In this installment, we will look at three different factors that could potentially explain the apparent over-valuation of MLPs (NYSEARCA:AMJ), (NYSEARCA:MLPN) based on multiples such as P/E, P/CF, and EV/EBITDA : Tax benefits, limited business risk, and the influence of low beta on the cost of capital.
It is frequently argued that MLPs deserve a valuation premium due to the tax benefits that they presumably confer on investors. MLP investors enjoy two tax advantages.
- First, due to the unique structure of MLPs, most income is not taxed at the corporate level but is passed through directly to the partners of the MLP.
- Second, up to 80%-90% of the cash distributions to MLP unit holders in a given year will receive a shield in the form of a tax deferral. The deferral benefit expires when the investor sells the units. Taxes are only deferred, not avoided. Still, this deferral can have substantial economic value. The economic benefit of this deferral will differ widely amongst investors according to their effective tax rates and their average holding periods.
Leaving aside the estate planning issues (because they are in a state of flux and they do not affect most investors), how much of a premium should MLPs command as a result of the various tax benefits that MLPs confer at both the corporate and individual level?
Corporate Tax Benefits
At the corporate level, the answer is fairly straight-forward: The valuation premium justified is equivalent to the difference between the effective tax rates of similarly situated C-Corps and MLPs in percentage terms.
The highest marginal tax rate for U.S. corporations is 35%. However in practice, effective tax rates for U.S. C-Corps in the S&P 500 have traditionally been in the 25% range. The effective tax rate for the utilities sector in 2010 was 21%. Thus, all things remaining equal, the free cash flow available to MLP unit holders will tend to be about 20%+ higher than would be the case if it were organized as a C-Corp. This would justify a valuation premium of around roughly 20%+ on an EV/EBITDA basis.
However, it is very important to note that there is zero premium justified on a P/E or P/CF basis due to tax considerations at the corporate level since corporate taxes are already deducted from the EPS and CFPS figures utilized in P/E and P/CF calculations.
Individual Tax Benefits
Should MLPs trade at a premium based on the tax deferral benefit at the individual level? Here the relative position of MLPs is much more ambiguous.
Under current law, qualified dividend payments from C-Corps are taxed at a maximum rate of 15%. By contrast, MLP distributions are taxed at ordinary income rates that can run as high as 35.0%. Thus, in principle, at the individual level, for high-income investors, the tax burden on an MLP investment is much greater than the tax burden on C-Corp investments.
However, the benefits of the tax deferred nature of MLP distributions must be taken into account. The benefit of a tax deferral will vary widely depending on the holding period, the assumed rate of reinvestment of the deferred taxes and the effective tax rate of each investor.
I have performed a simulation assuming the top marginal rate for both dividends and ordinary income, a 5% annual distribution plus 5% annual capital appreciation. On this basis it takes a holding period of slightly more than 10 years for the benefit of tax deferral to equilibrate the advantage that holding C-Corps has for the investor due to the lower dividend tax rate.
While some investors hold MLPs for 10 years or more, the vast majority of investors do not. A sample of volume data suggests that the average holding period for MLPs is in the 3-4 year range. Given this sort of average holding period, according to my calculations, MLPs should actually trade at a discount of about 5% to C-Corps based on tax considerations at the individual level – without taking account the problems associated with complex MLP filings.
All in all, based on tax considerations at both the individual and corporate level, MLPs warrant a valuation discount of 5% on a PE and P/CF basis, while a premium of about 15% is warranted on an EV/EBITDA basis – all other variables such remaining equal.
In sum, the ability of tax considerations to justify premium valuations for MLPs tend to be exaggerated. Certainly, the massive valuation premiums that MLPs currently command on a P/E, P/CF and EV/EBITDA basis are not justified on this basis.
Limited Business Risks
Although there are significant exceptions, MLPs tend to operate in business segments characterized by relatively low risk and high reliability of cash flows. All other variables remaining equal, this fact undoubtedly merits a valuation premium for MLPs.
The valuation premium on this basis will differ widely in accordance to the specific industry that the MLP operates in. For example, MLPs in the upstream oil and gas sector such as LINE and EVEP are subject to substantial commodities risks. Thus, these MLPs do not deserve large valuation premiums on the basis of business risk. By contrast, pipeline MLPs such as EPB and SEP deserve some level of premium given the relatively limited business risks that characterize this sector.
Having said this, it is my view that investors tend to underestimate the risks in MLP business models. No business model is immune from significant risk. In the fullness of time, all business models tend to have their “days in the sun” and “dark ages.” In this regard, in my view, many investors may be excessively complacent regarding non-negligible long-term business risks inherent in many MLP business models.
For example, many investors believe that MLPs offer a hedge against inflation, given the nature of their contracts that are generally reprised annually in accordance to the CPI. However, U.S. investors tend to understand very little about how these types of businesses are actually affected in an inflationary environment.
Historically, in countries with high inflation, utilities stocks tend to get devastated for two reasons. First, there is the issue of the timing of rate increases and the rise in costs. The latter always precedes the former. When costs rise daily and tariffs rise only yearly, this lag can cause enormous cash-flow losses. Second, MLP’s operate in highly regulated sectors. In an inflationary environment, regulatory risks multiply. Governments come under political pressure to limit utility tariff increases. Furthermore, government officials often try to use their power over utilities’ pricing to contain the inertial forces of inflation. Finally, in inflationary times governments around the world have often passed laws outlawing inflation indexation of contracts precisely to avoid automatic price increases and concomitant price spirals.
The risk of high inflation is one instance in which the risks faced by MLPs are much greater than those faced by companies that sell consumer staples. There are others.
In an article like this it is impossible to comprehensively evaluate all long-term business risks faced by MLPs. For now, I will simply note that while lower business risk is a factor that favors MLP valuations, this advantage should not be exaggerated – particularly when viewed over long periods of time. Over time, things can and do change. What seems like a sure thing now, will rarely seem that way decades into the future.
Low Beta and The Cost of Capital
Publicly traded MLP stocks tend to exhibit significantly less volatility than the average stock in the S&P 500. Over the past five years, the average Beta of the MLP sector has been approximately 0.70.
Many MLP investors claim that they do not care about stock volatility; that they only care about the consistency of distribution streams. Ironically, to the extent that were true, then no benefit to the cost of capital would accrue to MLP valuations from a lower beta.
Having said that, in terms of the Capital Asset Pricing Model (CAPM) method of equity valuation, the lower level of volatility of MLP stocks merit a relatively lower cost of equity capital for said MLPs. This lower cost of equity derives in higher NPVs of future cash flow relative to comparable companies, and therefore higher implied multiples of cash flow relative to comparable companies.
For example, on the basis of Beta analysis alone, MLPs might warrant a 9% premium relative to the S&P Utilities sector. More impressive yet, all other things being equal (e.g. growth, liquidity, and etc), the justified valuation premium of MLPs versus the average stock in the S&P 500 might be in the neighborhood of 40%.
Having said that, there are many reasons to doubt that MLPs on a sectoral basis can ultimately be afforded any substantial advantage in a proper calculation of the cost of equity capital. The most important reason for this has to do with the built-in Incentive Distribution Rights (IDR) of the General Partners in MLPs where this structure is in place.
Briefly, equity investors in MLPs with an IDR such as EEP and ETP must demand a higher return for any given level of projected cash flow, compared to shareholders in a C-Corp, given that under IDR schemes an ever-increasing percentage of incremental future cash flow will belong to the GP and not the limited partner (LP).
Thus, the higher rate of return that LP unit holders must demand for a given quantity and timing of future cash flow will be higher than is the case for a comparable C-Corp. This effect will tend to overwhelm any beneficial impact on the cost of equity capital that accrues to MLPs from a lower Beta.
Indeed, it can be shown mathematically that an MLP with a maximum IDR tier structure of 50% such as KMP and BWP (relatively common) deserves an equity cost of capital of more than 60% higher than a C-Corp, on this basis alone.
As can be seen, this particularity of the MLP structure tends to overwhelm any advantage to the cost of capital of MLPs that is derived from the Beta effect. Thus, it is doubtful that any sort of valuation premium can be justified for MLPs on a sectoral basis in a P/CF or EV/EBITDA comparable analysis based on the relative cost of equity capital.
MLPs are overvalued on a relative basis by a very wide margin on a P/E, P/CF and EV/EBITDA basis compared to comparable industries or groupings such as Dividend Aristocrats, Utilities or Telecom.
Some analysts have claimed that certain advantages of MLPs such as the stability and reliability of distributions, tax deferral benefits, low business risk and low beta justify some degree of valuation premium for MLPs on an EV/EBITDA basis.
Having said that, I have not seen any serious analysis that would suggest that a valuation premium of anywhere near 100% on a P/CF or EV/EBIDA basis could be justified or sustained for MLPs in the long term. To the contrary, in this article I have demonstrated that such a valuation premium can by no means be justified.
Thus, even taking the many advantages conferred by MLPs into account, the inevitable conclusion is reached that MLPs are very overvalued on a relative basis.
Indeed, when other factors are considered that have not yet been discussed, MLPs may begin to look even more overvalued. This will be the subject of a future article in this series.
The next article in this series will take a comprehensive look at the historical evolution of MLP valuations on a relative basis using several criteria. This will show that MLPs are not just overvalued to other sectors right now, but that the level of relative overvaluation of MLPs is currently extremely high on a historical basis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.