Big Obstacles Face Retail MLP Investors

Includes: EPD, KMP, MMP, PAA
by: Factoids

Generally speaking, the income producing S&P 500 stocks offer something close to a 2% yield and 8% dividend growth, for a long term total return expectation of 10%. Price appreciation will tend to follow where the dividend increases lead. When you invest via mutual funds, you surrender one percentage point or more of that return expectation in fees subtracted by those funds. The average midstream MLP (Master Limited Partnership) in my coverage universe offers a yield of 6.37% and distribution growth of 5.42% - providing a long term 11.79% total return expectation. If you take advantage of the discount that you capture from buying higher growth and lower yielding MLPs, you can generate a portfolio with a 12% or higher total return expectations. At the same time, you can harvest the benefits of tax deferment. There are substantial potential rewards to be had by those who face the challenges of buying individual MLPs. I plan to write much more about that "carrot" in future articles. This article is about the "stick" that beats investors away from those carrots. Specifically, this article is mostly about stick number four - MLPs and Metrics.

Stick Number One - Taxes

The National Association of Publicly Traded Partnerships web site has offered access to intro MLP reports. For the current list of free reports - click here

I am not an accountant - so I will not touch on that issue. I use a CPA - and the expense of using a CPA did not significantly climb once I started MLP investing. I have a long list of net-buddies that own MLPs and use Turbo-Tax. MLPs do have some wrinkles that will test those with light inputting skills. But people with average tax software IQs can handle MLPs. And there are message boards filled with grey beards who will help you when a problem arises. Please do a message board search before posting your questions. The odds are strong that your problem has been answered multiple times before.

Stick Number Two - MLPs and IRAs

The experts will tell you that you can not safely put MLPs in IRAs (Individual Retirement Account). MLPs that produce positive UBTIs (Unrelated Business Taxable Income) can generate taxes on funds that are held inside IRAs - as opposed to taxable events being caused by withdrawals for other equity holdings. The answer to this problem is simple: Put only negative producing UBTI MLPs in IRAs. Do not put positive UBTI producing MLPs in IRAs. I will touch (or pound) on that issue in a separate article - providing a list of negative producing UBTI MLPs created by a list of close to 100 volunteers who have shared their tax data.

Stick Number Three - MLPs and EPS

Most income seeking equity investors are somewhat familiar with REITs (Real Estate Investment Trusts). REITs produce earnings releases that focus on FFO (Funds From Operations). You know that dividend coverage by FFO is the important metric while dividend coverage by EPS is a meaningless metric. Many income seeking equity investors are somewhat familiar with telecommunication companies that have higher dividends per share than EPS. They know the telecoms need cash flow coverage of the dividend, not EPS coverage of the dividend. The same is true for MLPs. They need to cover their distributions with DCF (Distributable Cash Flow).

Stick Number Four - MLPs and Metrics

By the time you have fought off the first three ogres with their menacing sticks, you are tired from the battle. Now you have to face ogre number four. He is bigger, stronger, meaner and faster. He is ugly - and smells worse than he looks. Most of you should wisely surrender and just buy MLP mutual funds, closed-end funds or ETNs (Exchange Traded Notes).

But if you beat this ogre, you get the prize of significantly better investment total returns. For me, that is a prize worth taking home.

We will take a meandering path and fight many battles from here on. Here is a quick outline for where I am headed in the remainder of this article:

The Catch 22 - you are lost without a good MLP update - none of the brokerages have good updates

How do I know they are all bad? - I asked

Brokerage reports do not have a retail investor focus

What makes the brokerage reports bad?

1. The failure to show the power of small differences
2. The failure to provide an adequate picture of risk
3. The failure to provide an adequate picture of growth

Couple that with the problems in MLP earnings releases

How most investors overcome these problems - borrowed opinions

The Catch 22 - you are lost without a good MLP update - none of the brokerages have good updates

I have tracked MLP stats since 2005 - and that has resulted in some perceptions with which I have a strong amount of certainty. You can not make sense of MLP valuations without price/DCF ratios. You need brokerage reports to get DCF projections. MLPs sell at a logical yield plus CAGR (projected Compound Annual Growth Rate of the distribution) metrics with some significant adjustments for risk. You need brokerage reports to get good distribution CAGR projections. The financial web sites that offer CAGRs have MLP projections that are based on EPS - and they are close to meaningless. MLPs with stronger distribution coverage ratios have better distribution growth. Put in a way that is close to universally true, companies with stronger earnings to payout ratios have stronger payout growth. As a rule of thumb, this is true for regional banks, REITs, BDCs (Business Development Companies), consumer staples, and the dividend paying technology and industrial companies in my coverage universe where I also track stats. There is also a correlation between payout growth and earnings growth. To get the stats that assist in verifying distribution CAGR projections, you need the stats from the brokerage reports. Proving the above perceptions will be the focus of several future articles.

How do I know the brokerage reports are all bad? - I asked

The majority of people responding to a recent message board survey say they infrequently are paying attention to the major brokerage MLP reports. Some of that may be due to most of the people who responded to the survey lacked access to those reports. But even if they (or you) lack access, the cost of switching to a discount brokerage that does provide access is not a major issue - as far as I currently know. A large percentage of those responding have been long term investors in MLPs who have reached their allocation limits on MLPs - and thus are not putting new money in the sector. That too would lower readership of the reports. I have privately messaged or emailed most of the participants - many of them for several years. I have a strong amount of confidence that the responses accurately reflected their perceptions and habits. The poll results:

I never or almost never read brokerage MLP reports 54
Brokerage MLP reports are OK - I sometimes read them 29
Brokerage MLP reports are valuable - I usually read them 18

It is important to note that this poll was taken from a group of message board reading investors who are definitely not the buy and forget it type. Close to 30% of these respondents had MLPs as an over 50% component of their total portfolio - and 50% had between a 20% and 50% weighting in MLPs. A potentially surprising 68% owned at least one of the lower yielding but higher growth "general partners". So the sample was not a group of uniformed yield hogs. But even for this group, it strongly appears that there is a general perception that the extra information the brokerage reports can provide is not worth the trouble to read.

Brokers' reports do not have a retail investor focus

From "Inside the "Black Box" of Sell-Side Financial Analysts" of March 2013, the researchers Brown, Call, Clement and Sharp find that "hedge funds and mutual funds are the most important clients to analyst's employers; defined-benefit pension funds, insurance funds, endowments, and foundations are of moderate importance; and retail brokerage firms and high net-worth individuals are of less importance." It is logical that the research products of the analysts would be a better fit with the audiences of higher importance.

Before I continue on - I want to cite two other findings from that research.

[1]"Consistent with II (Institutional Investor) surveys regarding what institutional investor clients most value, ... industry knowledge is the most important determinant of analysts' compensation. Analysts also respond that their standing in analyst rankings or broker votes, professional integrity, and accessibility/responsiveness are important determinants of their compensation. Consistent with II surveys, the accuracy and timeliness of analysts' earnings forecasts and the profitability of their stock recommendations are the lowest-rated determinants of analysts' compensation."

The Brown, Call, Clement and Sharp surveyed the analysts - not their bosses. Given that taking calls from fat cat institutions are more important than "timeliness", it is not surprising that the market hears of downgrades and upgrades well after well after the factors that caused those changing ratings have been priced into the market.

On the other hand,

[2] "... the analysts we surveyed say II rankings are far less important to their career advancement than broker votes."

I know that I am focused and determined in my communication with my brokers - because I am predominantly in communication with them when I initiate a transaction. My conduct could easily come across as arrogance. I could be easily guilty of acting like brokers are the sales clerks that they really are when it comes to buying individual stocks. I could be easily guilty of acting like brokers are not among the smartest persons in the world. So giving that position, I am not instructing my brokers on how to vote in their appraisals of their analysts. We, the retail investors, really are in a position of some potential power that we are failing to use. In the end, we get the quality of analyst reports that we demand. And as a group, we have not been informed enough to demand the quality of reports that we need.

Given that the reports are not for us, the reports fail to start at point one, then proceed on. They start at point seven (or the point of understanding of the full time institutional investors) and proceed with insufficient context. We need to be hit in the face with context. And the key audiences for those reports do not.

What makes the brokerage reports bad?

1. The failure to show the power of small differences

If I were generating a quarterly report for the retail investor audience, here is how I would start the report.

Price Changes and Total Returns Since the Beginning of 2009, 2008 and 2007

06-21-13 12-31-09 Change 12-31-08 Change 12-31-07 Change 12-31-06 Change
Company Price Price Price Pr+Dist Price Price Pr+Dist Price Price Pr+Dist Price Price Pr+Dist
Large Capped MLPs
BPL Buckeye 66.60 54.45 22.31 48.15 32.25 106.51 161.36 49.41 34.79 77.52 46.48 43.29 95.65
BWP Boardwalk 29.97 30.03 -0.20 24.17 17.78 68.56 120.68 31.10 -3.63 32.18 30.82 -2.76 39.01
EEP Enbridge 29.31 26.84 9.20 36.60 12.75 129.88 203.09 25.27 15.99 60.60 24.69 18.71 71.91
EPD Enterprise 58.73 31.41 86.98 114.21 20.73 183.31 235.01 31.88 84.22 124.26 28.98 102.66 153.30
ETP Energy Transfer 47.54 44.97 5.71 33.54 34.01 39.78 87.08 53.88 -11.77 24.59 54.10 -12.13 29.97
KMP Kinder Morgan 80.67 60.98 32.29 59.08 45.75 76.33 121.22 53.99 49.42 94.67 47.90 68.41 126.45
MMP Magellan 51.43 21.66 137.44 164.46 15.10 240.60 288.75 21.68 137.22 177.03 19.30 166.48 217.65
NS NuStar 43.85 56.09 -21.82 5.24 41.06 6.79 54.09 53.30 -17.73 26.23 55.77 -21.37 27.39
OKS OneOK 48.22 31.15 54.80 82.31 22.77 111.77 158.92 30.62 57.48 99.40 31.67 52.26 99.06
PAA Plains All-Amer 53.26 26.43 101.51 128.29 17.34 207.15 258.41 26.00 104.85 145.76 25.60 108.05 156.01
WPZ Williams 48.88 30.67 59.37 93.16 11.94 309.38 417.44 39.20 24.69 63.82 38.70 26.30 71.22

44.33 78.88 134.55 140.45 43.23 84.19 49.99 98.87

There are huge differences in total return over a relatively short period of time - which is just under 7.5 years. Most of those differences can be accounted for in shifts of forward distribution growth. For example, ETP has gone from a high growth projection in 2007 to a much lower projection today. The same is a little less true with BWP. At the same time, the growth projections for MMP and PAA have increased. But for many in this large cap midstream group, the shift in growth projections has been small. Let's parse the historical returns into three groups and include average yearly distribution growth from Q2-06 to Q4-12 after their tickers.

Those that have out-performed: EPD (5.93%), MMP (8.81%) and PAA (6.40%).
Those that did around average: KMP (7.72%), OKS (6.02%) and BPL (5.00%).
Those that did worse than average: NS (3.09%), ETP (3.06%), BWP (4.95%), and EEP (2.75%).

Even accounting for the CAGR (the forward Compound Annual Growth Rate of the distribution) projection shifts, there are huge total return differences between the 3% distribution growers and the 6% growers. I believe the average retail investor fails to grasp the importance of what they think is a tiny difference in CAGR - and the effect it can have over a relatively short period of time. This investor in EPD and MMP thought he was being smart in buying those higher distribution growing MLPs. But even this growth oriented investor did not project the significant size of the difference those decisions would have.

Let me three-peat this one key point (or theory) for emphasis: Most of the differences in share price appreciation for stocks in the same sector can be accounted for in shifts of forward distribution growth projections. The second most important factor is the absolute distribution growth amount itself. Put in plain words: The most important thing is changes in CAGR. The second most important thing is CAGR. CAGRs are that dang important. That is what I see when I look at the history. That is what the numbers are telling me. I believe that you have the power to listen in and hear the same thing I am hearing.

2. The failure to provide an adequate picture of risk

While growth is very important (and more on growth is upcoming) - risk is important, too. Here is an analogy for risk that I believe should be in every MLP update at least once per quarter. Let's say you use a discount brokerage. And to offset their lower cost of services, they have one trick up their sleeve. They roll the dice each time you place a bid for a stock. If the die comes up under 8 - they place the bid for the stock you want. If the die comes up 9 or above, the brokerage then buys for you a stock of their choosing - one from their inventory of stock ownership they are trying to unload. How long would you stay with that brokerage?

That is exactly what risk mean to me. Different stocks - and different MLPs - have business models that produce EBITDAs of higher or lower predictiveness. You can buy a stock with a well covered distribution and a high growth potential - and them in the nest sector update - the DCF projection changes, the distribution coverage ratio changes, the distribution growth projection changes, and even the risk perception changes because of the DCF projection oscillation. I've been there and done that. In a very real sense, I ended up with a different stock than the one I thought I had purchased.

The MLP updates are doing a poor job in explaining the importance of risk; showing which MLPs are higher risk; and explaining the attributes of each MLP that causes those risk attributes.

Lower risk most often results in getting what you pay for. And this "getting what you pay for" attribute is something that you can know before the purchase. The "getting what you pay for" attribute is strongly reflected in the bond ratings - and it is the reason why MLPs with better bond ratings tend to sell for lower yields than other MLPs with similar CAGRs. There are lots of low growth MLPs with good bond ratings. Failure to see the data without the CAGR context will cover up that correlation. Buying a MLP with lower risk means having to accept a lower "yield plus CAGR" - because those who understand the risk attributes have correctly inflated the valuations for lower risk options. You can't get safety for free.

We can close to universally accept that the 10 year treasury sells at a yield just north of 2% while the 'risky' BBB rated BDC baby bonds with maturities in 2023 sell at yields around 6%. That is a big spread! But we accept that the spread is justified. I believe that BDC (Business Development Company) yield spread to the ten year treasury is overly wide because there is not a large audience that understands BDCs. One of the reasons REIT (Real Estate Investment Trust) yield spread is small is due to the visibility of REIT earnings that makes FFO (Funds From Operation) projections atypically accurate. On the other hand, when we are presented with the good and predictable equities that have "unknown" or poorly known risk differences selling at only a 2 percentage point discount to the bad or less predictable equities, the yield hog that is in us all balks at the premium you have to pay to purchase "good". I am not writing that low risk sells at more of a discount than is justified. I believe that low risk normally is correctly priced into the lower yielding options. I believe that the retail investor has a problem visualizing or sizing the attractiveness of the lower risk attribute. And the current brokerage reports are failing to correct that impairment for most retail investors.

Providing justification for risk differences is easy! There are simple metrics to explain it.

1. Historical DCF prediction accuracy - because companies with more volatile business models have yearly DCFs that are harder to accurately project. That risk attribute shows up in these historical numbers. This highly informative risk metric is on I have never seen in any analyst report.

2. Current DCF projection spreads between the high and low numbers - because companies with more volatile business models have wider spreads in their projections from different analysts.

3. Bond ratings - because companies with more volatile business models have lower bond ratings.

4. Bond yields - a mostly redundant indicator to ratings, but the market can price bonds in a way that shows some slightly disagreement with the ratings. I have also found that all BBB rated bonds are not created equal. One can find in the bond yields evidence of this inequality.

5. Credit facility costs - because companies with more volatile business models have higher costing credit facilities. This is also an informative risk metric that I have never seen in any analyst report.

6. Debt to market cap ratios - because leverage is a factor in risk and equity investors are paid after the debtors are paid. As an equity investor, I know I will never be first in line. But I want the line ahead of me to be relatively short.

7. Debt to EBITDA ratios - because leverage is a factor in risk and companies with volatile EBITDAs require better ratios to make up for their volatility.

8. EBITDA to interest expense ratios - because leverage is a factor in risk and companies paying higher interest rates can have healthy debt to market cap ratios while having sickly interest rate coverage ratios.

Give us - the retail investors - the stats that assist in assessing risk and the message has the potential to sink in. And there are lots of stats that can be used to justify a risk assessment. Many brokerages provide updates that contain some of those "justifying" stats. None of the brokerages have reports that contain all of those stats. None of the brokerages connect those metrics to their risk assessments. Very few brokerages provide a single number assessment for risk. Almost all brokerages use the DDM (dividend discount model) as part of their target price producing formula - and the DDM requires a "single number" risk assignment.

3. The failure to provide an adequate picture of growth

The reports are a little less lacking when it comes to growth projections. Most offer their own distribution CAGRs. Few offer consensus CAGR projections. And when they do - they just note the differences. I perceive that my fellow retail investors need a short justification provided in one to three reasons why the brokerage is more or less bullish. Tell us if you expect margin expansion; or volume expansion due to drilling in key areas; or growth from cap ex spending; or a good distribution to DCF ratio that promotes distribution growth. But they fail to provide justifications on the same page where the differences are noted. You have to go to a different page of a very long document - or even to a different document. Few note any differences. And those who note their justification expressed them in rather obscure terms.

In the example provided close to the beginning of this message where I explained risk - I told of how the stocks' DCF projection fell, and that reduced the growth projection and safety perception. I did not know it at the time, but that purchase was made based on an out of consensus - and above consensus - DCF projection. If I had knowledge of the out of consensus nature of the DCF projection at the time of purchase, I probably would have avoided that purchase.

The problems I have listed above are the problems with the 'good' updates. Many brokerages produce reports that are even more lacking in positive attributes.

There are still brokerages that fail to do DCF projections. I would never buy a 'regular' stock without knowing the P/E ratio and the dividend coverage ratio. Without a DCF projection, we lack the numbers to build price to DCF ratios and distribution coverage ratios. Without those ratios and a number for DCF growth, we lack a key component in building a logical and believable CAGR projection. Those types of MLP updates are worthless. There are even brokerages that fail to provide distribution CAGR projections. Those updates are worthless. There are far too many brokerages producing worthless updates - and that is even before the topic of the skimpy sizes of the coverage universes is considered.

Couple that with the problems in MLP earnings releases

The earnings releases of the MLPs themselves are also obstacles to finding and using key metrics. Some MLPs still provide insufficient transparency on the DCF numbers. I will tell you that MLP valuations are mostly about DCF, DCF growth and DCF coverage of the distribution. That "DCF is the main thing" message is not the story an investor receives from many earnings release presentations. And that makes the earnings releases produced by the MLPs a problem.

On the other hand, there are many REITs that have provided supplemental earnings releases providing excellent earnings and operating metric transparency. That level of excellence in transparency has not resulted in superior intelligence and analysis among REIT investors. Most retail investors are going to be lost and clueless no matter how good the earnings information turns out to be. But that should be good news only for those investors willing to do their home-work - their extra effort can result in superior insight that should then produce superior returns. It should not be an excuse for MLPs to under-perform in their duty to report their earnings.

We can not count on the analysts helping us out on this. When is the last time you heard an analyst on a conference call give a CEO a really hard time on a transparency issue? I am told that such events have happened. But I can only remember one example. For the analyst, a key priority is achieving and maintaining good relationships with the management teams in the sector he covers. He needs the CEO or CFO to return his phone calls. He is not going to put that relationship in danger by asking uncomfortable questions during conference calls. And he will also be hesitant to put in danger the other business of his firm when they call on the same executives with solicitations to be a part of their debt offerings and secondary equity offerings.

There are several MLPs that fail to take questions from retail investors in their conference calls. And there is some justification for this. Many of the calls are long enough already. But that is not consistently the case for all MLPs that fail to accept questions from us thin kittens. A retail investor with a question is often treated as if they are a nuisance by several of the MLP executives. Having listened to hundreds of conference calls over the years, I believe I know why they may feel that way. Retail investors have a poor history of asking intelligent or relevant questions. The executives want to provide the appearance that they are both informed and concerned about our questions. We have often generated questions that are obstacles to them reaching that goal. They are best served delegating the task of answering retail questions to their Investor Relations department. And IRs tend to exist to send out copies of the last annual report.

How most investors overcome these problems - borrowed opinions

The majority of retail investors are due diligence light. They invest via borrowed opinions. They borrow opinions from their broker - but in most cases their broker will not know MLPs. They borrow opinions from the brokerage reports - are more specifically the headlines of the brokerage reports. They borrow opinions from message boards. they borrow from the talking heads on CNBC. Due to the fact that the average MLP is beating the S&P 500, they can be content with this path to moderate success.

I have provided a long and intimidating list of problems that sums to a mountain of an obstacle to climb before one can form their own informed opinion. There are no short cuts past those problems. But I will try - in the articles to come - to guide you up that mountain. We are not going to collectively cry out to the brokerages and MLPs to change their ways and expect to see immediately and sufficient improvement.

Those problems of obtaining key metrics are going to stick around. We can choose to omit owning MLPs - and suffer the consequences of lower portfolio yields and lower total returns. We can delegate to others the choice of which MLPs to buy by purchasing funds or ETNs (exchange traded notes) - and suffer the consequences of not trying to capture some large growth opportunities while at the same time having the fund's fees subtracted from our returns. For most investors, this is the best option. Or we can face those problems and climb those obstacles with the extra effort will result in higher reward. I strongly prefer option three. This is a labor intensive and mentally taxing option at the time of purchase decision. I have had the good fortune of making decisions that I do not need to revise that often. And the returns on those decisions have been sizable. The market has produced returns that justified the extra effort.

But with all the problems of prying loose meaningful data from those long, boring, obscure data filled and context light brokerage reports, why even bother with them? I am strongly convinced that without the DCF and CAGR projections from those reports, the retail investor is lost. And until one generates confidence in growth projections and valuations based on those two projections, you will lack the confidence to invest in the lower yielding options that offer the potential for the highest total returns. Keep in mind the huge differences in total returns over the last seven years one can find in the stats provided above for the large cap MLPs. There is a substantial payout for buying wisely. One can not buy wisely without a strong dose of DCF and CAGR awareness. And one can only attain DCF and CAGR awareness by selectively mining that data from brokerage reports.

This is the first of a series of articles that will assist investors in building an outperforming MLP portfolio. While I will end the series with specific suggestions, the goal of this series is to assist you in developing specific skills that will help you build your own list of suggestions. In addition to those skills, you will also need access to the currently faulty brokerage MLP reports.

It has been my experience that it is not what you buy that matters - it is what you hold on to. When one has confidence that they know the key metrics, one tends to hold on to investments with superior performance metrics. When one buys based on borrowed opinions, both the confidence to pull the trigger on the right investments and the comfort to hold those right investments is lacking. Ask any investor who sold MLPs during the downturn of 2008. Doing the due diligence that builds your confidence and comfort is a labor that produces above average returns.

For those of you needing a preview to those suggestions, Enterprise Products Partners (NYSE:EPD), Kinder Morgan Energy Partners (NYSE:KMP), Magellan Midstream Partners (NYSE:MMP) and Plains All American Pipeline (NYSE:PAA) are on that list.

Disclosure: I am long EPD, KMP, MMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.