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Executive Summary:

  • We have a unique view of the business models of MLPs in that we build an in-depth discounted cash flow model for each one of them.
  • Without a constant inflow of new capital (either via new debt or new equity), most (if not all) MLPs would be unable to sustain existing distribution payouts. This makes them notoriously more difficult to assess on a financial basis; either an MLP is able to raise capital (its general partner decides it will) or it isn't (its general partner decides it won't, or the market doesn't accept new units).
  • We hold two MLPs in the Dividend Growth portfolio: Kinder Morgan Energy Partners and Energy Transfer Partners. Both entities are dependent on the capital markets, as with any other MLP. We do not foresee a similar scenario happening with Kinder Morgan and Energy Transfer Partners as that which happened to Boardwalk Pipeline, but the key risk remains: the majority of an MLP's distribution strength comes from its access to the capital markets (and new money), which is not guaranteed, nor is it organic.

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You can't get far researching master limited partnerships [MLPS] on Valuentum's website without encountering the following warning:

Firms in the oil and gas pipeline industry own or operate thousands of miles of pipelines and terminals--assets that are nearly impossible/uneconomical to replicate. Most companies act as a toll road and receive a fee for transporting natural gas, crude oil and other refined products (and generally avoid commodity price risk). Though there is much to like, most constituents operate as master limited partnerships and pay out hefty distributions that can stretch their balance sheets. Additional unit issuance (dilution) has become common, and capital-market dependence is a key risk. We're neutral on the group.

We have a unique view of the business models of MLPs in that we build an in-depth discounted cash flow model for each one of them. In a discounted cash flow model, an MLP's need for additional equity (or debt) issuance in order to keep its cash balance in the black (positive) while still paying out hefty distributions is readily apparent. Without a constant inflow of new capital (either via new debt or new equity), most (if not all) MLPs would be unable to sustain existing distribution payouts. This makes them notoriously more difficult to assess on a financial basis; either an MLP is able to raise capital (its general partner decides it will) or it isn't (its general partner decides it won't, or the market doesn't accept new units). Since almost all MLPs have retained relatively easy access to the capital markets since the Great Recession, counting on future equity and/or debt issuance to sustain what otherwise could be considered too lofty of a distribution payout hasn't been a problem.

All that changed this week with Boardwalk Pipeline (NYSE:BWP). The MLP shocked the market by slashing its quarterly distribution considerably to $0.10 from $0.5325. The entity noted that:

the reduction in the distribution will free up internally-generated cash to help fund growth and reduce leverage in order to strengthen the balance sheet during…difficult market conditions.

What we read this to be is that Boardwalk/Loews (NYSE:L) floated the idea of issuing new units (or new debt) and was unable to get enough interest to fill liquidity needs (or maintain investment-grade status) to satisfy the existing distribution levels. When management received word of that, the MLP decided to simply "rip the Band-Aid off" as opposed to slowly cutting the distribution over time. Unitholders may have fared better with a smaller distribution cut (at this juncture), but the company having to go to the equity markets for new capital and still having to cut the distribution would have sent shareholders to the exit anyway. On a fundamental basis, Boardwalk has been facing headwinds as a result of unfavorable market fundamentals negatively impacting its natural gas transportation and storage revenues.

Though MLPs are typically stable, cash-rich businesses, their hefty distribution payouts add significant liquidity and balance sheet risk. For MLPs, the dependence on new capital is undeniable. If the capital markets are supporting an MLP and its distribution yield, the MLP's distribution yield will be sustained. If the capital markets aren't supporting an MLP and its distribution yield, the MLP's distribution yield will not be sustained. With respect to almost every MLP (and unlike almost every corporation that pays a dividend), earnings do not cover the distribution payment, and many distributable cash flow calculations show depreciation and amortization (D&A) being a multiple of maintenance capital expenditures (for Boardwalk, this multiple was nearly 4 in 2013). At most corporations (non-MLPs), D&A is roughly equal to maintenance capital expenditures, implying that across the MLP universe, real organic distributable cash flow is much lower (if capital spending matches D&A, as it should in equilibrium). Without access to the capital markets, the distribution of any MLP cannot possibly be maintained.

Valuentum's Take

We hold two MLPs in the Dividend Growth portfolio: Kinder Morgan Energy Partners (NYSE:KMP) and Energy Transfer Partners (NYSE:ETP). Both entities are dependent on the capital markets, as with any other MLP. We do not foresee a similar scenario happening with Kinder Morgan and Energy Transfer Partners as that which happened to Boardwalk Pipeline, but the key risk remains: the majority of an MLP's distribution strength comes from its access to the capital markets (and new money), which is not guaranteed, nor is it organic. Though shares of Boardwalk Pipeline are now trading below the low end of the fair value range, we're not interested in scooping them up. We do not expect to make any changes to the fair values estimates of any MLP at this time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Source: You Must Know This If You Own An MLP