Here are four basic points that I consider when I rate the safety of an MLP investment.
1. Payout ratio based on distributable cash flow (DCF). DCF is the best measure of an MLP’s profitability, as it effectively takes into account their ability to avoid paying corporate income taxes. In contrast, earnings per share do not capture an MLP’s profitability. An MLP earns a ratings point on this criterion depending on the extent to which its DCF covers its distribution and is exposed to commodity prices.
Kinder Morgan Energy Partners LP (NYSE: KMP), for example, earns a safety point for a 1.03-to-1 coverage ratio because its DCF hinges primarily on fee-based income. On the other hand, Penn Virginia Resource Partners LP’s (NYSE: PVR) 1.02-to-1 distribution coverage ratio doesn’t warrant a safety point because the firm’s coal mining royalties depend on commodity prices. A 1-to-1 coverage ratio is equivalent to a 100 percent payout ratio.
2. Percentage of DCF that’s fee-based. I’m bullish on prices for oil and NGLs and somewhat less so for natural gas. But the less a company relies on sales of these commodities, the less volatile its revenue will be over the long haul. As a result, I reward companies with fee-based income of 75 percent or higher with a safety rating point. Enterprise Products Partners’ (NYSE: EPD) ability to boost distributions every quarter throughout the 2008-09 financial crisis is a testament to the power of its fee-based energy infrastructure model.
3. Debt due through Dec. 31, 2012. If we’re going to have a reprise of the 2008 credit crunch--an increasingly unlikely event--the companies that stand to suffer the most are those with substantial near-term refinancing needs. Absolute levels of debt can be dealt with if maturities are long enough. I prefer MLPs with no debt maturities--bonds, loans or credit agreements--between now and the end of 2012. That’s plenty of time for another credit freeze to thaw. Any MLP whose debt maturities are less than 5 percent of its market capitalization also qualify.
4. At least one distribution increase in the last 12 months. There’s no better guarantee that a distribution is safe than a recent increase to an MLP’s payout. There’s also no better indication that a particular MLP is growing its business. Fourteen of the 17 MLPs in our model Portfolios at MLP Profits have boosted their distribution at least once in the past 12 months. The three holdouts were involved in transactions that should lead to future distribution growth.
I believe that MLP investments that satisfy these criteria are on a sure-fired path for success, even in this uncertain market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.