All income stocks sell at a logical yield plus CAGR (projected Compound Annual Growth Rate of the dividend or distribution) metrics with significant adjustments for risk. The evidence for that valuation theory will be provided in a future article - for now I just ask you to accept that theory as fact. Lower yielding stocks strongly tend to be the higher payout (dividend or distribution) growth stocks - or stocks with lower risk. These valuations are reflected in the price to earnings ratios in two about to be listed ways. In summation, the higher distribution growth stocks will strongly tend to have (1) lower yields; (2) higher price to earnings ratios; and (3) lower earning payout ratios.
It is my contention that MLP valuations have historically been and currently are based on DCF (distributable cash flow) numbers and not EPS numbers. There is some correlation between those two metrics. And due to that correlation, there will be a majority of instances where EPS metrics can be a close substitute for DCF metrics when it comes to price to earnings ratios. The key to seeing that it is the DCF numbers that are the key numbers is in (1) the exceptions where DCF and EPS numbers vary significantly; (2) the test as to whether the price to DCF or P/E ratios reflect the valuations; and (3) the test as to whether distribution to DCF or distribution to EPS ratios reflect the distribution growth projection.
To do that three point test, I will produce the P/E and Price/DCF metrics. We will start with a focus on four large cap midstream where - in order of occurrence - things are currently going bad, fair, good and great.
- NuStar Energy NuStar (NYSE:NS) - currently a troubled MLP with no distribution growth in the last twelve months; a distribution payout ratio that is higher than current DCF at 114.06% - but that ratio improves to 99.55% of DCF in 2014; and a yield of 9.99% that reflects those troubles.
- Enbridge Energy Partners (NYSE:EEP) - a lower growth MLP where distribution growth has been 2.07% in the last twelve months; a distribution payout ratio that is 107.62% - but that improves to 94.52% in 2014; and a yield of 7.42% that reflects its lower anticipated distribution growth.
- Kinder Morgan Energy Partners (NYSE:KMP) - where things are going fine and distribution growth has been 8.33% in the last twelve months; a distribution payout ratio that is 94.89%; and a yield of 6.45% that reflects those good attributes.
- Magellan Midstream Partners (NYSE:MMP) - where things are going great and distribution growth has been 20.83% in the last twelve months; a distribution payout ratio that is 79.30% - indicating forward distribution growth that is around half the outstanding last twelve month growth rate; and a yield of 3.95% that reflects those great attributes.
Based on the DCF payout ratios for 2014, all the distributions are safe. The relative safety of the distribution is reflected in their yields. One can clearly see the correlation between the payout ratio and the current trends in distribution growth. Add the that, one can clearly the see correlation between yields and projected distribution growth when the distribution growth projection is based on the distribution to DCF ratio.
MLP P/E Stats 6-21-13
|Earnings / Share||Earn. Growth||P/E Ratios||13 EPS Range|
|Large Capped MLPs|
MLP Price/DCF Stats 6-21-13
|DCF / Unit||DCF Growth||Price/DCF Ratios|
|Large Capped MLPs|
My DCF projections are currently the mean projections from 8 brokerages - and at times I have used as many as 10 brokerages to produce those projections. My EPS projections are the current numbers found at Yahoo Finance.
- NS has a current anualized distribution of $4.38 and a 2013 EPS projection of $1.70 - making the EPS payout ratio 257.65%. NS has a 2014 EPS projection of $2.42 - making the EPS payout on the 2014 projection 180.99%.
- EEP has a current anualized distribution of $2.174 and a 2013 EPS projection of $1.03 - making the EPS payout ratio 211.07%. EEP has a 2014 EPS projection of $1.27 - making the EPS payout on the 2014 projection 171.18%.
- KMP has a current anualized distribution of $5.20 and a 2013 EPS projection of $2.65 - making the EPS payout ratio 196.23%. KMP has a 2014 EPS projection of $2.87 - making the EPS payout on the 2014 projection 181.18%.
- MMP has a current anualized distribution of $2.03 and a 2013 EPS projection of $2.25 - making the EPS payout ratio 90.22%. MMP has a 2014 EPS projection of $2.57 - making the EPS payout on the 2014 projection 78.99%.
Based on the EPS payout ratios for 2013 and 2014, none of the distributions are safe except for MMP. One cannot see the correlation between the payout ratio and the current trend in distribution growth. If the distribution were an unsafe as the distribution/EPS ratio reflects them to be, NS, ESS and KMP should be selling at significantly higher yields.
- NS has a 2013 P/E of 25.79 and a 2014 P/E of 18.12.
- EEP has a 2013 P/E of 28.46 and a 2014 P/E of 23.08.
- KMP has a 2013 P/E of 30.44 and a 2014 P/E of 28.11.
- MMP has a 2013 P/E of 22.86 and a 2014 P/E of 20.11.
The best MLP has the lowest 2013 P/E ratio and the second to lowest 2014 P/E ratio. That would not make sense if EPS was the key earnings metric.
- NS has a 2013 Price/DCF of 11.42 and a 2014 Price/DCF of 9.97.
- EEP has a 2013 Price/DCF of 14.51 and a 2014 Price/DCF of 12.74.
- KMP has a 2013 Price/DCF of 14.72 and a 2014 Price/DCF of 14.35.
- MMP has a 2013 Price/DCF of 20.09 and a 2014 Price/DCF of 17.86.
I see a perfect alignment in the Price/DCF ratios and the expected future distribution growth for the MLPs.
Are you convinced yet?
Let's do the test again with BWP, EBP and PAA.
- Boardwalk Pipeline Partners (NYSE:BWP) - a lower growth MLP where distribution growth has been 0.00% in the last twelve months; a distribution payout ratio that is 99.07% that improves to 96.38% in 2014; and a yield of 7.11% that reflects its lower growth.
- El Paso Pipeline Partners (NYSE:EPB) - a MLP transforming from fast growth to average growth - where distribution growth has been 21.87% in the last twelve months; a distribution payout ratio that is 90.84% that slowly improves to 89.53% in 2014; and a yield of 6.05% that reflects its average growth.
- Plains All American Pipeline (NYSE:PAA) - a higher growth MLP where distribution growth has been 10.05% in the last twelve months; a distribution payout ratio that is 70.12% - but that declines to 74.43% in 2014; and a yield of 4.32% that reflects its higher growth.
If DCF is a good valuation metric, then the forward distribution growth can be gauged by the distribution to DCF ratio - and that expectation is reflected in the yield. EPB has grown its distribution twice as fast as PAA over the last twelve months - and based on that metric of distribution growth inertia, EPB would logically have the lower yield. But the market is correctly using the distribution to DCF to project forward distribution growth - which results in PAA having the lower yield. BWP almost lacks distribution coverage in 2014 - and the last twelve month distribution growth has been zero. In all three cases, the distribution to DCF ratio does a superior job in explaining the current yield.
- BWP has a current anualized distribution of $2.13 and a 2013 EPS projection of $1.38 - making the EPS payout ratio 154.35%. BWP has a 2014 EPS projection of $1.43 - making the EPS payout on the 2014 projection 148.95%.
- EPB has a current anualized distribution of $2.48 and a 2013 EPS projection of $2.15 - making the EPS payout ratio 115.35%. EPB has a 2014 EPS projection of $2.17 - making the EPS payout on the 2014 projection 114.29%.
- PAA has a current anualized distribution of $2.30 and a 2013 EPS projection of $3.11 - making the EPS payout ratio 73.95%. PAA has a 2014 EPS projection of $2.91 - making the EPS payout on the 2014 projection 79.04%.
Based on the distribution to EPS ratio, only the distribution for PAA is safe. The lack of safety as pictured by the distribution to EPS ratio is not reflected in the current yields. It is obvious that the market is regarding the distribution to EPS ratio as being meaningless.
- BWP has a 2013 P/E of 21.72 and a 2014 P/E of 20.96.
- EPB has a 2013 P/E of 19.07 and a 2014 P/E of 18.89.
- PAA has a 2013 P/E of 17.13 and a 2014 P/E of 18.30.
The higher the P/E ratio, the worse the prospects for the MLP. That is the opposite of what it should be if P/E was a meaningful ratio.
- BWP has a 2013 Price/DCF of 13.94 and a 2014 Price/DCF of 13.56.
- EPB has a 2013 Price/DCF of 15.01 and a 2014 Price/DCF of 14.80.
- PAA has a 2013 Price/DCF of 16.24 and a 2014 Price/DCF of 17.24.
The higher the Price to DCF ratio, the better the prospects for the MLPs. That is exactly what is should be if the Price to DCF ratio is meaningful.
Buckeye Partners (NYSE:BPL), Energy Transfer Partners (NYSE:ETP), ONEOK Partners (NYSE:OKS) and Williams Partners (NYSE:WPZ) are all cases where CAGR projection shifts are happening now. That makes them less perfect examples for doing the kind of valuation tests I have done above.
I also want to note that there is some correlation between the distribution to EPS ratio and those MLPs which produce positive UBTIs (unrelated business taxable income) when held in IRAs. Specifically, MMP and PAA - the two MLPs shown in this data to have EPS numbers that are less than their distributions - produce positive UBTIs.
I believe that the evidence I have provided is convincing. DCFs matter. EPS does not. I believe that two of the key valuation questions an investor can ask is (1) "is the distribution safe?" and (2) "can the distribution grow?". The answer to those questions is found using DCF numbers. You are lost using EPS numbers.
Once one has the perception that DCFs matter and that DCFs are needed to confirm a CAGR projection - then the need for DCF data is put in the correct focus. That data is only provided to those who have access to the analyst produced research product. And that data is only provided by some analysts - not all of them.
One final note on DCFs. In data that I have not provided in this article, one can see the effect on the year to data price changes when compared to year to date changes in DCF projections. The MLPs with upgrades in the DCF projections have also tended to be the MLPs that have outperformed sector average. The same comparison done with changes in EPS projections and year to date unit price changes shows a significantly smaller correlation.
This is the second of a series of articles that will assist investors in building an outperforming MLP portfolio. While I will end the series with specific suggestions, the goal of this series is to assist you in developing specific skills that will help you build your own list of suggestions. In addition to those skills, you will also need access to the currently faulty brokerage MLP reports - an issue covered in the first article of this series. For those of you needing a preview to those suggestions, EPD, KMP, MMP and PAA are on that list.
The link to the first article in this series can be found here