Market Commentary: Nothing Can Be Said to Be Certain, Except Death and Taxes
JUST VOTE YES...TO THE PROPOSED OKE/MMP MERGER
This past Mother’s Day, ONEOK, Inc. (NYSE: OKE) and Magellan Midstream Partners, L.P. (NYSE: MMP) announced their definitive merger agreement – unanimously approved by both companies’ Boards. OKE is paying a 22% premium to MMP’s closing price on the day prior to the announcement (May 12th). MMP unitholders will receive $25 in cash and .6675 shares of OKE share for each share of MMP. Since the proposed merger announcement (and as of 7/21/23), MMP has appreciated 18.0% compared with 6.0% for the Alerian Midstream Energy Index (AMNA) benchmark, 4.3% for OKE and 10.0% for the S&P 500. Presumably, MMP’s unit price would fall if the transaction were not consummated.
Magellan Midstream unitholders and ONEOK shareholders will decide on September 21, 2023, whether to approve the proposed merger of the two companies. As a follow up to our May 23rd commentary, “It Takes Two to Tango,” we believe that stakeholders of both companies should vote “yes” for the merger. Simply put, the new company with a more diversified set of assets will be stronger, better positioned for growth through energy cycles, and realize commercial and cost synergies that are likely to exceed managements’ conservative estimate (in our view) of between $200 and $400 million.
With more than a decade of rapid production growth, the infrastructure to support the oil and gas industry has largely been built by the midstream energy companies. Hence, there is less need to spend capital and available cash to reduce debt, pay dividends and buyback shares to enhance shareholder value. ONEOK has reduced debt, while Magellan has bought back approximately 12% of its units outstanding. Another alternative to create shareholder value is through consolidation when organic growth opportunities that can generate attractive returns are limited.
Price Performance Since Merger Announcement
TAXES ARE COMPLICATED…
Some MMP investors are unhappy because the transaction is a taxable event for them. What complicates the situation is that everyone’s cost basis is different and the longer the units are held, the greater the tax burden. Unless the holder intends to hold the units until death and pass them to their heirs, taxes will come due upon sale. In fact, some taxes are likely already due annually because unitholders are responsible for their share of income generated by the partnership. To be clear, we are not giving tax advice. Investors should consult with their tax advisors. (Please see the bottom of page 3 for an overview of MLPs.)
THOSE OPPOSED TO THE DEAL MAKE THE FOLLOWING ARGUMENTS:
1) The 22% premium being offered is too low and does not adequately compensate MMP unitholders for the taxes they will owe. Our response: These are two separate issues. The price that is being paid should reflect the intrinsic value of MMP, not the tax liability of unitholders. For example, if I have a gain on the sale of my home, do I expect the buyer to pay my capital gain taxes? Taxes that are deferred are liabilities that ultimately must be paid (unless the unitholders intend to own them until death). Taxes owed will depend on a unitholder’s holding period. The longer the holding period, the lower the cost basis and the higher the tax liability. According to MMP’s analysis, about 65% of units outstanding have been held for five years or less and less than 25% of its units have been held for more than 10 years. The $25 per unit cash portion of the transaction should exceed the amount of taxes owed in most cases and on average approximates $13.40 per unit based on MMP’s calculations.
Tax Impact of Pending OKE-MMP Merger
Source: Magellan Midstream Partners, L.P.
1 Assumes 06/30/2023 close, maximum federal tax rate, 20% (199A) deduction on partnership income, 5% state rate, ACA tax of 3.8% and $67.50 value at closing.
The implied acquisition price for MMP at the time of the merger announcement was $67.50 (based on the appreciation of OKE’s stock price since then, the implied acquisition price has risen to $68.88). This seems to be a fair price. Fourteen Wall Street analysts at the time of the merger announcement had one year price targets for Magellan that ranged from $53 to $64 per unit. According to Morgan Stanley’s analysis of the transaction, the acquisition price implied an enterprise value-to-EBITDA (a proxy for cash flow) multiple of 12.3x compared to an average multiple of ~10x for a peer group.
2) MMP unitholders will see a reduction in current income.
Our response: On a pre-tax basis, MMP holders are receiving annual distributions of $4.20 annually. However, MMP estimates that for folks that have held units for over ten years, in other words, those that have the highest deferred tax liability, within three years nearly 60% of the distribution will be owed in taxes. After three years, the distribution per unit is expected to grow to ~ $4.46, but after taxes, unitholders will have just $1.94 per unit in cash. After the merger, MMP unitholders will own .6675 OKE shares and receive $2.55 per share (.6675 times OKE’s annual declared dividend per share of $3.82) in qualified dividends or about $1.55 per share after paying taxes. They will also receive $25 per share in cash that as already noted, should exceed their tax liability.
3) OKE expects to benefit from the step-up in Magellan's tax basis from the transaction. The benefit from the basis step-up has an estimated total value of approximately $3.0 billion, and an estimated net present value of approximately $1.5 billion.
Our response: Again, the analysis to vote yes or no should rest on the value of the transaction compared to the intrinsic value of MMP. Additionally, unitholders that decide to hold on to the OKE shares that they will receive in the merger will benefit.
4) MMP unitholders prefer to decide on the timing of when to sell their units… or hold them until death do them part.
Our response: Shareholders can rarely (if ever) influence the timing of merger and acquisition proposals. Additionally, the longer they hold the units the greater their tax liability. That is because over time, there will be less depreciation expense to shelter income resulting in higher allocation of income to unitholders. Magellan estimates that “long-tenured unitholders will soon owe taxes each year that amount to approximately 60% of the distributions they receive.”
AN OVERVIEW OF MLPS: OKE is structured as a c-corp, while Magellan is structured as a master limited partnership (MLP). Instead of shares, MLP interests are denominated in units and instead of dividends, unitholders receive distributions. Holders of MLP units are essentially limited partners in the business and are allocated a portion of the company’s income and are responsible for paying their proportional share of the income taxes owed by the company. The good news for MLPs holders is that in the early years, most of that income is sheltered by depreciation expense, taxes are deferred, but not eliminated. A future tax liability accrues over time. The quarterly distributions that MLP owners receive are not the same as dividends received from a corporation. They are deemed a return of capital and lowers the owners’ cost basis. When MLP units are sold, the accumulated depreciation expense is recaptured and taxed at the holders’ ordinary income tax rate and the difference between the selling price of the MLP units and the cost basis is taxed at the capital gains tax rate. As with other securities, the cost basis in the MLP units is stepped up to fair market value upon the owner’s death and their heirs avoid taxation on any previous distributions. The bad news, unless unitholders intend to hold the MLP units until death due them part, they will have to pay taxes. Indeed, the longer the units are held, the greater the tax bill and the likelihood that some taxes will be owed on the allocation of income.
JUNE REVIEW: ENERGY REBOUNDS AS U.S. ECONOMY REMAINS RESILIENT The rundown:
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 6.2% compared to 6.6% for the S&P 500 and 4.7% for its customized benchmark.
SAM’s Energy Transition Portfolio generated a return (net) of 4.5% vs. 3.1% for its customized benchmark.
Midstream outperformed in June with a total return of 7.0% as measured by the Alerian Midstream Energy Index (AMNAX).
Utilities and the clean energy sector generated a total return of 1.6% and 0.8% as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the S&P Clean Energy Index (SPGTCLTR), respectively.
All 11 sectors in the S&P 500 reported a positive performance including Energy with a 6.6% monthly total return. June month-end WTI crude oil and Henry Hub natural gas prices approximated ~$70 per Bbl ($70.66) and ~$2.50 per MMBtu ($2.48), respectively, which were up 4% and 18% from month ago prices.
RESULTS: YEAR-TO-DATE & SINCE INCEPTION
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 11.2% and 58.9% for the 1-year and since 11/10/20 inception periods, respectively. This compares to a total return of 5.9% and 53.8%, respectively, for its customized benchmark and 19.6% and 30.8%, respectively, for the S&P 500.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 3.4% and 8.4% for the 1-year and since 4/29/21 inception periods, respectively. This compares to a total return of 2.6% and 3.6%, respectively, for its customized benchmark and 19.6% and 9.4%, respectively, for the S&P 500.
Sam Partners’ Infrastructure Income and Energy Transition Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality clean energy companies, midstream energy companies and utilities that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of greater than 5% and growth potential of ~5-7%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and adheres to strict ESG criteria, offers investors a current yield of greater than 4%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.
Siegel Asset Management Partners is a registered investment adviser located in Plainview, New York. The views expressed are those of Siegel Asset Management Partners and are not intended as investment advice or recommendation. This material is presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness, or reliability. All information is current as of the date of this material and is subject to change without notice. Third-party economic, market or security estimates or forecasts discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates or forecasts. Certain products and services may not be available in all jurisdictions or to all client types. Unless otherwise indicated, Siegel Asset Management Partners' returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.