As the popularity of Master Limited Partnerships (MLPs) has exploded in the last few years, there has been some confusion regarding how to value these assets. Since MLPs are different entities from LLCs or corporations or REITs, the metrics that measure performance of these asset classes are not always ideal to measure the performance of MLPs. Since I have noticed several articles recently highlighting criteria I do not think are appropriate, I think it's worth the time to take a look at what investors should be looking for in the MLP area. Besides the yield on an MLP, which has the greatest impact on the price of the MLP's unit price, there are a few other numbers I like to look at. The three most valuable metrics in my opinion, for valuing MLPs are the distribution growth, the distribution coverage, and the yield spread between the MLP's yields and 10-year US Treasuries.
Distribution growth is important because it shows that the MLP is both healthy and continuing to grow. There are both stocks and bonds that investors could buy to get the 5-8% yields that MLPs offer, but how many of these have the growth history in distributions that MLPs have? Magellan Midstream Partners (NYSE:MMP) has increased distributions 199% since its 2001 IPO. Kinder Morgan Energy (NYSE:KMP) has increased distributions 630% since 1996. These are staggering growth numbers that were not destroyed in the financial crisis, that are not threatened by changing consumer preferences, new technologies, or a weaker dollar. Growth rates in the distribution slows and accelerates, but neither of these two MLPs has ever paid a lower distribution than the year earlier. That ability to consistently grow the business, and the distribution, is surely a better metric than a P/E ratio.
The next metric is the distribution coverage ratio. This number is basically a measure of how much extra money the partnership had left over after paying the distribution. A coverage ratio of 1.0 means that the MLP paid out all the money it had available for distributions, and retained none. A 2.0 coverage ratio means that the MLP paid out half of the money it had available for distributions. Think of this number as both a safety net and a measure of future distribution growth. Firms with a 1.2 coverage ratio could be paying out 20% more in distributions, but are keeping that money to reinvest in the business. By being conservative and keeping a cushion, the MLP is able to make the distribution each quarter without needing to worry about any cash shortfalls from short term problems, such as outages due to storms. In addition, the retained earnings can be put back into new growth projects, limiting the need to sell new units or issue new debt. Sunoco Logistics Partners (NYSE:SXL) recently reported a 2.0 coverage ratio for Q2, and Enterprise Products Partners (NYSE:EPD) reported a 1.5 coverage for the first half of 2011. Those levels of distribution coverage mean without any new projects coming online, distributions could be increased substantially from here.
While the first two metrics deal with MLPs at a partnership by partnership basis, the yield spread between MLPs and the 10-year Treasury is a good metric for looking at the group's value as a whole. Since MLPs are designed to return capital to unit holders, they are sensitive to interest rate fluctuations. Think of the difference between the yield on MLPs and the 10-year as a measure of the risk investors are willing to take. This spread, which is historically between 200 and 249 basis points over the last decade, has been somewhat less reliable in the last 3 years, as the financial crisis and QE activities have caused fluctuations in both the equity and bond markets, causing the spread to blow out towards 10% in the depths of the crisis.
With the 10-year currently yielding 2.23%, adding the spread gives you a target range of yields on MLPs between 4.23% and 4.72%. Now consider that nearly every MLP in the Alerian MLP Index yields 5% or greater, and the index itself was yielding 6.19% at the end of June, nearly 4% above the 10-year. This makes MLPs look somewhat cheap compared to historic terms, as yield and price move inversely. A chart of the yield spread for EPD shows a spread that is similarly large relative to the period before the financial crisis. Click to enlarge:
Click to enlarge
I believe that the distribution yield, in addition to distribution growth, distribution coverage ratio, and the yield spread to the 10-year US, are the best metrics to measure MLPs. These metrics provide a good idea of how fast the distribution is growing, how safe it is, and how expensive the MLP is based on the "risk free" 10-year.
However, it is a mistake to assume that all MLPs are the same, and to just buy an exchange traded fund or note. Certain partnerships do not have General Partners to make IDRs to, and other GPs are publicly traded. Some MLPs own pipelines or storage assets, others own oil wells, so it's important to do some research before simply buying based on a high yield. I have ranked the top holdings of the Alerian MLP Index in an earlier article, as well as where the partnerships stack up based upon distribution growth and coverage ratio. Also, remember that MLPs often issue new units to fund their growth, so wait for the dips caused by these offerings to add to positions.
Disclosure: I am long EPD.