Better still, these returns actually understate the portfolios’ overall gains because seven recommendations were added during the third quarter and weren’t included in the portfolios for the entire return period. Weighing these partial quarterly returns against the Alerian’s return for the entire quarter is not a valid comparison. In fact, some MLPs were added to the portfolios only a few days before the quarter ended.

If we exclude those seven picks and look only at picks held for the entire quarter, the Aggressive Portfolio was up 27.5 percent, the Growth Portfolio was up 22.4 percent and the safety-first Conservative Portfolio was up 12.5 percent.

We’re pleased with the performance of the MLP Profits Portfolios, but it’s only natural to ask if the gains are warranted by underlying fundamentals whenever a portfolio posts substantial gains in a single quarter. In fact, one of the most common questions asked by new subscribers is if it’s still a good time to start buying our recommendations in light of recent run-ups.

The short answer is that our favorites still offer compelling fundamentals and aren’t expensive based on historical norms. Of course, not all MLPs are great buys and selectivity is absolutely crucial; roughly one-third of the partnerships in our How They Rate table are rated sells. And we carefully adjust our buy targets frequently to reflect current market conditions; we recommend buying only those trading under their targets.

Ultimately, the fundamental that matters most for MLPs is the sustainability of and potential growth in distributions over time. As a whole, MLPs have survived the financial crisis in excellent shape; the best-positioned names have held or continued to boost their distributions over the past year.

That performance has continued in the third quarter: 20 of the 48 MLPs that comprise the Alerian Index have announced their third quarter distributions. Of that total, 13 will pay more in the current quarter than one year ago and 10 have boosted their payouts sequentially, paying more in the current quarter than they did three months ago.

Only one of the 20 MLPs has announced an outright distribution cut and that MLP, Dorchester Minerals LP (NSDQ: DMLP) varies its payout every quarter based on shifting commodity prices. Dorchester’s inconsistent payout and commodity leverage is the main reason we rate the stock a “Hold” in How They Rate.

Distribution announcements to date suggest that the sector is healthy as a whole. Of course, as Roger Conrad noted in last week’s Growth MLP Spotlight, A Better Way, third quarter earnings season is just getting started–most of the partnerships we cover report between now and mid-November.  

Reading MLP Results

Earnings reports provide key insights into the sustainability of current quarterly distributions as well as the potential for future payout hikes. As noted in the A Better Way and Upside for G&P MLPs, we’ll be paying extra attention to any MLPs whose businesses are sensitive to commodities prices. With both oil and natural gas prices moving higher, commodity-sensitive names should fare better.

When analyzing earnings reports issued by MLPs, don’t fall into the common trap of looking at earnings per unit (EPU) figures, the MLP equivalent of earnings per share (EPS) for a normal corporation. EPU results for MLPs are widely reported in the financial media and on financial websites but are completely irrelevant. The most important metric to watch is distributable cash flow (DCF), not earnings per unit.

Earnings per share are an accounting construct and are a useful figure for evaluating results for most corporations. But earnings by definition include a large number of non-cash charges–expenses that don’t actually involve a company paying out any money.

The most common and prevalent non-cash charge to earnings for MLPs is depreciation. Most in the group are asset intensive businesses with expensive physical assets such as pipelines, terminals and storage facilities. Under traditional accounting, these assets depreciate over time; MLPs face astronomical depreciation charges on their huge asset bases.

But depreciation and other accounting constructs don’t represent a real cash charge or expense, nor do they affect a MLPs ability to pay distributions to unitholders. Because distributions are the group’s primary attraction, investors should focus on actual cash generated by the business–this cash forms the basis for the distributions paid to investors.

Distributable cash flow (DCF) is the most common measure of an MLP’s actual distribution power. To calculate DCF, companies add non-cash charges back into earnings and then subtract what’s known as maintenance or sustaining capital expenditure. Maintenance capital spending is an estimate of the amount required to ensure that existing assets remain in working order–that is, the actual cash amount the MLP must spend to sustain its business.

Conservative Portfolio favorite Enterprise Products Partners (NYSE: EPD) demonstrates the extent to which depreciation charges can skew results. The company generated net income in the second quarter of $186.6 million, but that includes a $156.7 million non-cash charge for depreciation and amortization. To calculate DCF, Enterprise added that $156.7 million non-cash charge back into earnings. The company’s actual cash cost to maintain its huge asset base in the quarter: a $33.1 million sustaining CAPEX charge.

In fact, MLP investors should actually be happy to see high depreciation charges. Depreciation and other non-cash charges are passed through to untiholders at tax time, providing a shield against tax liability. Simply put, these non-cash charges are a major reason for the tax-advantaged treatment of MLP distributions.

Let’s take a look at Enterprise Products Partner’s results over the past few quarters.


Source: Bloomberg, Enterprise Products Partners, MLP Profits

This table shows the reported earnings per unit (EPU), distributable cash flow (DCF) per unit and distributions per unit for each of the past three quarters. Based on earnings per unit, Enterprise has not covered any of its past three distributions; in the second quarter for example, Enterprise reported EPU of $0.32 and a cash distribution of $0.545 per unit for a total shortfall of $0.225 per unit. And that doesn’t even factor in the incentive distribution fee–an additional 9 cents per unit–that Enterprise must to its general partner.

Enterprise has 459 million units outstanding, so the shortfall between the company’s total earnings and total distributions was a massive $103.3 million in the second quarter alone. Logically, it would be totally impossible for a company to sustain that shortfall for even a few quarters without being forced to cut its payout. But Enterprise has done just the opposite, announcing its 21st consecutive quarterly distribution increase.

Logically, this simple example shows the EPU figure bears no relation to an MLP’s actual earnings or distribution power. Nonetheless, you will still see the occasional article, even from reputable websites, erroneously comparing MLPs’ payouts with EPU figures.

The distributable cash flow offers a far better metric. In the October 10 issue of Personal Finance Weekly, Strong Parents Make Healthy MLPs, I explain how the general partner’s take of an MLP’s distribution is calculated.  Even after adjusting for this fee, Enterprise has easily covered its distribution in all three of the quarters listed in the table above.

Valuations

The best MLPs have been raising their distributions despite a shaky economy and continue to amply cover their payouts based on distributable cash flow (DCF). The final consideration is valuation.

Because most investors purchase MLPs to earn a yield, one of the most common ways to value an MLP is to compare its yield to that of a 10-year US government bond. The yield on the 10-year–currently hovering just above 3.4 percent–is considered a risk-free rate of return.

Obviously, even the most conservative MLPs carry higher risks than US government bonds; the difference between an MLP’s yield and the 10-year yield represents the amount investors are being paid to assume that risk. To make a long story short, the higher the spread relative to Treasuries, the cheaper the MLP is on a yield basis.

My final table compares the yield on each of the MLP Profits Portfolio Holdings to the 10-Year US Government Bond yield.


Source: Bloomberg

To calculate this table, I examined weekly data for each MLP back to the first week it traded as a public company. I calculated each MLP’s average and median spreads to government bonds.

The table shows that of the 17 MLPs recommended across our three model Portfolios, only two have a current yield spread that’s lower than their long-term average. And the two MLPs currently offering a lower-than-average yield over Treasuries are both relatively young MLPS with a short history as public companies. That means that their historical average yields spreads reflect only a limited history; this measure isn’t as valid for these young MLPs as for names with a long trading history.

In particular, look at Enterprise Products, Kinder Morgan Energy Partners (NYSE: KMP) and other older MLPs on this list. Because these firms have a long history as publicly traded companies, the historic yield comparisons are particularly relevant. Both firms are offering a yield spread over Treasuries of close to double the long-term average.

Although units of our favorite MLPs experienced a nice run-up in recent weeks, the table above suggests that they’re not overvalued by historical norms. In fact, most MLPs are offering an unusually large yield spread over Treasuries; MLPs with sustainable yields and the potential for growth remain a good value.