- Bloomberg has issued a negative report on MLPs, highlighting concerns of a bubble.
- High retail ownership is not necessarily problematic.
- MLPs will profit from growing US production and have sustainable distributions.
- With a solid distribution, KMP is a buy at current levels.
Bloomberg has come out with a very negative report on Master Limited Partnerships ("MLP") as one analyst called them "the next great investment debacle" (report available here). Bloomberg even quotes one individual investor who credits his 16% one-year gain to "blind luck." Bloomberg essentially argues that MLPs are overly owned by retail investors, are too complicated to understand, and are too risky to sustain current payout ratios. Within the report, Bloomberg spends a disproportionate time discussing Kinder Morgan Energy Partners (NYSE:KMP), which has become a popular target of negative MLP articles.
First, it is true that retail investors own a disproportionate amount of MLPs. Bloomberg cites a Wells Fargo (NYSE:WFC) estimate that individual investors own about 65% of MLPs. It is popular for money managers to suggest individual investors are fools; after all if they admitted individual investors can do well, they would have fewer assets under management. As partnerships, MLPs are pass-through entities with investors receiving a K-1. This can complicate tax filing and provide added headaches for mutual funds. Most indices also shun partnerships, which cuts the institutional ownership. In 2008, bank stocks were owned in droves by institutions, but they still fell dramatically. There are technical factors that make institutions less interested in MLPs, and high retail ownership is not in and of itself a sign of a bubble.
Next, it has been popular to say MLPs are too complicated to understand, but they are no more complicated that a typical stock, which also requires serious analysis before making an investment decision. Further, it is wrong to lump all MLPs into one group just as one would not lump all energy stocks into one category. Exxon Mobil's (NYSE:XOM) business is much different than Halliburton's (NYSE:HAL). Some MLPs like KMP and Enterprise Products Partners (NYSE:EPD) are focused on transporting energy while others like Linn Energy (NASDAQ:LINE) and Atlas Resource Partners (NYSE:ARP) drill for oil and gas. These firms will perform far differently over the next few years as KMP and EPD are driven by volume while LINE and ARP are driven more by end-prices.
It is no more difficult to understand Linn's business than to understand Chesapeake (NYSE:CHK). Primarily, it is a drilling company while Kinder Morgan owns a network of pipelines that transport oil and gas. There is nothing about these businesses that make it impossible to understand how they work. One also does not need to be an expert in energy to invest in an MLP just as one does not need to know how an iPhone works to invest in Apple (NASDAQ:AAPL).
The only complicating factor in MLPs is that there is a general partner who manages the MLP. Some like EPD and LINE own the GP, negating its impacting. Others like KMP have third-party general partners; in this case, it is Kinder Morgan Inc. (NYSE:KMI). KMI is paid incentive distribution rights (a percentage of cash flow) with the current rate for additional cash flow generation being 50%. Again, this is not overly complicated. A separate entity operates the assets of the partnership and gets paid more when the partnership does better.
Bloomberg also argues there are fundamental problems with the business model as some distribute more cash than they generate. One called the model a "bit of gimmick" as MLPs issue "more equity to fund the distribution and growth. It works until it doesn't work." Again, we cannot paint all MLPs with the same brush. There are certainly some bad actors that pay out too much as Boardwalk Pipeline Partners (NYSE:BWP) showed. However, this is not true of most MLPs.
MLPs use "distributable cash flow," which is essentially sustainable free cash flow. DCF is operating cash flow less maintenance cap-ex; growth cap-ex is not subtracted. Conservative MLPs like EPD and Plains All American (NYSE:PAA) pay out much less than they earn, and KMP will pay out about 95-100% of its DCF this year with a distribution of roughly $5.59 (all financial and operating data available here). KMP operates its pipelines on long-term contracts, which makes its cash flow extremely predictable and stable. There is nothing inherently risky about returning sustainable free cash flow to investors. Many corporations return the majority of their cash to investors; this is no different.
For any company with DCF that is higher than the distribution, it is incorrect to say they issue equity to fund the distribution. They issue equity and debt to fund growth projects. Rather than retain earnings, they issue debt and equity. There is nothing unsustainable about this model. KMP has a backlog of $14 billion, which will allow it to significantly grow its payout even though it is funded by equity. Whether projects are funded by retained earnings or common equity is more of an accounting difference than anything else.
Investors can choose to invest in a corporation that retains earnings and pays less today or an MLP with a higher payout today but issues equity. These are two different models, and neither are inherently bad, though both can be abused with some MLPs paying too much and some corporations carrying far too much cash on the balance sheet. Bloomberg furthers the myth that MLPs are risky and pay out too much. KMP pays out slightly less than it generates, and so long as it continues to execute on its plan, the distribution will grow. MLPs are not the next great bubble. There is an energy boom in the U.S. that necessitates far more infrastructure. Investors should continue to invest in MLPs as the bearish cries continue.