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MLP Profits

By Roger Conrad on July 12, 2010

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It’s been roughly a year since Elliott Gue and I launched this advisory. In that short time, the broad-based Alerian MLP Index has returned right around 50 percent, roughly twice the S&P. Of our Portfolio recommendations, 16 of the 20 we’ve made have bested the Alerian, with two more than doubling our money.

Of the remaining four, three are relatively new additions that haven’t had time to pan out. And our sole “laggard,” Energy Transfer Partners LP (NYSE: ETP), is nonetheless up more than 20 percent from our recommendation last August. We’ve also been able to take advantage of market dips such as the Flash Crash in May to re-recommend our favorites at discounted prices.

I sincerely hope you’ve been able to share in these profits, which, despite these returns, hasn’t been as easy as it may seem in retrospect. For one thing, over the past year there’s been a strong temptation for income investors to sell out of their holdings on every market rally.

Some have adopted the technique of using trailing stop-losses, which automatically generate a sell order when a stock falls a certain percentage below its peak. They’ve all too often found themselves whipsawed out of good positions on what proved to be temporary down moves. That’s mainly because so many others had stop-losses at the same percentage, so when the target price was hit a massive wave of sell orders came on the market at the same time. That sent prices plunging and then rebounding sharply as buyers came back and short-sellers locked in profits.

We spent a lot of print warning readers against using this so-called risk avoidance technique. And with the markets this summer still fear-ridden, we’re repeating that advice now. Mainly, too many people are still using stop-losses in popular income paying stocks on the mistaken impression they’re limiting potential losses in a downturn. In reality, they’re only locking in very bad selling prices for MLPs during selloffs, when they should be thinking of using the dips to add to positions.

As we’ve demonstrated over the past year, there are times when it makes sense to take some money off the table in particular MLPs. We did it first with Williams Partners (NYSE: WMZ), which surged when general partner Williams Companies (NYSE: WMB) merged it with a sister MLP. And we did it again when Navios Maritime Partners LP (NYSE: NMM) temporarily out-ran its prospects.

Also, we continue to advise periodic rebalancing of your holdings the way professional money managers do. All too many investors will sit and watch a particularly high-flying stock grow to become an inordinately large piece of their portfolios. No matter how strong the company is, it’s then a risk to do serious damage to the portfolio should an unexpected mishap occur, or even just profit-taking.

You don’t have to make moves every day. But every few months, it makes sense to cut down a particularly large holding and disperse the proceeds among the rest of your portfolio. That way you won’t be at risk to being sunk by a reversal at one company. And as market history has shown time and again, one month’s underperformers are often the next month’s outperformers, provided the underlying companies are still solid, as are all of our MLP Profits Portfolio picks. Moving out of a high-flyer and into a laggard can dramatically increase your returns in this way.

Ensuring individual MLP quality is our main objective in this advisory. And we’re coming up on another golden opportunity to assess underlying companies’ strength, second-quarter earnings reporting season. The list below shows the date each pick is scheduled or projected to report its numbers. Projected dates are indicated as such by “(estimated)” for estimated dates.

Conservative Portfolio

  • Enterprise Products Partners LP (NYSE: EPD)–July 26
  • Genesis Energy Partners LP (NYSE: GEL)–Aug 6 (estimated)
  • Kinder Morgan Energy Partners LP (NYSE: KMP)–July 21
  • Magellan Midstream Partners LP (NYSE: MMP)–August 3
  • Spectra Energy Partners LP (NYSE: SEP)–Aug 5 (estimated)
  • Sunoco Logistics Partners LP (NYSE: SXL)–July 21 (estimated)

Growth Portfolio

  • DCP Midstream Partners LP (NYSE: DPM)–August 6 (estimated)
  • Energy Transfer Partners LP (NYSE: ETP)–August 10 (estimated)
  • Inergy LP (NSDQ: NRGY)–August 4 (estimated)
  • Kayne Anderson Energy Total Return Fund (NYSE: KYE)–n/a
  • Targa Resources Partners LP (NSDQ: NGLS)–August 6 (estimated)
  • Teekay LNG Partners LP (NYSE: TGP)–Sept 21 (estimated)

Aggressive Portfolio

  • Encore Energy Partners LP (NYSE: ENP)–July 28 (estimated)
  • EV Energy Partners LP (NSDQ: EVEP)–August 10 (estimated)
  • Legacy Reserves LP (NSDQ: LGCY)–August 5 (estimated)
  • Linn Energy LLC (NSDQ: LINE)–August 6 (estimated)
  • Navios Maritime Partners LP (NYSE: NMM)–July 28 (estimated)
  • Penn Virginia GP Holdings LP (NYSE: PVG)–August 5 (estimated)
  • Regency Energy Partners LP (NSDQ: RGNC)–August 10 (estimated)

We’ll be recapping the highlights of all of these reports in MLP Profits as they appear, and more importantly what they mean for unitholders. Then we’ll look at what we see through the prism of our MLP Profits Safety Rating criteria, which are as follows.

Percentage Fee-Based Income. MLPs that rely on fee-for-service or for use of their assets have much steadier cash flows than MLPs that rely more on economic activity and commodity prices. Not every fee-based MLP is either safe or worth owning. And some are quite expensive now, including Conservative Holding Spectra Energy Partners LP (NYSE: SEP), which again trades well above our buy price of 27.

But we do award one point to any MLP that draws cash flows primarily from a fee-based business. We don’t include tanker revenue locked in by long-term contracts or oil and gas producer revenue locked in by price hedging as equivalent to true fee income, which comes from activities such as operating pipelines and energy storage systems. Neither do we include activities such as gas gathering, where activity depends heavily on commodity prices, or any processing, where margins depend on commodity price spreads. Profits in these areas are inherently variable.

Payout Ratio. Lower payout ratios are always better. The most important thing when ranking an MLP on this score is to use the right measure of profits. Earnings per share (EPS) will always paint a misleading picture, since MLPs typically try to minimize taxable earnings. But even distributable cash flow (DCF)–which factors in MLP tax advantages–can be misleading, depending on how management calculates it.

Unlike EPS, which is a measurement under Generally Accepted Accounting Principals (GAAP), there is no standardized measure for DCF. Most do calculate it roughly the same way, so their numbers are a useful standard. But every quarter we have to wade through the financial statements to ensure that’s the case and that DCF is really DCF. That is a measure of earnings that adds back in those tax avoidance items, which are mainly accounting expenses that involve no outlay of cash, such as depreciation.

Maintenance capital expenditures, which are needed to run the business and maintain equipment, are also taken out. A coverage ratio of 1.25-to-1 is equivalent to a payout ratio of 80 percent and generally indicates a well-covered and therefore a safe distribution with upside potential. But the more fee-based income an MLP has, the higher a payout ratio it can sustain. And conversely, the more commodity price-sensitive an MLP, the lower its payout ratio (higher coverage ratio) it should have to be considered safe. MLPs that meet this criterion also receive one point under the Safety Rating system.

Debt. As we’ve pointed out in recent weeks, our MLP recommendations have been able to use generation-low interest rates to slash interest costs, eliminate refinancing risk by extending debt maturities economically and fund asset acquisitions and construction. Moreover, credit conditions now are markedly different than they were in 2008 before the onset of the last crisis. Finally, management teams of most MLPs have continued to act as though another credit crunch remains a risk, i.e. they’ve adhered to exceptionally conservative financial policies. But controlling debt remains a long-term concern for our holdings.

We award each a point under our safety ratings system if debt is 60 percent or less of total capital. That’s a level which would not be at all impressive at an ordinary corporation. But with MLPs’ tax advantages, it’s a very healthy level indeed.

Dividend Growth. Nothing highlights a strong MLP like consistent dividend growth. We award any company a point for growing its distribution over the last 12 months.

Below, we indicate the percentage dividend growth for each holding for the past year, along with the number of consecutive quarters each has boosted. Note that volatile energy prices have made it very difficult for commodity price-sensitive MLPs to boost distributions over the past couple years. That’s something we expect to see change in coming months, as energy prices revive and our picks continue to expand their bases of cash generating assets.

Conservative Portfolio

  • Enterprise Products Partners LP (NYSE: EPD)–up 5.7%, 23 quarters
  • Genesis Energy Partners LP (NYSE: GEL)–up 9.2%, 19 quarters
  • Kinder Morgan Energy Partners LP (NYSE: KMP)–up 2.7%, 1 quarter
  • Magellan Midstream Partners LP (NYSE: MMP)–up 1.4%, 1 quarter
  • Spectra Energy Partners (NYSE: SEP)–up 13.4%, 10 quarters
  • Sunoco Logistics Partners (NYSE: SXL)–up 10.4%, 20 quarters

Growth Portfolio

  • DCP Midstream LP (NYSE: DPM)–0%, 0 quarters
  • Energy Transfer Partners LP (NYSE: ETP)–0%, 0 quarters
  • Inergy LP (NSDQ: NRGY)–up 6.3%, 34 quarters
  • Kayne Anderson Energy Total Return Fund (NYSE: KYE)–0%, no quarters
  • Targa Resources Partners LP (NSDQ: NGLS)–0%, 0 quarters
  • Teekay LNG Partners LP (NYSE: TGP)–up 5.2%, 1 quarter

Aggressive Portfolio

  • Encore Energy Partners LP (NYSE: ENP)–0%, no quarters
  • EV Energy Partners (NSDQ: EVEP)–2.2%, 13 quarters
  • Legacy Reserves LP (NSDQ: LGCY)–0%, 0 quarters
  • Linn Energy LLC (NSDQ: LINE)–0%, no quarters
  • Navios Maritime Partners LP (NYSE: NMM)–up 6.2%, 3 quarters
  • Penn Virginia GP Holdings LP (NYSE: PVG)–up 2%, 1 quarter
  • Regency Energy Partners LP (NSDQ: RGNC)–0%, 0 quarters

Taken together, our four criteria give a pretty good indication of the level of risk to MLP distributions. A low rating doesn’t necessarily indicate a sell any more than a high rating always means a buy. But if you’re looking for a way to match our recommendations to your own personal investing objectives, it’s the way to go.

Conservative investors who just want growth and safety should stick with our Conservative Holdings. Those who want to experience big gains from rising energy patch activity–particularly in shale gas and natural gas liquids–will want to draw more from our Aggressive and Growth MLPs.

The key is to build a mix of MLPs from the group or groups best matching your objectives, buying in at the lowest possible prices. We’ve had a nice opportunity to do so the past couple months, particularly the weeks on either side of May’s Flash Crash. We may get another golden opportunity later in the summer to do so, should fears about the global economy bubble over again.

The key to using these pullbacks to your advantage is first to resolve to ride it out, as long as the underlying businesses of your MLPs are healthy. Again, we’ll have a golden opportunity to assess business strength later this month. And from all indications, we’re going to see another robust round of numbers.

It’s possible some of our picks will falter, and that’s why we have to review the numbers, particularly those that form the foundation of our safety ratings system as described above. But as long as the numbers support the current level of distributions–or, better, their ability to grow–there’s no reason to abandon positions no matter how wild things get with share prices. That means don’t use stop-losses, particularly trailing ones.

Second, resolve to view dips in prices of solid MLPs as opportunities to buy. Most brokerages will accept buy limit orders which will only be executed if a certain price level is reached. Placing one may not get you into a particular MLP right away or even ever. But on those crazy days like we saw in May, it can get you in at a dream price that ensures explosive total returns as well as a high current yield.

At this point it looks like 950 to 1,000 is the potential downside for the S&P 500, should we see another selling wave as so many fear. Should that happen MLPs would probably sell off, too. That’s what we’ve seen in every correction so far, as investors dump everything but Treasuries on days when they worry most about the economy. In fact, MLPs have often been hit especially hard, due to poor use of stop-losses.

As long as the numbers show no risk to the MLPs’ dividends, there’s no reason to consider selling on these dips. And the opportunity to pick up MLPs that look pricey now is likely to be staggering.

Tax Talk

Legislation to tax carried interest used by hedge funds and some MLPs to avoid income taxes still looks uncertain. Wall Street has had some success fighting off some of the more draconian proposals and the provision may not even make it into the omnibus financial reform bill now being ironed out in Congress.

Nonetheless, we continue to advise you avoid all financial MLPs such as AllianceBernstein Holding LP (NYSE: AB). A yield of less than 7 percent for AllianceBernsten is in no way compensation for the risk if there’s a new tax. Stick to energy.

Many investors continue to worry about the possibility of having to pay taxes on unrelated business taxable income (UBTI) on MLPs held in IRA accounts. Again, the general rule is anyone with less than $1,000 in UBTI across their portfolio will not have a liability. And only accounts of institutional size have any possibility of generating that much UBTI.

MLPs, for example, lose their tax status if they generate more than 10 percent of their income from what are considered non-qualified sources, i.e. UBTI. As a result, the amount of UBTI generated by most MLPs is very small. Some, particularly those that own and operate infrastructure like pipelines, actually generate negative UBTI. This can be used to reduce total portfolio UBTI, which is more likely to be generated by energy producer MLPs for example.

The bottom line: UBTI is simply not a big deal for anyone who doesn’t hold tens of thousands of shares of MLPs in their account as institutions do. And again, you don’t file K-1s for your holdings. Rather the custodian of your IRA files a form that summarizes your account’s MLP positions.

The only reason we prefer holding MLPs outside IRAs is opportunity cost. That is putting them inside means you don’t get the benefit of return of capital on dividend income. That is there’s no tax due on return of capital in the year the dividend is paid. Rather, it comes off your cost basis and is taxed as a long-term capital gain when you sell. And if you will an MLP to your heirs, the cost basis steps up to the current price, wiping out the tax liability completely.

If you hold MLPs in an IRA, you’re going to be taxed at the same rate you would be for withdrawing any funds from the account. You will be able to shelter capital gains, however, just as you would for any other investment.

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