Recommendations in our Conservative Portfolio generate cash flows from fee-based businesses such as interstate pipelines and storage facilities–assets that produce revenues regardless of commodity prices and the state of the overall economy.

But don’t assume that concentrated exposure to fee-based businesses means that our Conservative Portfolio recommendations can’t grow distributable cash flows and raise distributions. Our favorites have taken advantage of improving market conditions to raise significant capital and have deployed that capital to make strategic acquisitions and fund organic growth projects.

In the March 19 issue of MLP Profits, Eye on Earnings, we discussed Conservative Portfolio holding Genesis Energy’s (NYSE: GEL) recent secondary offering of 6.25 million units. Although the stock took a hit in the wake of that announcement, the selloff presents an outstanding buying opportunity for an MLP with solid long-term growth prospects.

As “Equity Offerings” suggests, we’ve witnessed the same basic pattern replayed with many of our Conservative Portfolio recommendations over the past year.

Source: Bloomberg

To create the table, we examined secondary offerings by our Conservative MLP recommendations since the beginning of February 2009. We measured total returns–distributions and capital gains–one-week, one-month and two months after each offering was announced. Units of almost every MLP in the table traded lower one week after announcing a secondary offering of units.

But these picks traded an average of 0.6 percent higher one month after the announcement and 6.1 percent higher two months later. None of these partnerships traded lower two months after announcing an equity offering.

The knee-jerk reaction to an equity offering is to sell because the issuance of new units dilutes existing holders’ stake in the firm. But equity offerings aren’t truly dilutive if the MLP uses the proceeds to make acquisitions that quickly add to distributable cash flow or to fund projects such as new pipeline construction. That MLPs issuing new units have quickly regained any immediate losses resulting from announcing secondary offerings is also a sure sign of the improving strength of global equity markets; our favorite MLPs have been able to raise significant capital by issuing new units with no major long-term negative impact to their unit prices.

Even more impressive: the quick recovery in credit markets over the past year. Although the consumer credit markets remain rather unforgiving, MLPs have raised billions of dollars by issuing bonds at attractive interest rates.

Source: Bloomberg

 “Debt on the Cheap” lists every bond issued by our Conservative Portfolio holdings since February 2009. In total, Conservative holdings have issued nearly $6.8 billion in new bonds over the past 13 months, and those bonds currently offer an average yield to maturity of just over 4.7 percent. That’s less than 100 basis points (1 percent) over the yield on a 10-year US government bond.

The word “acquisition” sends chills down the spines of many investors because of high profile deals gone wrong. Examples include Quaker Oat’s acquisition of juice drink maker Snapple in 1994 for $1.7 billion; just three years later, Quaker sold Snapple to Triarc for just $300 million. And what investor can forget the long list of ill-fated technology mergers and acquisitions during the tech boom, a trend that culminated with Time Warner’s (NYSE: TWX) infamous $284 billion purchase of AOL (NYSE: AOL) in 2000.

Bad deals aren’t unheard of in the MLP space, but the risk of an ill-fated tie-up is lower for MLPs than it is for most companies. The market typically vales MLPs based on their ability to pay distributions and grow distributable cash flows; distribution cuts can be disastrous for an MLP’s unit price. The shareholder base seeks steady income from quality assets, not promises of long-term growth and synergies. Accordingly, MLPs typically cannot afford to make deals that would threaten payouts aren’t quickly accretive to distributable cash.

Source: Bloomberg

 “Shopping Spree” enumerates the acquisitions made by Conservative Portfolio recommendations over the past year. As you can see, activity accelerated in the second half of 2009 as credit market conditions quickly improved. Our picks took advantage of easy access to credit and strong credit quality to buy assets from shakier firms on the cheap.

Spectra Energy Partners’ (NYSE: SEP) $300 million purchase of the NOARK Pipeline system from Atlas Pipeline Partners (NYSE: APL) in May 2009 is a case in point. The financial crisis and Great Recession hit Atlas hard because of the company’s exposure to natural gas processing–a business sensitive to commodity prices.

Gas gathering lines are small diameter pipelines that connect individual gas wells to processing or treatment plants and the interstate pipeline network; when gas prices decline, drilling activity slumps, impacting the volume of gas traveling through gathering systems and the number of new wells that must be hooked up to these systems. Even more important, Atlas was heavily indebted; as cash flows declined, the MLP was at risk of violating covenants covering its debts.

After cutting its distribution wasn’t enough, Atlas discontinued its payout entirely in spring 2009. But despite those cash-conserving efforts, Atlas was forced to raise capital amid weak credit and equity market conditions that prevailed in early 2009. As a result, the company was forced to sell-off its NOARK pipeline to service its debts.

A 565 mile pipeline that extends from Oklahoma through Arkansas into Missouri, NOARK was one of Atlas’ most valuable assets. As a regulate pipeline, NOARK’s tariffs enable the owner to earn a steady return on capital and guarantees a certain minimum cash flow.

And NOARK serves some of the country’s fastest-growing centers of gas production, including the Fayetteville Shale of Arkansas. NOARK already had interconnects with Spectra’s network of pipelines; the acquisition complemented the company’s existing position well.

Spectra’s NOARK purchase was immediately accretive to Spectra’s distributable cash flow and one of the main reasons the MLP boosted its distribution several times over the past year. This is a clear example of a strong, well-capitalized MLP buying up distressed assets on the cheap from a weak MLP. Spectra Energy Partners remains a buy on any dips under 27. Atlas Pipeline Partners has taken steps to address its excess debt but still doesn’t offer a distribution; we continue to rate it a “Sell” in How They Rate.

Kinder Morgan Energy Partners (NYSE: KMP) also took advantage of distressed asset sales to grow in 2009. Kinder Morgan Energy Partners is one of the nation’s oldest and largest MLPs. Its 10-year bonds yield around 5.15 percent, among the cheapest cost of capital for any MLP. In recent years, the partnership has emphasized organic growth, focusing considerable resources on building new assets rather than acquiring other firms or existing assets.

For example, Kinder Morgan Energy Partners is the company behind the Rockies Express (REX) pipeline that carries natural gas from the Rocky Mountains east to the Pennsylvania-Ohio border. By signing long-term, fee-based contracts with producers, the partnership guaranteed a solid return on capital from the regulated pipeline.

That being said, Kinder has made its share of acquisitions in recent years, including the purchase of 290 gas treating plants last October from Crosstex Energy (NSDQ: XTEX), another shaky MLP. Like Atlas, Crossstex had too much commodity sensitivity and was forced to eliminate its payout entirely last year and to attempt to raise cash by selling assets.

We explained the natural gas treating business in the March 15 issue of MLP Profits, MLPs and Natural Gas Liquids. Treating plants are used to remove the carbon dioxide (CO2) that naturally occurs with natural gas in underground reservoirs. As we explained in that issue, gas from the Haynesville Shale tends to be relatively high in CO2 content but low in natural gas liquids (NGLs). That means that gas from this region requires significant treatment before it’s at pipeline standards; Kinder purchased 290 treatment plants as part of its deal with Crosstex, all of which are ideally located to serve fast-growing Haynesville production.

How will weak gas prices affect production in the Haynesville Shale? The impact will be less profound than many assume because the Haynesville is among the lowest-cost plays in the US; producers have boosted in the region while cutting back elsewhere. Louisiana is one of the few US states that’s consistently grown its gas production over the past nine months.

Kinder Morgan Energy Partners rates a buy under 65.

Although improvement in credit and equity markets has reduced the number of distressed assets, opportunities still exist. With gas prices at depressed levels, partnerships have an opportunity to buy gas-producing properties or gas-related assets on the cheap. A low cost of capital makes organic growth an attractive option. After all, low gas prices likely will result in higher demand and, correspondingly, the need to transport and store larger quantities of gas.

Cheap Capital Equals More IPOs    

We’re also monitoring initial public offerings of MLPs. In 2006 and 2007 several new MLPs listed their units on the New York Stock Exchange or Nasdaq, taking advantage of strong equity markets to raise capital. Many of these MLPs were formed out of existing companies.

In many instances, exploration and production (E&P) companies would spin off their midstream assets–pipelines, storage and terminal facilities–into an MLP. Such assets generate steady cash flows but are capital intensive and don’t increase oil or gas production.

Because the market traditionally has valued E&P firms based on their ability to grow production and reserves, midstream assets didn’t generate much upside in share prices. By creating and listing shares in an MLP that holds midstream assets, E&P outfits were able to raise inexpensive capital for their drilling programs. And in most cases, the parent company doesn’t give up control of the assets put in the MLP; parent companies generally control the general partner of the MLPs they sponsor and hold a significant ownership position.

And MLPs aren’t taxed at the corporate level; spinning assets into an MLP makes those cash- generating assets significantly more attractive to investors. Investors eagerly bought up these IPOs for their steady, tax-advantaged payouts in 2006 and 2007.

Some of these new IPOs were attractive investments. For example, Williams Partners LP (NYSE: WPZ), an MLP we recently sold from the Growth Portfolio for a 118 percent gain, was formed by E&P outfit Williams Companies (NYSE: WMB) for the rationale just outlined. Less desirable IPOs generated fees for investment bankers and took advantage of strong demand but plunged during the 2008-09 bear market.

With capital markets opening again and existing MLPs performing well, the MLP IPO market is showing signs of rebirth. I keep tabs on this market by monitoring S-1 registration statements filed with the Securities and Exchange Commission (SEC). These filings go through several iterations before a stock makes it to the public markets, but a careful analysis of these filings can give investors a good idea of which new MLP IPOs are worth watching.

One we’re watching carefully is Chesapeake Midstream Partners, which is being sponsored by natural gas-focused E&P giant Chesapeake Energy (NYSE: CHK). The company filed its first S-1 on Feb. 16, 2010, a move management hinted at during several calls over the past year. Chesapeake Energy has to build out significant midstream infrastructure to support its operations in the Haynesville, Marcellus and Eagle Ford Shale. These midstream assets would likely fetch far superior valuations inside an MLP. 

This potential new MLP looks interesting for several reasons. First, Chesapeake Energy’s drilling programs are well supported by joint-venture deals it has inked with major international energy firms such as Britain’s BP (NYSE: BP) and France-based Total (NYSE: TOT). These deals enable Chesapeake to continue funding its drilling activities even when gas prices remain volatile. And although Chesapeake Midstream Partners would focus primarily on gas gathering, a commodity-sensitive business line, this exposure is mitigated by long-term gathering contracts that have a hefty fee-based component.

And the S-1 form for this potential IPO suggests that Chesapeake Energy will grow the MLP through asset drop-downs, a strategy that worked for Williams Companies and Williams Partners LP. At first, Chesapeake Midstream Partners primarily would own gathering lines related to Chesapeake Energy’s Barnett Shale play in Texas. Over time, parent would sell additional assets to the MLP. The sale of these assets would be priced so that Chesapeake Midstream’s distributable cash flows would increase immediately–a key to distribution growth.

There’s no guarantee that Chesapeake Midstream Partners will ever see the light of day, but we’ll continue to monitor this development as well as other potential IPOs.