Magellan intermediary partners (NYSE: MMP) and Enterprise Product Partners (NYSE: EPD) both offer tempting distributions, earning 11.5% and 10.8% respectively, to the current share price. Before you jump into either stock, however, you need to understand why these returns are so high. The answer to this question will help you determine which is the best option for long-term dividend investors.
A difficult period in terms of energy
Magellan and Enterprise both own intermediate installations that help move oil and natural gas around the world. This is a fairly conservative segment of the whole energy sector, because it is mostly built around paid assets. Essentially, intermediary actors collect fees for the use of pipelines, storage, processing and transport infrastructure that they own and operate. The prices of the goods passing through their systems are also not that important to master limited partnership bottom line. Enterprise and Magellan each generate over 85% of their revenue from commissions, typically from long-term contractual relationships.
The key factor for these intermediary businesses is demand. With the onshore energy sector in the United States having experienced substantial growth for many years, the demand for the services provided by intermediary companies had been enormous and the industry was in a growth mode. Enterprise and Magellan had built new assets to grow their businesses. However, COVID-19 has shaken the industry – economic shutdowns and social distancing measures taken to slow the spread of the pandemic have dramatically reduced demand for oil and natural gas.
Worse, when demand fell sharply earlier in 2020, the excess supply ended up in storage. This excess will likely need to be overcome before fossil fuel prices can rise again, which will limit drilling. Therefore, there does not appear to be a miracle solution to the imbalance between global supply and demand affecting the energy sector. And that’s having a notable impact on the mid-market, which has seen a drop in demand for assets that currently exist in key markets. Additionally, construction plans are evolving as low demand means there is no immediate need to continue building new pipelines. This lousy backdrop helps explain the massive returns offered by Magellan and Enterprise. It should also be noted that some of their peers have already resorted to distribution cuts.
Indeed, whereas previously investors focused on the ability of an intermediary player to increase its disbursements, they are now focusing on the survival or otherwise of these distributions. This is the factor that differentiates Magellan and Enterprise.
If you look at the financial foundations of the two partnerships, they are more or less on an equal footing. The company’s financial debt toEBITDA ratio, the typical way leverage is measured in the median space, is around 3.7. For Magellan, this metric is 3.2 and although its balance sheet looks a bit cleaner, both have ratios that are actually downmarket for the industry. In addition, both hedge their ongoing interest costs solidly, with Enterprise at 4.8x and Magellan at 5.6x. When it comes to financial strength, these two partnerships are roughly in the same place. And, most importantly, the two seem strong enough to get through this difficult time in one piece.
Where things start to differ significantly between the two, however, is the coverage of the cast. Magellan only hedged its distribution approximately 1.1 times in the second quarter. Management is committed to maintaining the distribution until the end of the year, but this statement did not generate much confidence among investors. Magellan is clearly leaving the door open to a distribution cutoff if industry conditions do not improve. This helps to explain its higher yield.
Enterprise is in a comparatively better position, with 1.6x second quarter distribution coverage. Before taking comfort in that number, however, it’s important to note that Enterprise has stopped increasing its distribution quarterly this year. The decision to break this multi-year trend was a statement about the harshness of the current environment for mid-market companies. It has much more leeway to continue its shareholder disbursements at current levels, but management is obviously looking to take a cautious approach to the future.
First of all, there is no material reason to panic about Enterprise or Magellan. In fact, Enterprise has made a compelling case for strong demand in the energy patch which, assuming the outlook turns out correct, will benefit both partnerships. However, given the current challenging environment and Magellan’s relatively low distribution coverage, Enterprise appears to be a better option for income-oriented investors at present. There is no way to guarantee that Enterprise’s distribution will hold up, but it certainly looks more secure than Magellan’s.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.