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Magellan Midstream Cut to Neutral

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Following Magellan Midstream Partners L.P.’s (MMP - Free Report) weak third quarter financial results, we have downgraded the oil pipeline and storage partnership to Neutral from Outperform.

Tulsa, Oklahoma-based Magellan Midstream Partners is a master limited partnership (MLP) that owns and operates a diversified portfolio of energy infrastructure assets. The partnership primarily transports, stores and distributes refined petroleum products and to a lesser extent, ammonia.

In 2011, the partnership’s pipeline volumes comprised 50% gasoline, 33% distillates (which include diesel fuels and heating oil), 10% crude oil, and 7% Liquefied Petroleum Gas (LPG)/aviation fuel. Magellan conducts its operations in three segments: Petroleum Products Pipeline System, Petroleum Products Terminals and Ammonia Pipeline System.

On October 31, Magellan Midstream announced dull third quarter 2012 earnings, with poor contributions from the business units. The oil distributor reported earnings per unit (EPU) of 35 cents (excluding mark-to-market commodity-related pricing adjustments), unchanged from the profit of the prior-year quarter. The result, however, fell shy of the Zacks Consensus Estimate of 44 cents. Total revenues, at $325.9 million, were down 25.2% year over year and were also below the Zacks Consensus Estimate of $468.0 million.

We believe that the operating scenario for pipeline operators will remain critical in the near to medium term. Magellan is also susceptible to lower-than-expected demand for refined products, commodity price fluctuations and cost overruns on expansion projects.

However, we acknowledge the partnership’s strong portfolio of energy infrastructure assets, capacity expansion plans and a sound liquidity position. Other positive attributes include its investment grade rating and strong track record for distribution growth. Over the last few years, the partnership has consolidated its position in the midstream business, achieved through a combination of organic efforts and accretive acquisitions.

In particular, following Magellan’s acquisition of petroleum storage and pipelines from a subsidiary of British major BP Plc (BP - Free Report) in 2010, the infrastructure asset provider owns one of the largest crude oil storages in the Cushing region while continuing to exploit opportunities necessary for improving the utilization of these assets.

Overall, we think the current valuation is fair and adequately reflects the partnership’s future growth prospects. As a result, our long-term total return expectation for Magellan Midstream remains rather muted. We do not see any significant price upside for the units in the next few quarters and expect the partnership to grow at a somewhat more conservative and sustainable pace. Our new long-term Neutral recommendation is supported by a Zacks #3 Rank (short-term Hold rating).

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