The Renaissance of Pipelines

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This is the final excerpt from IMA’s winter letter.

Pipelines are undergoing a renaissance today, but it’s not the one you think. The previous renaissance of shale oil and natural gas development was anything but a good outcome for this industry. Capital-intensive industries, contrary to common opinion, don’t benefit from increased demand for their product. Increased demand attracts competition. In a capital-intensive business it is very difficult to increase your capacity just a little. These industries don’t work that way, and here is why: Larger investments bring lower costs on a per-unit basis. But when everyone does this it also brings lower prices (revenues) per unit.

To make things more complicated, the pipeline industry is structured as master limited partnerships (MLPs). MLPs are mostly owned by retail investors who hold them to get one shiny object – yield. These companies generate enormous cash flows, while maintenance capital expenditures – basically, the expenses of maintaining their pipelines – are relatively small (10-20% or so of their cash flows).

To grow cash flows, once a company has an established pipeline network, it can do any number of things: It can raise prices for transporting products in its pipelines. It can make small investments to improve the interconnectivity of its pipelines, thus increasing the value of the pipelines to its customers, which also brings higher prices. It can send more products through its pipelines (of course, they are limited by capacity). There are probably a few other small things it can do, and we are sure these companies did them. A company can also do big things – build new pipelines, for instance. Improvements in oil and natural gas extraction technologies brought an enormous amount of petrochemicals to the surface, and they need to be transported.

Here is the problem. Since their investors were attracted to dividends, these companies would pay out most of their cash flows in that form, and whatever cash flows were left they’d put into new projects; but those cash flows were not enough, so… yes, they’d borrow a lot of money. But even borrowing was not enough, so they would pay large dividends and then issue shares (MLP units). They’d pay 6% dividends and then turn around and issue 3% of new shares. Retail investors were delighted to collect 6%, ignoring the fact that the pie now needed to be shared with 3% more shareholders (the stock price would decline 3%).

From 2008 to 2014 none of those things mattered. Investors infatuated with high and rising dividends drove prices of these companies higher in a straight line. This party ended in 2014, when lower oil prices exposed overcapacity in the industry.

That is not the renaissance we are referring to.

The renaissance of today is the one of cash generation. The pandemic and low commodity prices increased uncertainty in the industry, and pipeline companies stopped investing in new projects and have thus been generating enormous cash flows. In our conversations with these companies we learned that this trend did not start in 2020 but a few years back, as their shareholder base changed from retail to institutional investors. They generate cash flows and then decide what is the best use for the cash (after they pay a reasonable dividend).

We spent a lot of time analyzing pipelines in January 2020. Two companies stood out back then: Magellan Midstream (MMP) and Enterprise Products (EPD). However, at the time we decided to do nothing – they were not cheap enough. Ten months later, they were.

MMP is in a category of its own. It has by far the best capital allocation record in the industry – a higher return on capital and the least (almost no) share issuance. MMP focuses on transmitting refined products (gasoline, diesel, jet fuel). It has very little competition in its pipeline routes and is often a sole supplier. The beauty of the pipeline business, if it is run properly, is that it is mainly a fee-for-service business where the supplier often guarantees minimum revenues.

One concern we had with MMP was electric cars: They don’t run on gasoline. We did a lot of modeling and realized that it will take a long time before gasoline goes away. Even if sales of electric cars increase, which we think they will, the number of gasoline cars on the roads will remain stubbornly high for a long time. Electric semi-trucks are a decade behind electric cars, and planes are… we don’t know how far they are behind semi-trucks. Also, as demand for gasoline declines, pipelines will be able to raise prices (kind of like cigarette companies are doing today).

As of this writing MMP is a $43 stock or so. It is earning about $4 today and should earn about $5.50 in 2024. It pays us about $4 of dividends. As things come back to post-pandemic normal and its free cash flows grow, the company will either buy back stock or increase its dividend. Over the next four years we will collect at least $16 of dividends. MMP should be trading at least at 15x earnings or $75. It was in the low $60s at the beginning of 2020 (and the 2017 high was $80). We’d argue that high, sustainable, growing dividend payments are more valuable in a near-zero (during and post pandemic) interest rate environment. Combine this with dividends, and MMP is worth around $91 to us.

MMP is a 45-cent dollar.

Enterprise Products (EPD) is the largest pipeline company in the US. Its main focus is on natural gas. Size is important in this industry. Pipelines are networks that connect producers with refineries and transportation hubs. As prices vary at various points, flexibility of this network allows producers to send their commodities to the points where they’ll get paid the most. Also, 89% of EPD’s revenue is from fees for services (take or pay contracts). We like EPD’s exposure to natural gas and natural gas liquids, because most of these products are used in manufacturing (plastics) and the generation of electricity.

EPD was not shy about spending money on new pipelines over the last five years, but neither was it shy about issuing new units (this was another reason for our initial hesitation about the company in January). EPD recently announced that it is slashing its capital expenditures to $800 million from $4 billion in 2019. EPD’s free cash flow (operating cash flow less capital expenditures) is due to explode from $1.77 in 2020 to $2.50–2.75 in around 2022 or 2024.

Our confidence in EPD is boosted by the fact that a third of EPD units are owned by the Duncan family (Dan Duncan, EPD’s founder, died in 2010). The Duncans have been a significant buyer of EPD stock lately.

EPD pays a $1.80 dividend, so over the next four years we’ll collect at least $7.20 in dividends. The stock should be trading at 15 times free cash flows, or $37.50 or so. Add dividends, and over four years EPD is worth $44 to us, give or take.

EPD is a 43-cent dollar.

Our Sell Discipline

A client asked whether there is a difference in our sell discipline between high- and low-growth companies.

Selling is one of the hardest parts of investing. I wrote a lot on the subject in the past, but let’s zoom in on how our selling practice differs between high-growth companies with long runways for compounding and slow-growth companies.

Let’s take McKesson, for example, MCK grows revenues 3%, maybe even 5%, a year (depending on drug price inflation). Its earnings growth will be helped by MCK buying back its stock. This will add another 3–8%, depending on the valuation of the stock (the cheaper the stock the more shares it can buy). When we look at McKesson’s earnings four years out, we have a relatively narrow range of fair values for the company. As the stock starts approaching our middle-of-the-road fair value, we’ll start decreasing our position. As it gets to the higher end of fair value, we’ll sell the full position. The difference between the low and high fair values for these two scenarios will probably be 15–25% or so. MCK is a very stable and predictable business. We may sell it in halves, thirds, or quarters. This is not a science but an art.

Then we’ll have companies that are run by owner-operators that have a high return on capital and a long growth runway. Let’s call them perennial compounders. With these types of companies we need to be more patient with our sell discipline than with McKesson. This combination of owner-operator (especially when he/she has skin in the game), high return on capital, and opportunities to reinvest this capital often surprises us with an upside scenario. We are a lot more patient (and forgiving) with this type of company.

We keep companies like McKesson on a relatively short leash. For companies like the perennial compounders we need to use a longer leash, one of those extendable leashes.

Read this before you buy your next stock

While the most recent client letter is proprietary for existing clients, we would be happy to share this sample from 2020 in this link.

(Drawing is by my brother, Alex Katsenelson. Prints available on ArtistUSA.com.)

Beethoven's Piano Concerto No. 3

Beethoven’s Piano Concerto No. 3 was composed in 1803, when Beethoven was 33 years old, and 12 years after Mozart’s death. It falls in the middle of the shifting tectonic plates of Beethoven’s being stuck in the Mozart era and finding his own independent footing as a composer (less “sunshine” Mozart and more darker, moodier Beethoven).

Music critics argue that this concerto was inspired by Mozart’s 24th piano concerto. Though both concertos are focused on the piano, Beethoven’s uses it to a much greater degree, and the piano was going through a major transformation at the time (I wrote about it here).

Beethoven was the piano soloist of the concerto at its premiere. The score for the piano part was not fully finished – Beethoven was playing it from memory. Ignaz von Seyfried, who was lucky to be chosen Beethoven’s page turner for that performance, wrote:

I saw empty pages with here and there what looked like Egyptian hieroglyphs, unintelligible to me, scribbled to serve as clues for him. He played most of his part from memory, since, obviously, he had put so little on paper. So, whenever he reached the end of some invisible passage, he gave me a surreptitious nod and I turned the page. My anxiety not to miss such a nod amused him greatly and the recollection of it at our convivial dinner after the concert sent him into gales of laughter.

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Vitaliy Katsenelson, CFA

I am the CEO at IMA, an investment firm that designs all-terrain portfolios that survive the worst markets and thrive in good ones. (Get our company brochure here, or simply visit our website).

In a brief moment of senility, Forbes magazine called me “the new Benjamin Graham.” 

I’ve written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. (I’m working on a third - you can read a chapter from it, titled “The 6 Commandments of Value Investing” here).

And if you prefer listening, audio versions of my articles are published weekly at investor.fm.