Master Limited Partnerships (MLPs) are a new type of investment with an excellent record of high rates of stable growth & mostly tax-free (until the ultimate sale) high yields. Despite this performance, they are still little appreciated & understood partially due to poor investor relations by the companies.
Emerging Asset Class
Their business typically involves building pipelines & terminals for transporting oil & gas. Capital additions are their form of addiction. They have to keep investing in more assets to build more pipelines & terminals, a national priority. Spectacular growth for MLPs is forecasted to grow many fold going forward because of a growing demand for energy needing more infrastructure investment.
MLPs emerged from a small industry with only a handful of participants in the middle 1990s to a large industry with over 50 companies today. Below is market capitalization of publicly traded MLP's value calculated by Standard & Poor's:
Market Capitalization ($B)
(All values are year end except for 2008 taken on August 7)
December 31, 1995, was the beginning of the Alerian MLP Index [AMZ] at 100. The index has risen to 273 with only modest swings around the trend line, including the extremely volatile period in the early 2000s. A recent measure of the beta for MLP is only 0.35. They have a second index, AMZX, which includes reinvested income. That index at 648 yields a compounded annual growth rate over 16%, double the comparable rate earned by the S&P 500. In recent years, MLPs gained attention & fans with this growth record.
AMZ; AMZX; Yield
12/31/96; 108; 117 (8.7%)
12/31/97; 127; 147 (7.9%)
12/31/98; 115; 143 (9.0%)
12/31/99; 99; 132 (10.9%)
12/31/00; 131; 192 (8.8%)
12/31/01; 176; 276 (7.1%)
12/31/02; 159; 266 (8.2%)
12/31/03; 214; 385 (6.5%)
12/31/04; 235; 449 (6.3%)
12/31/05; 237; 478 (7.0%)
12/31/06; 283; 602 (6.4%)
12/31/07; 301; 679 (6.4%)
08/29/08; 273; 648 (7.7%)
MLPs typically offer high yields, maybe because of their association with utilities. For most companies, 80-90% of the income is not taxable in the current year. However, tax advantages brings tax hassle. These companies are limited partnerships which pay distributions, not dividends. Instead of sending 1099s, companies issue K-1 tax statements around March 15. The portion not taxed is used to reduce cost basis. After cost basis is reduced to zero, years in the future, distributions will be taxable. In addition, these businesses compete in many states which may require dealing with various state taxes. However, these tax numbers can be handled by popular tax packages.
One way to value MLPs is based on the spread of their yield over the 10 year Treasury bond. The yield on the MLP index is expected to be 200 basis point above the yield on the Treasury bond. This relationship has gone through a lot of trials in the last year. In mid 2007, Treasuries fell in price sending their yields to 5¼% while the MLP index was marching to a record level of 342, driving down its yield so the two yields came within a few basis points of being equal (the spread was essentially zero). As it turns out, that would have been an excellent time to buy Treasuries & sell the MLP index component companies. With the increase in Treasury bond prices & fall of the MLP index, the yield spread has widen to 390 basis points currently, 7.7% for MLP index vs 3.8% on Treasuries. Years from now, people will look back on this time with fond memories about this unusually wide spread, remembering the good old days when these high yields on were available on MLPs .
Correlations with Commodity Prices
Commodity prices do not correlate with MLPs. For example, oil prices doubled in the last year while MLPs have been sliding. Changes in oil prices are similar to changes for other fuel commodities and they also do not correlate with the MLP index. In addition, MLPs have a very low beta, unlike the high volatility for fuel prices. However, especially this year, changes in the MLP index have followed or at least took cues from changes in oil & other fuel prices.
Limited partnerships take a little getting used to because they are complicated. Generally they are composed of limited partners & general partners. The limited partners supply 98% of the capital expecting to get a return on their passive investment. The general partners supply 2% of the total capital. They are the active managers who are rewarded when profits achieve goals. They get a low percentage on first earnings earned. As income rises, they receive a higher percentages of profits for achieving goals. Income is divided into tiers, income in the higher tiers brings bigger rewards to general partners. At some companies, general partners receive 50% of profits in the highest tier. Profit sharing agreements vary from one firm to the next. Each investor will have to decide what is reasonable on splitting profits. An alternative is not to worry about the profit splits, instead accept the arrangement as satisfactory if they have a good track record.
Two companies, Kinder Morgan (NYSE:KMR) and Enbridge Energy (NYSE:EEP), also have I-unit shares. Each share of I stock is backed by one unit from the partnership. Distributions paid to unit holders are paid as stock dividends to shareholders of the class I stock, similar to a company dividend reinvestment plans. These stocks do not issue K-1 or 1099 statements, making them friendly for individual shareholders and retirement accounts (such as IRAs).
Distributable Cash Flow
Distributions paid to unit holders come from distributable cash flow, a measure which is not consistently defined. Real estate trusts (REITs) pay dividends from an alternative earnings metric, "Funds From Operations or FFO." FFO has an industry definition used by all REITs for determining how much cash earnings are available for dividends. Some MLPs talk about distributable cash flow.
Even when there is a definition, there is no accounting standard to supply a number consistent from one company to the next. Lacking an accounting standard makes it difficult to evaluate a company's ability to pay & raise distributions. Companies have a constant need to sell more units for more capital to build more pipelines.
Thus, management has an incentive to increase distributions frequently (i.e. 2, 3 or even 4 times a year). An investor will have to calculate alone that $3 of earnings plus depreciation & other non cash items accruing to all units holders justifies a distribution of $4.80. If that distribution is increased to $4.88, it is difficult to understand the rationale for the increase (especially when earnings decline). The industry needs a standard, similar to FFO in real estate, to be used by investors for better understanding discipline used to determine distributions.
For those interested in learning more, some investment firms have written primer reports on MLPs with more information about the industry. These free reports are available on the web.
Below are listed 7 MLPs:
Prices are closing prices on 8/29/08.
MLPs have excellent track records with relatively mild price fluctuations around their growth trend line, high yields (largely tax free) with excellent prospects for rapid growth going forward from strong demand for more oil & gas pipelines. These prospects have attracted many investors and this investment should gain popularity in the future.
Disclosure: none (currently)