Master limited partnerships (MLP) are truly in the sweet spot of the investing universe: tapped into the explosive growth of energy-from-shale, financing growth with the lowest cost of capital in their history.
An acute shortage of pipelines, processing facilities and other infrastructure means MLPs are able to almost fully contract assets before turning the first shovelful of earth. Meanwhile, the market for capacity on existing assets is the tightest in memory.
Kinder Morgan Energy Partners LP (NYSE: KMP), for example, this week reported capacity on one of its western pipelines was 65 percent over-subscribed. Despite the drop in natural gas prices, throughput in that side of its business is up 11 percent from last year. That was a major reason for the MLP’s 16 percent increase in distributable cash flow, the most important measure of sector profits.
Like iPhones in Beijing, energy companies’ need for midstream assets has literally outstripped available supply. And that means more assets will be built, generating more cash flow and distribution growth. Kinder Morgan, for example, now forecasts an 8 percent bump in its distribution this year, due to what CEO and founder Richard Kinder called “the most diverse set of opportunities at any time in Kinder Morgan’s 15-year history.
MLPs’ strengths haven’t gone unnoticed by investors. The group has been one of the top-performing sectors the past few years, even as MLPs been among the most generous and reliable dividend payers. Kinder Morgan, for example, yields around 5.4 percent, nearly three times the average yield on the S&P 500.
Like many MLPs, Kinder Morgan broke out to a new all-time high this week. Those relentless gains have provoked greater caution from some investors. And they have a point: Rising prices mean higher investor expectations, which increase the possibility of share price-damaging disappointments.
Earnings that don’t quite measure up are always a catalyst for selling. So are equity offerings, as investors fret about possible dilution. The good news is prices generally recover swiftly, as it becomes clear the capital is being raised on the cheap and will finance expansion that will generate higher cash flow and distributions. But the near term impact can be somewhat off-putting, particularly if enough stop-losses are triggered.
Posted opinions in the analyst community and even blog posts can have an even greater impact on prices. A recent piece published on Seeking Alpha, for example, created a great deal of investor consternation by suggesting pipeline company earnings headed for a steep decline, as regional availability of natural gas eliminated the need to ship the fuel across country.
This opinion is, of course, diametrically opposed to the facts. Not only have pipeline volumes never been higher for gas. But everything being built is basically oversubscribed before it’s placed into service. Producers sign long-term contracts that in many cases are “take-or-pay,” meaning the owner gets the money whether any energy is shipped or not.
Finally, MLPs such as Kinder Morgan are hardly one-trick ponies. Even if gas pipeline shipments should slow, they have other assets to pick up the slack. Kinder Morgan is also a leading shipper of ethanol to California, which mandates the fuel’s use by law. And it has a growing presence in natural gas liquids (NGLs) and oil infrastructure as well.
None of that mattered, however, to investors who sold pipeline stocks across the board in response. And with so many living in perpetual fear of a reprise of the 2008 crash, we can expect more such volatility in coming months.
That being said, top-quality MLPs still boast a favorable combination of high yield and growth that’s basically unmatched in the investment markets. In addition, they pay a portion of distributions as return of capital, meaning no tax is due the year received. Instead, it’s deducted from the cost basis and is taxed as a capital gain when you sell. MLPs can also be willed to heirs, in which case the one-time step-up in cost basis wipes out the tax liability entirely.
Even the much-feared Form K-1–which MLPs send out instead of 1099s–isn’t nearly as onerous as it was in past years. In fact, numbers can be plugged directly into most tax preparation software. And for those who MLPs in IRAs, there are no such concerns at all, other than potential unrelated business taxable income (UBTI), which won’t reach the $1,000 taxable threshold unless investors have truly institution-sized accounts.
Many investors like to lump all stocks in a sector together, one reason why exchange traded funds (ETF) are so popular. Those who choose wisely, however, can earn much more generous returns and capture higher income as well.
Here’s what we look for in an MLP.
Payout Ratio/Coverage Ratio. The payout ratio compares the distribution to the income that pays for it. The greater the margin between income and the distribution, the safer the payout and the more likely it is to grow.
For MLPs the key measure of income is distributable cash flow (DCF). MLPs’ unique structure allows them to minimize taxable earnings per share (EPS), the measure of profitability for ordinary corporations. DCF factors in this ability to shelter income from taxes by adding back in those tax avoidance items, which are mainly accounting expenses that involve no outlay of cash. Maintenance capital expenditures are taken out of cash flow, as they represent cash needed to run the business and maintain equipment.
Most MLPs express the payout ratio by dividing DCF by the distribution as a “coverage ratio.” This is basically the inverse of what most corporations do, which is expressing the distribution as a percentage of income. The result, however, conveys the same information. That is a coverage ratio of 1.25, for example, is equivalent to a payout ratio of 80 percent. A higher coverage ratio/lower payout ratio is preferable to a lower coverage ratio/higher payout ratio.
Commodity-Price Exposure. The more reliable an MLP’s income the higher a payout ratio or lower a coverage ratio it can sustain. Pipeline MLPs, for example, have extremely reliable revenue as it’s based on fees. Commodity producer MLPs, in contrast, are ultimately at the mercy of commodity prices.
Debt. With the possible exception of Fitch, credit raters have generally lost their credibility in recent years and credit ratings are of limited utility, other than for pension funds and other institutions whose charters restrict them to owning only investment grade securities. As a result, we use debt-to-capital and debt refinancing needs to judge balance sheet strength.
Dividend Growth. Consistently growing distributions not only increase your income stream. They’re also the surest catalyst for higher MLP unit prices over time. We prefer management to lift the distribution each quarter but generally award a point for any company that has increased its payout at least once in the past 12 months.
If that sounds good, I invite you to sign up for our complementary new e-zine focused on master limited partnerships, MLP Investing Insider.
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