In a recent article, I cited three reasons why high-yielding stocks in certain sectors were particularly vulnerable to a price collapse in the event of a severe stock market decline. One of the reasons I cited was the severe relative overvaluation of high dividend producing sectors such as MLPs, CEFs and income (or royalty) trusts.
Many readers expressed skepticism that MLPs might be overvalued. In this article I will specifically address the relative overvaluation of the MLP sector.
What Valuation Metrics To Use?
As can be seen in the table below (click to enlarge), besides dividend/distribution yield, no matter what valuation metric is used, the MLPs that comprise the Alerian Index (AMJ) (e.g. Enbridge Energy Partners (EEP), Oneok Partners (OKS), Kinder Morgan Management (KMR) are significantly overvalued relative to the S&P 500 ex-financials. Worse still, MLPs are even more overvalued when compared to potentially comparable dividend-paying sectors or stock groupings such as Dividend Aristocrats, Utilities and Telecom.
PE Metrics. When analyzed on a PE basis, MLPs are significantly overvalued relative to the S&P 500 ex-financials, Dividend Aristocrats, Utilities and Telecom – whether on a trailing or a forward PE basis. When analyzed on a PEG basis, the overvaluation of MLPs becomes even more significant.
It is often pointed out that PE ratios are not the best way to perform comparable valuations on MLPs given the particularities of the corporate structure. This observation is mostly correct. It is more correct to value MLPs on cash flow metrics – EV/EBITDA in particular. But as can be appreciated below, cash flow comparables do absolutely nothing to increase the relative attractiveness of MLPs
P/CF. This metric is purported to present a fairer picture of the value of an MLP than PE. This is true, but only marginally so. By adding back the entirety of depreciation and amortization to net earnings, P/CF does not take into account maintenance capital expenditure, thereby overstating true owner earnings. Furthermore, P/CF is fundamentally inaccurate due to the fact that a good chunk of the “CF” is actually distributed to the General Partner (GP). It is not uncommon for MLPs to pay out more than 20% of available cash flow to the GP, while “common” or “limited” unit-holders receive 80% or less of available cash flow. Finally, P/CF does not take into account the indebtedness of MLPs relative to other companies or sectors.
Despite the fact that P/CF tends to overstate the cash flow available to limited partnership (LP) unitholders (i.e. common shareholders) and that it understates the debt, as can be seen in the table above, MLPs are still overvalued based on this metric. MLPs have roughly the same P/CF multiple as the S&P 500 average despite significantly lower projected cash flow growth. Furthermore, the components of the MLP Alerian Index (AMJ) are more than 100% overvalued on a P/CF basis when compared to comparable sectors such as Utilities and Telecom. This extreme overvaluation on a P/CF basis exists despite the fact that Utilities and Telecom actually have significantly higher projected cash flow growth rates.
EV/EBITDA. This is by far the most widely used and the most analytically correct comparative multiple utilized to value MLPs. EV/EBITDA is an improvement over P/CF because it takes the debt levels into account. However, EV/EBITDA suffers from two of the other defects of P/CF: First, the distributions to the GP are not deducted. Second, maintenance capex is not deducted. Thus, EV/EBITDA valuations will tend to overstate the value of MLPs compared to stocks in other sectors.
Despite the above, MLPs are severely overvalued on an EV/EBIDA basis. MLP’s are 60% and 70% more expensive than the average stock the S&P 500 and Dividend Aristocrats, respectively. Furthermore, MLP’s are significantly more than 100% overvalued in relation to comparable sectors such as Utilities and Telecom on an EV/EBITDA basis.
As an asset class, MLPs are extremely overvalued compared to the average stock in the S&P 500. The overvaluation becomes worse when MLPs are compared to similar sectors and groupings such as Dividend Aristocrats, Utilities and Telecom. Indeed, the overvaluation of MLPs as a whole appears to be in the magnitude of 100%.
Having said this, valuation multiples can never be analyzed in isolation. Other factors impinge on fair relative valuations. In the case of MLPs there are some factors that tend to mitigate the apparent overvaluation. Other factors tend to make the relative valuation of MLPs even worse.
In the next article in this series I will specifically analyze factors that might mitigate the apparent relative overvaluation of MLPs. The article will address the following issues, amongst others:
- Consistency and reliability of cash distributions
- Tax deferral benefits
- Limited business risks
- Low Beta