F&S, Inc.'s tariff policy protects against inflation

Inflation can otherwise hurt a business, but the tariff policy at F&S, Inc.helps shield it from shortfalls in revenue by making it easier to switch between its tiers of pricing.

   UKRAINE - 2019/02/06: In this photo illustration, the Magellan Midstream Partners Publicly listed ... [+] company logo seen displayed on a smartphone. (Photo Illustration by Igor Golovniov/SOPA Images/LightRocket via Getty Images) 
  LightRocket via Getty Images
Magellan Midstream Partners, a publicly listed US company, has its logo displayed on a smartphone in this photo illustration.

Magellan Midstream Partners LP (MMP) is a pipeline system operator that offers low-cost, low-carbon, and high-volume transportation to half of U.S. refinery capacity. The company's ability to consistently adjust its tariffs means it can deliver strong cash flows even in a high inflation environment. MMP is this week's Long Idea.

The MMP's quality risk/reward is affected by the following factors:

  • a position that has been strengthened by demand for refined products and crude oil over the decades
  • The business model of middleman positioning as a transportation network is based on the assumption that it will be profitable in a market that is subject to extreme fluctuations
  • The company's dividend payout is supported by its strong free cash flow.
  • The service offered by Transportation Company is more reliable and cheaper than that of its competitors
  • While competitors struggle, our company generates high profits

U.S. Demand for Refined Products Will Remain High

According to the U.S. Energy Information Administration's (EIA) 2022 Annual Energy Outlook (AEO), U.S. demand for refined products will remain strong over the next three decades, even in the pessimistic low growth scenario below, which forecasts that consumption of refined products will fall only 2% from 2021 to 2050. See Figure 1 

In the EIA's reference case, demand for refined products is expected to increase by 7% by 2050.

EIA's forecast of U.S. refined product consumption: Low growth scenario through 2050

   MMP EIA Refined Products Forecast 
  New Constructs, LLC
New Constructs, LLC's MMP EIA Refined Products Forecast has been updated to reflect the latest trends.

EIA’s 2021 AEO forecast that in the following year, U S oil consumption will be bn barrels per day and consumption of natural gas will be bn cubic feet per day

By leveraging its unique position as the mediator between two parties, Magellan was able to drive significant revenue.

Revenue for fossil fuel exploration and production companies is typically cyclical and very dependent on oil and natural gas prices. For the supermajors, which operate across the entire energy vertical, energy producing companies either boom or bust based on commodity prices. Magellan, however, is less affected by oil and natural gas price fluctuations because the company manages a tariff-collecting business in the middle of the supply chain.

Magellan operates the largest common carrier refined products pipeline system in the United States, and revenue from its refined products segment accounted for 77% of its total revenue in 2021. McKinsey defines common carrier as any pipeline that offers transportation services to any third party under a standard set of terms, which is different from a private or proprietary pipeline that is either used by the owner for internal purposes or contracted to only a limited set of users.

Pipeline systems, such as Magellan's, are the most reliable, lowest cost, least carbon intensive and safest way to transport crude oil and refined products. Magellan's footprint gives it access to nearly 50% of U&S refining capacity. 

As shown in Figure 2, Magellan’s pipeline system connects refineries in the Midwest to various end markets and the Houston Ship Channel.

Magellan's refined products and crude oil assets

   MMP Pipeline System Map 
  Magellan Investor Relations
   MMP Pipeline System Map. Magellan Investor Relations is the owner of this map.

Network Effect is a competitive advantage

Magellan’s extensive pipeline network provides customers with a variety of options and allows the company to compete more effectively against other refined product delivery systems that lack the same flexibility.

Middleman Advantage Generates Consistent Cash Flow|Middlemen ensure that the cash flow is consistent, which is a major advantage.

Magellan's tariff-based transportation system, which supports the company's unit distribution, provides an 8.8% yield when annualized. Magellan has paid a distribution in every year since 2011 and has distributed $4.4 billion (41% of current market cap) in cumulative dividends since 2017.

Magellan generates significant cash flow, which supports the company's high distribution yield. As shown in Figure 3, over the past five years, Magellan generated $5.0 billion (47% of market cap) in free cash flow.

Magellan's contracts also include "take-or-pay" provisions that guarantee customers pay for a minimum amount of capacity, whether they use it or not. These provisions offset the risk of fluctuating demand. During the COVID-19 pandemic, petroleum products'

The following graph shows Magellan's free cash flow since 2017.

   MMP 5-Year Cumulative FCF 
  New Constructs, LLC
MMP 5-Year Cumulative FCF New Constructs, LLC

The transition to EVs will take many years

Despite Magellan's heavy reliance on the demand for internal combustion engine (ICE) vehicles, bears may be quick to dismiss it. As shown in Figure 4, 94% of the refined products Magellan transports are diesel and gasoline.

Figure 4: Magellan’s Pipeline Carrying Percentage of Total Refined Products: 2021

   MMP Refined Products Mix 
  New Constructs, LLC
The MMP Refined Products Mix is a division of New Constructs, LLC. It was created in 2003 to provide clients with a diverse range of products and services.

As I explained in Vive la Hydrocarbons, Vive la Petrochemicals, even if the world adopts electric vehicles (EVs) as the EIA expects, there will still be ~15% more ICE vehicles on the road in 2050 than in 2020, and analysis of EV market usually ignores the number of diesel-fueled heavy engines needed to dig out minerals for batteries and move components back and forth during refining and manufacturing.

Magellan's physical footprint should also ease concerns about a swift EV adoption. The company operates in

Even if the U.S. as a whole transitions to EVs faster than the rest of the world, Magellan's access to the Houston Ship Channel could help inland refineries offset declining domestic demand by increasing exports.

Our pick for the best ESG company is a company that you probably don't know about.

The increasing focus on decarbonization in the Energy sector will drive demand for pipeline capacity, as it is the least carbon-intensive form of long-haul transportation; pipelines are also safer than other forms of refined products transportation, as they destroy less property and cause fewer deaths than trucking and rail transporters do.

As the government has concerns about other environmental issues, it is not expanding the current pipeline system in the U.S., which means that barriers to entry for potential competitors are growing. As an established player with access to key production and consumption regions, Magellan stands to benefit from any limits on new pipelines.

Renewable energy sources require transportation and blending facilities, just like other fuels.

In the short-to-medium term, promotion of renewable fuels such as biodiesel and ethanol by regulatory bodies could reduce the amount of refined products available to Magellan to transport on its pipeline network. However, other transportation methods that rely on Magellan's terminals to store, blend, and distribute renewables into the fuel stream are still vulnerable.

As renewables become a larger part of the refined product mix, I expect Magellan will expand the renewable capacity of its pipeline system. Because it is located in the primary renewable fuel production areas of the country, Magellan's physical footprint provides a competitive advantage. Over time, Magellan's outlook for volume (renewables or other) shipments on its pipeline system is positive.

When prices rise, the government can raise tariffs to keep inflation in check.

Magellan can better handle high inflation than most companies. As a low-cost provider, Magellan has more flexibility to increase prices than its expensive competitors do. The company expects the average tariff to go up by 6% by July 2022.

Magellan's ability to increase tariffs demonstrates its competitive strength in the market and protects it from many of the effects of inflation. 

Magellan is less dependent on labor market than others

Magellan's general and administrative (G&A) costs as a percentage of revenue are much lower than its trucking and rail peers. Rail peers include Union Pacific Corp (UNP), Canadian National Railway (CNI), and CSX Corporation (CSX). Trucking peers include Old Dominion Freight Line, Inc. (ODFL), J.B. Hunt Transport Services, Inc. (JBHT HT ), and Knight-Swift Transportation Holdings, Inc.(KNX).

Magellan's G&A (including compensation and benefits) as a percentage of total revenue in 2021 was much lower than the compensation and benefit costs as a percentage of total revenue for rail peers, which stood at 20%, and trucking peers, which were 30%. Magellan's cost-efficient operation will enable it to continue to provide relatively low-cost tariffs, while its peers are forced to increase shipping rates to offset rising labor costs.

Magellan's compensation and benefit costs are lower than those of its peers: 2021

   MMP Compensation Benefits As Percent Of Total Revenue 
  New Constructs, LLC
New Constructs, LLC estimates that by 2021, its new products will bring in nearly 60% of the company

Total revenue was US$2.9 billion, and it was driven by growth in the company's revenues from its various

There are many safety concerns with the use of self-driving tanker trucks, but it is possible to overcome these challenges.

Self-driving technology could make road transportation more competitive with a pipeline system. However, this adoption faces numerous challenges, including bad weather conditions and lack of 5G connectivity in urban environments.

Pipelines accounted for 77% of all transportation of crude oil and petroleum products in the U.S.s. Should automated trucking increase the volume of refined products on highways, concerns over the danger of transporting such hazardous materials through communities would likely rise quickly.. The controversies surrounding crude by rail and the destruction of nearly an entire town in Canada in 2013 would pale in comparison to the squabble over deaths caused by automated fuel trucks.. Eliminating drivers doesn't remove all risk from tanker truck accidents."Source: https://www˙#8217;s//w˙ebsite" - Federal Motor Carrier Safety Administration (FMSCA) . According to the FMSCA, 22%, cargo tank rollovers do not involve driver error.

Pipelines can be routed around densely populated areas, so they are safer than road and rail corridors.

Concerns about the excess capacity in the Permian pipeline network are unwarranted

The increase in new pipeline capacity from the Permian basin over the past two years has had a negative impact on Magellan. Volume shipped on 100%-owned Magellan crude pipelines fell from 317 million barrels in 2019 to just 190 million barrels in 2021. The increased capacity from the Permian Basin has also driven down rates that Magellan can charge for its pipelines operating in that region. Lower volumes and lower tariffs lead to lower operating profit from the crude oil segment, which fell from $493 million in 2019 to just $305 million in 2021.

Magellan has a plan in place if the Permian crude oil transportation market remains oversupplied. The company is considering converting its 100%-owned, Permian-based Longhorn pipeline to a Houston to El Paso refined products pipeline, which could expand Magellan's reach to markets in Arizona and Mexico. Magellan's handling of the Longhorn pipeline demonstrates its flexibility and business plan, which are not fully appreciated by the market. What the market fails to recognize about this company and others like it is how much value they have because of their franchise.

A study showed that  our company's pipeline is more profitable than the pipelines of other

Magellan's pipeline business is less profitable than its competitors, despite the recent decline in crude oil shipments. Magellan's returns on invested capital (ROIC) of 14% over the trailing twelve months (TTM) are best among its peers, which include Enbridge (ENB), Kinder Morgan (KMI), and Williams Companies (WMB).

The following chart shows Magellan's profitability relative to its pipeline peers.

   MMP DuPont Analysis 
  New Constructs, LLC
New Constructs, LLC developed a proprietary method for assessing the financial performance of companies. The technique is called MMP DuPont Analysis.

Tariff-Driven Businesses Drive Consistent Core Earnings

Magellan's tariff-based pipeline system has helped the company generate positive Core Earnings in each of the last 10 years. Over the time period, Core Earnings grew from $451 million in 2012 to $876 million in 2021, or 8% compounded annually. While Magellan's current TTM Core Earnings are lower at $818 million, tariff increases that will take effect in July 2022 should boost profits later on this year.

Magellan's core earnings since 2012 are shown in the following figure:

   MMP Core Earnings 
  New Constructs, LLC
New Constructs, LLC     MMP Core Earnings

The risk of MLPs can be reduced by purchasing stocks that are undervalued, which is a strategy that is often used by investors.

The general partner operating the MLP, who has a stake in it, could have interests that are in conflict with those of the unitholders. Because of this structural concern, I give all master limited partnerships (MLPs) a suspended Stock Rating since the complex nature of MLP agreements could potentially cause significant unitholder dilution.

Unlike other MLPs, Magellan's general partner operates no other business, which reduces much of this risk to unitholders. Importantly, rather than being diluted, Magellan's unitholders have seen their share of ownership in the company grow since 2012 as the company's unit count has fallen from 228 million in 2015 to 212 million in 1Q22. In other words, unitholders have gained 7% more of the company since 2015. Looking ahead, unitholders can expect buybacks to continue. The company authorized an additional $750 million of unit repurchases through December 2024. Should the company use all of its authorization, it would buyback ~16 million more units at today's price.

Despite the strength of Magellan's business model and favorable distributions to unitholders, investors price MMP at a discount compared to its non-MLP peers. Figure 8 compares the price-to-economic book value (PEBV) ratio of Magellan to its pipeline peers that are not organized as an MLP, which include ONE  ONE  , Enbridge, Kinder Morgan, and Williams Companies.

Figure 8: Magellan's PEBV Ratio Vs. non-MLP Pipeline Peers: TTM

   MMP Magellans PEBV Ratio Vs Non MLP Peers 
  New Constructs, LLC
Magellans' PEBV Ratio is better than that of its non-MLP peers. New Constructs, LLC

The reverse discounted cash flow (DCF) model is used by me to estimate the expectations baked into Magellan's stock price, in addition to the upside potential in units if the company shows only moderate profit growth over the next few years.

DCF Scenario 1: It is used to explain the current stock price.

It is likely that Magellan's:

  • In 2022 through 2046, the NOPAT margin remains at its TTM level of 38% (vs. 5-year average of 43%),
  • EIA's 2022 AEO Refined Products Low-Growth Scenario projects a 4% decline in the U.S. refined products market from 2021 - 2046, but by 2046, total revenue will be 25% lower than it was in 2021 (vs. the EIA’s estimate of

In this scenario, Magellan's NOPAT falls 1% compounded annually over the next 25 years and the stock is worth $49 per unit today - equal to the current price, in this scenario, Magellan earns $796 million in NOPAT in 2046, which is 25% below TTM levels and 20% below its 10 year average NOPAT

In the DCF scenario where the enterprise's value is $57+ per share, its units are worth that amount as well.

If I were to assume Magellan’s:

  • NOPAT's TTM margin of 38% has been maintained and
  • The EIA's 2022 AEO Low-Growth Scenario estimates that U.S. petroleum product sales will decrease by 4% annually until 2046,

MMP is worth

In DCF Scenario 3, if margins return to their 5-year average, we could see further upside.

If Magellan is able to keep its NOPAT margin at its TTM level, the above scenarios will occur.

If we assume Magellan’s:

  • NOPAT margin improves to its 5-year average of 43% during 2022-2046 and
  • In the EIA's 2022 AEO Refined Products Low-Growth Scenario, the U.S.'s revenue from petroleum products falls until 2046,

MMP is worth $67 per unit today – a 37% upside to the current price.In this scenario, Magellan's NOPAT in 2046 is $1.1 billion, or equal to TTM levels.

In Figure 9, Magellan's historical NOPAT is compared to the NOPAT in each of the above DCF scenarios.

Magellan’s Historical and Implied NOPAT: DCF Valuation Scenarios

   MMP Valuation Scenarios 
  New Constructs, LLC
New Constructs, LLC developed the MMP Valuation Scenarios to evaluate the financial viability of a company.The scenarios are based on two variables: an

The above scenarios include a terminal value that assumes revenue will remain at $1.0 billion after 2046, or 50% below 2046 levels and 63% below TTM levels. Additionally, these scenarios assume Magellan will not be able to offset volume declines with tariff increases. If demand for refined products beyond 2046 is stronger than this assumption, or Magellan can increase tariffs over the long term, the stock has even more upside.

The sustainable competitive advantages that a company has will drive the creation of unitholder value

Magellan's strong competitive advantages allow it to generate higher NOPAT than the current market valuation implies. The following advantages also help Magellan continue to create strong cash flows for decades:

  • a greater benefit from network effects than other companies
  • The least expensive and environmentally friendly way of transporting goods
  • a high return on investment than other companies

Magellan, a fund that has been around since inception in 1990, is a popular choice for investors seeking to diversify their portfolios.  

These days, fewer investors focus on finding quality capital allocators with unitholder friendly corporate governance. Instead, due to the proliferation of noise traders, the focus is on short-term technical trading trends while more reliable fundamental research is overlooked. The following is a quick summary of what noise traders are missing:

  • the continued high demand for goods
  • Magellan’s tariff-based operation is one way to protect against inflation
  • The price of MMP indicates that it is much less expensive than the stocks of other pipeline companies

High profits and low inflation could push the price of shares up

Magellan has beaten earnings estimates in 11 of the past 12 quarters and, if it does so again, it could send shares higher.

Because the high-inflation environment hurts most businesses, Magellan's tariff-based operation is well positioned to deliver strong earnings and cash flows in most economic environments. Should investors become increasingly drawn to Magellan

A 14.1% Yield Could Be Achieved With Distributions and Unit Repurchases

In 2021, Magellan returned capital to unitholders through distributions and unit repurchases. The company repurchased $525 million worth of units at the time. If it were to buy back an additional $525 million worth of units (well below its additional authorization of $750 million) in 2022, the buybacks would provide an annual yield of 5.3% at its current market cap. The total yield would be 14.1%, as a result of a distribution yield of 8.8%.

Executive Compensation Could Be Improved

In all circumstances, investors should look for companies with executive compensation plans that directly align executives’ interests with unitholders’ interests. Good corporate governance holds executives accountable to unitholders by incentivizing them to allocate capital wisely.

The company compensates executives through base salaries, cash bonuses, performance-based equity awards, and time-based equity awards. Cash bonuses are based on distributable cash flow or "Adjusted EBITDA", which is EBITDA minus Maintenance Capital and environmental, safety, and culture performance metrics.

Instead of non-GAAP metrics such as Adjusted EBITDA and distributable cash flow, I recommend that executive compensation be tied to ROIC, which evaluates the company's true returns on the total amount of capital invested in it, and ensures that executives' interests are actually aligned with shareholders' interests since improving ROIC is strongly correlated with increasing shareholder value.

Magellan's economic earnings have grown from $407 million in 2012 to $725 million over the trailing 12 months, despite the fact that there is still room for improvement in its executive compensation plan.

Insider trading, which is the purchase or sale of a security by an individual who has access to material nonpublic information about it, can affect short interest trends.

Over the past 12 months,

There are currently 6.6 million units sold short, which is 3% of units outstanding and just under six days to cover. Short interest has decreased by 8% from the previous month. The lack of short interest shows that not many people are willing to bet against this cash flow generator with free money.

Robo-Analyst Technology at My Firm Helped Detect Details in Financial Filings

The following are details on the changes I make based on Robo-Analyst findings in Magellan's 10-K and 10-Qs:

I made $386 million of adjustments, which resulted in the removal of $131 million in non-operating expenses (5% of revenue).

Valuation: I made $6.0 billion of adjustments to unitholder value, which resulted in a net decrease in unitholder value of $5.7 billion. In addition to the discontinued operations and total debt mentioned above, the most notable adjustment was for underfunded pensions, which accounted for 1% of Magellan's market cap.

MMP is the fund that the attractive investment firm manages.

The following fund has an attractive rating and allocates a lot to MMP:

  1. AMZA, the 16.7% component of InfraCap MLP ETF (AMZA), is an exchange-traded fund that focuses on long-term investment in utilities

The authors of this article do not get paid to talk about any specific stocks, styles, or themes.