Close
FEATURED STRATEGY

Trades This Easy Should Be Illegal

Trades This Easy Should Be IllegalNot long ago, a mysterious signal showed up in Wynn Resort’s stock chart. In just weeks, share prices rose 53%. But you would have left a lot of money on the table… because a simple two-sentence set of instructions would have turned that same 53% gain into a stunning 296% winner. That’s good enough to turn $5,000 into a staggering $19,800. Now, it’s about to happen again. Here’s how to get the profit instructions.

 

A Broken Record on Broken Models

Two weeks ago my colleague Igor Greenwald and I conducted the first monthly web chat of 2016 for subscribers of The Energy Strategist and MLP Profits. We hold these chats on the second Tuesday of each month.

In this session we addressed nearly all the questions, but there was one remaining that gets right to the heart of investing in the MLP sector.  

Q: Could you comment on a Valuentum article that believes the entire MLP business model is doomed? A key point in their thinking is that the accounting of free cash flow is flawed and that eventually distributions will be severely cut. The article concedes that a quick return to much higher priced oil would save MLPs, but they see that as a low probability within the next year or two.

In recent months there have been a number of negative articles on MLPs by Brian Nelson, the president of Valuentum Securities. For example, see MLP Business Model Still at Risk.

As an investor, I am a firm believer in reading and dissecting opinions that are different from my own. I would encourage readers to read through some of Mr. Nelson’s articles on the topic so you understand the issues he highlights.

The fundamental question at hand is whether the business model is at risk. To me, this suggests not a question of whether the sector is fairly valued at today’s commodity prices, but rather that the business model itself is flawed.

Let’s briefly review the differences between a taxed corporation (commonly known by its U.S. tax code designation as a C Corp) and a publicly limited partnership (most often a legal sub-category known as the master limited partnership, or MLP.)

MLPs don’t pay corporate income tax; instead, they pass their income on to unit holders (shareholders). That’s why they’re known as “pass-through” entities. This arrangement avoids the so-called “double taxation” of dividends paid by traditional corporations to shareholders.

All else being equal, when a corporation and an MLP each generate a dollar of income, the MLP should be able to distribute more of it to investors since it didn’t have to pay taxes on that income.  

But that’s not the MLPs sole tax advantage, because its distributions are largely tax-deferred. Thanks to energy pipelines’ typically hefty depreciation allowance, much if not all of an energy MLP’s distribution is termed “return of capital” and thus not immediately taxable. Instead,   distributions in excess of net income reduce the recipient’s investment cost basis. The result is a larger reported capital gain (or a smaller loss) when the units are sold, with the portion of the gain attributable to past depreciation and depletion taxed as personal income.The other tax advantage of MLPs accrues to heirs when such investments are passed down rather than sold. Such transfers step up the cost basis of the units to their current price, wiping out the  deferred tax obligation on past distributions.

 Since MLP distributions confer considerable tax advantages, it only makes sense for the partnerships to pay out much of their cash flow, even if that means relying on constant infusions of debt and equity capital for expansion projects. A few MLPs, notably Enterprise Products Partners (NYSE: EPD) and Magellan Midstream Partners (NYSE: MMP), do in fact reinvest a significant proportion of their cash flow.

But those that do not aren’t really “running a Ponzi scheme” or operating “a doomed business model” as the ill-informed critics would have it. They’re simply maximizing their tax advantage at a cost of higher leverage and market risk.

That hasn’t been a problem in normal times, thanks to reliable and reliably growing cash flows from the MLPs’ midstream energy assets. But with midstream equity prices down sharply the cost of selling additional shares or units has grown unjustifiably high for many issuers, forcing them to rely more on debt or else to cut distributions in order to finance expansion.

That’s not really something unique to MLPs, as the C corporation Kinder Morgan (NYSE: KMI) proved recently when it became one of the very few midstream operators to this point to cut its payout.

But such distinctions, and the fact that midstream cash flows and distributions so far are holding up pretty well, matter little to those playing on investors’ fears.   

We believe strongly that the MLP model is sustainable, while current equity prices are in many cases unsustainably low. But the road from here to big capital gains is winding and hazardous. The one hazard we’re not losing any sleep over is whether most MLPs will be able to raise outside capital again, because all of our top picks at MLP Profits retain the ability to do so.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

 

 


You might also enjoy…

 

Retirement Woes Are About to Vanish

Will I have enough money in my retirement years?

That’s the question on the minds of so many Baby Boomers nowadays. But you can set those worries aside.

Because master trader Jim Fink is releasing step-by-step instructions on how to collect a $1,692.50 payment on Thursday… and every Thursday after that.

Jim explains everything in a new presentation—but you only have a few more days to watch it.

Watch it here while there’s still time.

Stock Talk

Add New Comment

You must be logged in to post to Stock Talk OR create an account