Magellan Midstream Holdings MGG
November 20, 2006 - 2:30pm EST by
2006 2007
Price: 22.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,377 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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MGG is the general partner in a partnership that has consistently increased distributions sequentially for the last 22 quarters with an annual growth rate of 16%. MGG trades 10% below its IPO price despite its steady results, pristine assets and 20+% growth outlook.  MGG is similar to other successful VIC names like KSL, XTXI, and MWP which also have general partnership interests in midstream energy assets.

Rate of Return Snapshot
MGG currently yields 4.25% based on annualizing its last quarter dividend to 93.2 cents.  Based on internal low risk organic growth alone, MGG’s dividend should consistently grow north of 20% for the next 5+ years.  By the end of 2009, using a 21% growth rate, MGG’s dividend should reach $1.70 or a 7.7% yield at current prices.  If  MGG trades at a 4.25% yield that would represent a $40 stock price or an 81% return.  During that time you will also receive about $3.90 in dividends bringing total return to about 100%.
Furthermore, given the strong steady growth of dividends, we believe that a 4.25% current yield is too cheap particularly versus other "yield" securities (REITs and Utilities), and that MGG should trade at a 3.5% yield which would value the units at 26.6 right now and 48.50 at the end of 2009.

What is Magellan Midstream Holdings?
MGG owns the 2% general partner interest in Magellan Midstream (MMP-NYSE), which entitles MGG to receive 2% of the cash distributed by MMP.
MGG also owns 100% of the incentive distribution rights which entitles MGG to receive 50% of the incremental cash flow generated by MMP.  For example, if MMP generates $30mm of additional distributable cash flow in 2007, $15mm of it will go to MMP and $15mm will go to MGG.  MMP’s dividend will increase by 22.5 cents or about 9.5% while MGG will increase about 24 cents or 27%.  Thus, MGG’s distributions will grow at 2.8X the rate of MMP’s distribution.  Management has stated that it intends to grow distributable cash flow to MMP by 8-10% on an annual basis.  At an 8% growth rate of MMP, MGG will grow at 21%.  At a 10% growth rate, MGG will grow in the mid 20’s%. Year to date MMP has grown distributions up about 14%.  Management has traditionally been conservative and risk averse.

Description of Magellan Midstream
Since MGG derives all its cash flow from MMP, it is really important to know what makes MMP so good.
MMP is separated into 3 divisions:  Pipeline System, Terminals, and Ammonia
Pipeline System-  MMP owns the largest refined products pipeline system in the United States at 8,500 miles.  Its pipelines span from the Gulf of Mexico through the Midwest and the Rockies.  MMP charges its customers tariffs for use of its pipelines and associated storage tanks, as well as other fees for blending and additives services.  Through direct access and interconnections with other interstate pipelines, MMP has access to more than 40% of the U.S. refining capacity.  75% of MMPs operating profit come from the Pipeline System.
Terminals-  MMP owns 7 marine terminals which hold 21 million barrels of refined product.  MMP also owns 29 inland terminals which are connected to other 3rd party pipelines primarily located in the Southeast.  MMP charges fees for use of its terminals, as well as other fees for blending and additives services.  Customer contracts are long-term with price escalators.
Ammonia-This 1,100 mile system transports and distributes ammonia from production facilities in Texas and Oklahoma to various locations throughout the Midwest.  MMP charges volume-based fees for use of the pipeline.  Ammonia represents just 1% of operating profit.
MMP largely makes its money by charging tariffs and fees for use of its pipelines and terminals.  It does not depend on high or low commodity prices to drive its business.  In recent quarters there has been some noise around their numbers due to GAAP accounting of inventories held under a supply agreement but it didn’t matter to cash flows.  Over 90% of their operating profit not directly affected by commodity prices.

While Magellan’s track record has been stellar, how will it continue to grow?
Magellan needs to grow at 8% or better in order for MGG to grow north of 20% per year.  This is highly attainable as described below:
What differentiates Magellan from other midstream MLPs is that it doesn’t rely on natural gas exploration to grow or high commodity prices to grow.  Neither does Magellan require acquisitions to grow.  It grows the following ways:
1)      Demand growth—Magellan’s Pipeline segment base volumes grow in line with end user demand growth of 1-1.2% in the Midwest and 1.5% in Texas, Rockies and Southeast.  The Terminal segment’s inland terminals have been growing at 5.9% over the last 5 years due to their strategic locations within the Southeast.
2)      Price Increases—Magellan has raised prices every year in line with PPI-Finished Goods.  On July 1, 2006,  FERC allowed refined product pipelines to charge PPI plus 1.3% for the next 5 years.  Based on the most recent PPI-Finished Goods index of 4.8%, Magellan was able to raise prices 6.1% to a significant majority of its tariffs in the Pipeline Segment.
3)      Changes in Government Regulations that require new infrastructure—Ethanol replacing MTBE requires additional tankage and fees at Magellan.  Biodiesel is also gaining traction and will require additional infrastructure while will allow Magellan to invest and charge more fees.  The switch to Ultra Low Sulfur Diesel which occurred in October 2006 is allowing Magellan to implement surcharges to its customers because of the investments Magellan have made over the years.  Magellan also gets to charge fees for adding lubricity to the pipelines which are now required with Ultra Low Sulfur Diesel.
4)      Refinery Expansions—Magellan connects directly to 11 refineries and has access to 40% of  refineries in the United States.  As refineries expand, Magellan will capture more volume at its terminals and pipelines.
5)      Increased Storage Demand—The United States has a lack of supply in storage of refined products due to continued demand growth, refineries running at full utilization, hurricane disruptions, and customers concern over a stable source of supply.
6)      Efficiency projects—Converting natural gas engines with electric, negotiating with power companies for lower rates, finding ways to utilize under-utilized  assets etc.
7)      Acquisitions—Magellan will selectively make acquisitions where it makes sense strategically and financially.  If Magellan does find an appropriate acquisition, it should be a huge catalyst for the stock in that MMP would issue stock and MGG would not suffer dilution.
So just looking at volume demand growth (1.2%) and price increases throughout Magellan’s system (conservatively 4%), Magellan could increase topline growth by about 5.2% with minimal growth capital expenditures.  Operating costs will increase at about 3.5% conservatively, so Magellan could increase bottomline line cash flow in excess of 5.2%, something in the neighborhood of 7-7.5% without significant growth capex or acquisitions.
If you add to that the growth capex that they have announced ($255mm) and additional low risk growth capex that they have not announced, annual cash flow growth should easily hit 10% which is equivalent to MGG’s dividends growing at about 25% year for the next several years.

MGG’s dividends (and MMPs for that matter) are 90% tax deferred through 2008.  Unitholders will pay little to no taxes until sold.  Dividends received will lower the holding cost of the unit purchase price.  Please consult your tax advisor.

Comparables and General Partners (“GPs”)
GPs are misunderstood and mis-priced securities.  While in general they are a leveraged way to invest in the underlying LP, they each have varying degrees of leverage.  But given that GP’s are a leveraged play, it is even more important to pick the right underlying LP.  I encourage everyone to read Lehman’s 9/13 piece on GPs.  Some L.P.’s offer higher yields but lower growth or more volatility in cashflows.
There has been a huge supply of general partners that hit the market in 2006 that have weighed down on the group.  Some of the names include VEH the GP of VLI, ETE the GP of ETP, BGH the GP of BGL, AHD the GP of APL, AHGP the GP of ARLP, HPGP the GP of HLND.  This supply has weighed down the performance of them as a group in 2006.  Given the plethora of supply and misunderstanding, we expect GP prices to rebound in 2007.
GPs are cheap versus other yielding instruments like REITs and Utilities
The GPs trade as a group at a current average yield of 4% and an average distribution growth rate of 18-19%.  Much of the dividend is tax deferred.  GPs have similar current yields as REITs and Utilities at around 4-5% but have a 4-6X higher growth rate.  REITS and utilities are only growing single digit if at all.  The superior growth is not reflected in the valuation of GPs.  Doobadoo’s writeup on shorting REITS may also give you a flavor of REIT valuation.
We feel the market will wake up to this discount and start buying GPs soon.
Several GPs are even cheap versus their underlying LPs
MGG currently trades at a 4.25% yield while its underlying LP, MMP trades at a 6.1% yield.  In order to match the 6.1% yield, MGG would have to be paying a $1.34 dividend which they will be doing in the middle of 2008.  With MGG growing at 2.8X times faster than MMP you would be much better off owning MGG.
Another example would be ETE which trades at a 4.3% yield, while its underlying LP, ETP trades at a 5.6%.  In order to match the 5.6% yield, ETE would have to be paying a $1.59 dividend which they will be doing in early 2008.  ETE is also cheap in our book.
The growth rate in dividends is not being reflected versus their slower growing underlying LPs.  This is magnified in the event of an acquisition if the underlying LP issues stock while the GP remains undiluted on the incremental cash flow from the acquisition.

MGG deserves a premium valuation to the GP group

Its track record of 22 consecutive distribution increases is one of the strongest in the industry.
Its business is largely not directly affected by commodity prices nor does it need heavy capex in order to grow.
Its volumes increase as time goes by, not decrease like other natural gas MLPs.
Low leverage:  MMP carries less than a 3X leverage ratio…Among lowest in group.  MGG has no debt.


MGG delivering on steady distribution growth like MMP has over the years.
Realization of GPs value versus other assets comparable yielding assets.
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