Macquarie Infrastructure: 10% Dividend Made Even Safer By Balance Sheet Improvements (NYSE:MIC-DEFUNCT-3024) (2024)

Macquarie Infrastructure Company (MIC) recently reported 3Q18 results, in line with management's estimates. The most important event occurring during the last couple of months is the sale of BEC (Bayonne Energy Center) which meaningfully improved the balance sheet (about 4x debt to EBITDA now). Apart from BEC, MIC has sold a couple of small non-core operations worth collectively $40M, and achieved a significant progress in repurposing IMTT tanks away from heavy residual oil. The target is to repurpose up to 3 million barrels; about 1.3 million of them should be already back in service at the end of 1Q19.

Apart from a new website design which comes with significantly improved disclosure in management's presentations, there is another positive development for outside investors: the base management fee paid by MIC to Macquarie has been partially waved (indefinitely). In words of the CEO Frost:

In short, the base management fee will now be calculated as 1% of our equity market capitalization less cash on the balance sheet. No fees will be assessed on holding company debt. We expect the management to continue to reinvest anything to which it is entitled in new primary shares. The annualized impact of these changes compared with a fees assessed to the third quarter is a reduction of approximately $10 million.

I view the removal of the incentive to pile up debt to increase management fee very positively, although, of course, it does not improve the business prospects of the company itself. Before this change, the dilution from base management fee was about 1.2% a year (at stock price about $40). The (potentially high) performance fee is not affected by this, but thanks to the 40% stock price drop earlier this year, it is very unlikely that any performance fees will be paid in the near-term future.

The $900M obtained from the sale of BEC were mostly used to decrease debt: $150M went to repayment of IMTT revolving credit facility, $250M to decrease asset-level financing, and the rest is being used for planned capital expenditures in 2018 and 2019 in order to avoid accessing any external capital, whether new debt or equity.

The end result of this year's efforts is a decrease in total outstanding debt from $3.6B to $2.7B, debt to EBITDA ratio of 4x (low end of the 4 to 4.5x target) and a stable BBB- credit rating. Average interest paid is 3.3%, but the weighted average remaining life of only 5.1 years is slightly concerning to me. The management plans to address this in next July when $350M of convertible notes mature. The paydown of various revolving credit facilities has created undrawn debt capacity of more than $1.5 billion, so liquidity is more than sufficient for all the present needs.

Despite all this, the company is actually financially quite constrained; it retains only about 30% of free cash flow and the low share price makes any share issuance very uneconomic. Perhaps the best illustration of this lack of flexibility is given by the CEO's comment during the 3Q18 conference call on why MIC decided to sell their existing wind and solar facilities: "We do not believe that the alternative of trying to achieve scale through acquisitions is something we can do effectively given our current cost of capital."

The future of the company is basically settled for the next two years: almost all available resources will be focused on strengthening IMTT by all the repurposing and repositioning (which includes improving access of existing tanks to rail and pipeline transportation options). In particular, there are $750M of capital projects under consideration, including $650M for IMTT over the next two years. Those projects are quite worthwhile; repurposing is done at 2-3x EBITDA multiple and repositioning at about 7-10x.

During this period the company will generate about $500M of free cash flow a year (you might want to check my previous article for details and compare them with the updated management's guidance; the numbers have not changed much since then). This cash flow will mostly be paid out as dividends ($342M a year), the remaining $160M will, together with the remaining proceeds from BEC sale, fund capex. During the recent management retreat, the capital allocation policy was discussed:

In that discussion I also noted that we would evaluate means of returning excess capital to shareholders, potentially in the form of a share buyback. However, to preserve and enhance strategic options available to us in the future it is essential that we invest in and grow the infrastructure characteristics of our businesses that we fund this using internally generated resources to the extent possible that we generate incremental tax yield in doing so. Any share repurchase program would have to accommodate these priorities.

In other words, they would like to repurchase stock (who would not at more than 10% immediate cash yield?), but have little money to do so since they will not allow buybacks to interfere with fixing IMTT or to negatively affect the balance sheet. I also take it as a hint that they would prefer repurchases to dividend increases for the time being. In addition, no new busines avenues will be pursued:

... we met with the board during the strategic retreat and decided that the most appropriate path forward in order to maximize shareholder value was really to focus on our core businesses in order to drive growth and EBITDA and free cash flow. We see the successful execution of that strategy then enables us to look at potentially other verticals, but for the time being our focus is at least clearly on our three core businesses.

And really our focus from a capital deployment perspective is reinforcing the infrastructure characteristics of the existing verticals and that goes hand in hand with the non-core divestitures that we've done over the course of the year as well. So really focus on existing businesses and seeing the trajectory of those businesses growing before we look at any external or any other verticals.

The interesting question is what will happen after those two years. I think that the key factor to determine what will happen will be the share price. I see basically two possible scenarios. First, if markets will gain confidence in the company and its management and will reward it by a significant increase in share price (e.g. to $60), more demanding plans can be conceived. I do not care much about this scenario now --- a 50% return in two years is nothing to worry about. [Caveat: this is not entirely true. If all other asset prices increase even more, it will be hard to reinvest the MIC dividends or the proceeds from a stock sale profitably. In such cases one is better off owning a compounding machine like Berkshire Hathaway (BRK.A, BRK.B).]

Second, if the share price continues to languish, I have to rely on sufficient value creation coming from the inside. If the company is able to cover its dividend (more than 10% dividend yield at present) and can find profitable ways of employing the excess $160M of cash flow every year, it should offset most of the cash income taxes. The resulting return would basically be the sum of yield and growth rate. As for growth, long-term average aviation growth is about 2.5% (aviation, in particular FBOs, comprises about 45% of MIC's business), and IMTT tanks' utilization of 85-90% planned for 2020 also offers some upside. I believe that almost all the assets MIC owns are at least somewhat resistant to pricing pressures and have some moat around them. Temporary softness is, however, quite possible:

"It is the case that we are seeing softness in Bayonne notably for gasoline and distillate. However, it is our expectation, that utilization will recover as we approach the implementation of IMO 2020 [sulphur regulation].

Yes, rates will clearly follow increases in utilization as excess capacity gets taken out. So we need to see how that plays out. But you will appreciate that as customers start to finalize what their approach will be to IMO 2020, whether it's sort of storing high or low sulfur bunker fuel or whether it's blending, Bayonne is ideally placed to respond to whatever customer’s response is. And therefore we anticipate that to drive utilization and then rates to follow. But as I said, but we're also quite clear, we're not simply waiting on a recovery or recovery in demand. We're also looking at these other projects which will enhance Bayonne’s infrastructure offering to our customers."

Altogether, I expect same-store growth of about 2%. On top of that, investing $160M at 12% FCF yield leads to about $20M growth in FCF, which is about 4%. (Note that this would be achieved whether the excess FCF is invested in new projects or in MIC's own shares trading at 10% dividend yield.) This results in per-share growth of 5% (thanks to the 1% dilution caused by the base management fee). Put together, it is reasonable to expect 15% total return by investing in MIC shares at prices under $40.

Risks

My main concern is a moderate to severe recession which would be bound to hit both IMTT and Atlantic Aviation. I don't claim to deeply understand either of those two industries, but my study of old MIC reports available on the company website indicates that both businesses held fairly well even through the 2008/9 downturn. Yes, Aviation's FCF was cut in half, but that is still fairly solid compared to what happened in most other cyclical industries. The payout ratio below 70% also gives some assurance that the dividend will not be cut further during temporary dislocations.

Anyway, MIC is not a company that would be able to actually turn a recession into a long-term benefit. It is, therefore, prudent to complement it with companies like Berskhire Hathaway or Brookfield's partnerships (if one is focused on yield) or use it as a part of an income portfolio which includes some bonds to be sold and rebalanced into equities during a market downturn.