Over the past fifteen years, master limited partnerships ("MLP") have been excellent investment vehicles as they pay out high distributions and have profited from rapidly growing domestic energy production. However, not all MLPs are created equal, and because of their structure, growth does not always translate to per unit growth. MarkWest Energy Partners (NYSE:MWE) is the perfect example of an MLP that pays out too much and will not be able to grow into its distribution sustainably.
The key financial metric for MLPs is distributable cash flow ("DCF"). It essentially amounts to operating cash flow less maintenance cap-ex. Growth cap-ex is not subtracted; in a sense, it could be considered sustainable free cash flow. An MLP then typically pays out all or most of its DCF to unitholders and funds growth projects through the issuance of debt and equity. If a company is not fully covering its distribution with DCF, an investor has to be concerned that it is paying out too much and cannot sustain the distribution. MarkWest fits this profile (investors can find all financial and operating results here).
Let's look at the last quarter. MarkWest generated $127 million in DCF, which was up 14% from last year's $112 million. For the full year, MarkWest had DCF of $483 million up 16% from last year's $417 million. This growth seems fantastic. However because of the MLP structure, MarkWest has to issue equity, and its unit count is up 10% year over year, which significantly slowed its distribution per unit. DCF per unit was roughly $0.81, but it paid a distribution of $0.86. As a consequence, the coverage ratio was only 94%. For the entire year, its coverage ratio was 99%. Going forward, MWE will have to grow DCF faster than the distribution to make the payout more sustainable.
Now, there is no doubt that MarkWest has tremendous growth opportunities. It is extremely well positioned in the Marcellus and Utica shale formations. Its natural gas processing has doubled year over year in the Marcellus to 1,401,700 Mcf/d. However, expansion is not cheap. In its 2014 guidance, MWE projects a growth cap-ex budget of $1.8-$2.3 billion. Assuming a 33/67 split between debt and equity, MWE unitholders will be diluted between 12% and 13%. To grow DCF/unit, headline DCF will need to increase by more than that.
In 2014, MWE expects DCF to be $600-$690 million. After accounting for the dilution, MWE would be able to sustain a distribution of $0.90 by the end of the year. This seems strong, but MarkWest does have a history of over-promising and under-delivering; it had to take down guidance dramatically last year. Moreover while the Marcellus is performing well, other operations are not as strong with Northeast natural gas processing volumes down 7% to 296,100 Mcf/d. There was some similar weakness in the Southwest. As a consequence, I expect DCF to come in right around the low end at around $580-$610 million, which would translate to about $0.83 in DCF/unit.
In order to maintain the distribution, MarkWest needs to perform extremely well. I expect it to deliver a coverage ratio of 1.00x in 2014, which will raise continued concern about the sustainability of the distribution. Given its weak coverage ratio, and significant cap-ex budget that will dilute investors, I would want at least a 6% yield to protect better against lackluster performance, which would suggest a fair price of around $57. At current prices, investors should look to other MLPs that have higher yields, strong coverage ratios, or better growth prospects like Enterprise Product Partners (NYSE:EPD) and Kinder Morgan Energy Partners (NYSE:KMP). Compared to these names, MWE is a sell.
Disclosure: I am long 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.