Desperately Seeking Yield Through Equities Redux: Part 8 - MLPs

by: Philip Mause

This series reviews various strategies for generating yield in the equity market. The first article dealt with BDCs, the second with agency mortgage REITs, the third with non-agency mortgage REITs, the fourth with telecom companies, the fifth with equity REITS, the sixth with utility stocks and the seventh with tobacco companies. This article will deal with Master Limited Partnerships (NYSEARCA:MLPS) and updates some information in a similar article written in the summer of 2011.

First of all, the original article and comments contain a great deal of helpful information and an investor interested in the sector should probably go back and review it. In summary, MLPs, like REITs and BDCs have their own peculiar tax rules. In general, they are partnerships, not corporations, and an investor typically gets a K-1 at the end of the year which is to be used in connection with tax filing. Reportable income may differ from the amount of dividend distributions. In some cases, the distributions are treated as a return of capital and are not immediately taxed as income but have the effect of reducing the tax basis of the stock held. This often results in what appear to be "phantom" gains (gains on stocks which have not gone up) and some of the comments last time suggested that these stocks be held until death so that heirs could take advantage of the step up in basis at death. I hope we do not see a Law and Order episode in which the motive for murdering Granny is to take advantage of the step up in basis on her MLP holdings. MLPs are not required to distribute a particular percentage of taxable earnings the way BDCs and REITs are and so have the ability to retain cash for expansion purposes.

One would think that these problems could be solved by holding MLPs in IRA's and other tax free accounts but, alas, there is a danger of unrelated business income if you do that. I have not found these problems to be insurmountable but they are a nuisance and an investor definitely has to be aware of them.

All we have talked about is tax and that is unfortunate because MLPs are often attractive on their economic merits. Most of them invest in energy infrastructure (oil and gas pipelines, natural gas gathering and liquids facilities, LNG facilities, etc.). The sector has been growing at a very healthy pace and a strategic developer of these facilities can do very well. The table below provides the price and quarterly dividend as of the date of the last article (7/4/11) and as of Friday's closing for Kinder Morgan Energy (NYSE:KMP), Enterprise Product (NYSE:EPD), Enbridge (NYSE:EEP) Boardwalk Pipeline (NYSE:BWP), Teekay LNG (NYSE:TGP), Cedar Fair (NYSE:FUN), Energy Income Growth (NYSEMKT:FEN), and ClearBridge Energy (NYSE:CEM). Prices are based on Yahoo Financial; dividend information is from each company's website.

Price 7/4/11 Div. 7/4/11 Price 3/15/13 Div. 3/15/13
KMP $72.90 $1.14 $86.56 $1.29
EPD $43.33 $.5975 $56.40 $.66
EEP $30.14 $.5135 $28.69 $.5435
BWP $28.88 $.5250 $28.69 $.5325
TGP $37.34 $.63 $40.50 $.675
FUN $20.66 $.10 $37.33 $.40
FEN $29.23 $.465 $33.79 $.51
CEM $22.30 $.355 $25.35 $.38

The group has performed relatively well. There have been no dividend cuts and some healthy dividend increases. FEN and CEM are closed end funds which provide exposure to a number of companies in the sector. My understanding is that owning them does not raise the K-1 set of problems but I am not a tax lawyer so I must leave you on your own on that issue. FUN operates a number of amusement parks. These tend to be wide moat businesses because it is hard to site a new one. The recession is a double edged sword because it leads families to choose FUN parks near home rather than Disney World but it may also lead some to skip parks altogether. FUN cut its dividend drastically in 2008 and again in 2010 and its price dropped to single digits. I picked some up at a little below $9 because the fundamentals looked solid and it has been one of my best recent investments.

TGP is involved in LNG facilities. It is a sign of the rapidly changing times that, in 2011, I wrote that TGP's business may be adversely affected because the United States may have a reduced need for LNG imports. I never would have guessed that LNG exports would be the next big thing for the industry.

You can own BWP by buying Loews (NYSE:L) and you will get it at a discount because L is selling for less than what is generally considered fair value.

Looking at this group and at some of the others, it seems clear that the potential to improve return by investing in equities rather than fixed income in order to generate yield is alive and well. MLPs will probably fare reasonably well if interest rates go up but do not look for them to go way up if the oil price rises. They are generally (although not universally) paid based on volumetric throughput not on dollar value of product transported. On the other hand, growing domestic production of oil and gas should require intensive use of their facilities and the future seems reasonably bright. I am still in FUN and I am looking at the closed end funds to replace some of my fixed income holdings. Be careful out there.

Disclosure: I am long FUN, L. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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