MLPs: Remove The Yield Blinders And Understand The Business Model

by: Clayton Rulli

We all know Master Limited Partnerships are in the spotlight these days, specifically upstream E&Ps and their questionable business models of hedged production that barely covers their juicy yields. Some would call these unique and tempting investments Ponzi-like in nature, while others classify MLPs as an almost necessary part of a diversified portfolio. I personally think MLPs can be an intelligent investment as long as you don't have your 5-10% dividend blinders on. What I mean is investors must be aware if the MLP business model, and why it may not be sustainable forever.

Since MLPs must payout a substantial portion of cash flow to unit holders, there usually isn't much left for meaningful expansions. Favored by investors for their yield and importance in the energy market, MLP share prices have grown tremendously. This has been great for the companies, as they have been able to sell a huge amount of shares in addition to issuing debt at relatively low rates due to investor interest. Because of successful issuances and the resulting acquisitions, MLPs can increase cash flows and raise their distributions as a result. This creates more investor interest, which raises unit prices, allowing the companies to again issue more shares to generate more funds for the next acquisition. It becomes a perfect cycle of expansion mostly funded by investors and hardly by cash flow. The funny thing is the most expensively valued and fastest growing companies can issue new shares at the lowest cost of capital, allowing for a quicker growth trajectory -- what a formula! This becomes an issue of philosophy that sort of reminds me of the chicken and the egg: Here's a flow chart:

So as payouts increase, more investors buy shares, which raises the share price even more, and the MLP issues even more shares and debt. This is a seemingly pleasant growth spiral for now... but when will it become toxic? The answer is either when they can no longer raise debt for expansions at the current lower interest rates, or when investors become less attracted to their yields and slow their buying. Another is possibly when a certain MLP gets too large to meaningfully grow. I must admit it's nearly impossible to predict when investor interest will slow, and it does seem like the limit is endless in consideration of the shale boom excitement and high energy prices. Another could be if a said MLP's current assets decay faster than anticipated, and instead of new issuances originally used to expand operations and grow distributions, they might unfortunately be used to maintain current assets and thus only maintain the current yields. Then what would happen?

I know you are doubting this could happen as do I, and honestly I'd hate for this to become a reality down the line. But what if? In light of all the Linn Energy hoopla lately as well as an enlightening article by Horizon Kinetics, I did some digging to analyze how rampant the issuing new shares to fund operations and/or expansions is or isn't, and I was surprised by the truth. Take a look at several popular upstream MLPs, Linn Energy (LINE), BreitBurn Energy Partners (BBEP) and Vanguard Natural Resources (NYSE:VNR) and their shares outstanding over the past several years:

In the last 3 years units outstanding have nearly doubled. Now let's take a look at the most popular midstream companies, namely Enterprise Products Partners (NYSE:EPD), Kinder Morgan Energy Partners (NYSE:KMP), and Energy Transfer Partners (NYSE:ETP):

My findings were worse than I thought, and one might say the truth is in the pudding. Even the biggest and strongest midstream MLPs have a strong history of issuing shares to fund projects and expansions. This isn't necessarily bad, as I believe if the companies efficiently use these funds to effectively grow operations and accretively enhance their yield, it is not net-dilutive to investors. However, will the virtuous circle of new issues that fund expansions which increase yields collapse someday? The answer is yes, it's only a matter of time; but I feel it may not be for quite a while. However, investors need to be aware of the MLP business model, and how its yield friendly nature retards its growth potential without the use of new share issuances to fill the funding gap. For now, the MLP world seems to hold promise considering the shale boom in the US, as long as investors understand their unique yet risky business model and its mortal future.

Disclosure: I am long EPD, LINE, QRE, KMP. 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.

Additional disclosure: I have owned shares of KMI and ETP in the last 6 months and may initiate long positions again at any time. I am long QRE via call options. I am long KMP via calendar bull call spreads