manufacturing PMI which is also below 50 and has been declining rapidly for most of 2018. Similarly falling Chinese wholesale inflation is a bad sign that China's growth rate is falling faster than previously anticipated.
While this isn't a short-term risk for EPD (or MPLX), should China's growth rate over time come in below expectations than the big growth runways those MLPs currently see in NGLs could be significantly shortened.
Finally with regards to MPLX, while the lack of IDRs and a self-funding business model makes this a low-risk stock, there is one negative scenario in particular investors need to keep in mind. Specifically that if MPLX becomes too overvalued, then Marathon might end up buying it in an MLP rollup as Valero (VLO) did with its MLP Valero Midstream Partners (VLP).
The good news is that there are key differences between VLP and MPLX, specifically that VLP was a drop-down focused MLP that still had IDRs that made profitable future growth harder. MPLX has completed all of its Marathon drop-downs and is 100% focused on organic growth, which it can self-fund with ease thanks to a lack of IDRs.
However, with the Andeavor Logistics acquisition potentially looming in its future (uncertain terms could keep unit price suppressed) investors need to still keep this low (but not zero) probability scenario in mind. Specifically, the risk is that those buying MPLX for its 8.4% yield and long-term 6% payout growth might end up owning shares of far lower-yielding Marathon (3.1% yield). What's more, Marathon, while a great refiner, has a far more volatile business model that will make long-term dividend growth less predictable relative to MPLX's quarterly hikes.
And of course, should MPC buyout MPLX then that would be a taxable event which could mean that long-term investors might see some negative tax implications as well.
I'll be the first to admit that the length and severity of the MLP bear market have shocked even veteran investors like me. Despite objectively great fundamentals and the best long-term industry growth runway in history, Wall Street continues to hate on even the highest quality blue chip MLPs.
However, as Benjamin Graham, Buffett's mentor and the father of value investing points out,
In the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company." - Benjamin Graham
As it turns out the long-term, made up of many short-term periods, can result in long industry bear markets that ignore even fantastic fundamentals and ridiculous valuations. That's especially true when you get a perfect storm of negative factors such as two oil crashes, four market corrections, and a negative regulatory rule change that spooked easily frightened retail investors (but didn't actually affect most MLPs).
But ultimately the most fundamental truth of investing is that a stock's intrinsic value is based on the cash flow and income it generates for investors. Enterprise Product Partners, Magellan Midstream Partners, and MPLX are all industry leading blue chips with proven track records of delivering generous, safe, and growing income, even in the most extreme economic or industry conditions.
Not just are their commodity insensitive and recession-resistant cash flows a solid source of income you can depend on, but their low-risk self-funding business models mean they can continue growing strongly for decades, no matter what the irrational and fickle stock market decides to do.
And with each of these MLP blue chips now trading at some of their best valuations in years (or in some cases ever) each is a very strong buy for your diversified income growth portfolio. That's why I added each to my new Deep Value Dividend Growth Portfolio in the past few weeks. Because with their excellent and improving fundamentals, I think these MLPs might be some of the hottest income stocks of 2019, but more importantly, generate 15% to 17% long-term total returns over the coming decade.
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