This is the final article in a four-part series of articles presenting fairly valued dividend income stock research candidates for potential inclusion in retirement portfolios. In Part 1, I focused primarily on fairly valued blue-chip dividend growth stock stalwarts with above-average growth of earnings and dividends for a focus on total return. In Part 2, I featured fairly valued higher-yielding dividend stocks with a focus on maximum current income and safety. In Part 3, I covered fairly valued REITs with a focus on high current yield and substantial cumulative total income potential.
With this final installment, I will present fairly valued MLP research candidates for those retired investors in need of maximum and/or high current income. However, before I present my list of MLPs, there are important distinctions and caveats regarding MLPs that need to be referenced and addressed. Although MLPs can be technically and legally included in qualified retirement portfolios, there are issues and complications with including them.
Drawbacks and Risks of Investing in MLPs
For starters, MLPs are not corporations; they are publicly-traded partnerships that enjoy a tax-exempt status granted by Congress. As such, the MLP avoids double taxation on their distributions (dividend equivalents) by passing on most of their income to their investor partners (unit holders). Consequently, investors in MLPs receive a K-1 tax form each year that must be filed, even in qualified plans. Although this is admittedly a nuisance, it can easily be handled by professional tax preparers, and even by individuals that are capable of and willing to file their own taxes.
An additional consideration and distinction as it relates to MLPs and taxes also needs to be addressed. The income from an MLP is passed through to its investors (unit holders) for tax purposes. However, the actual cash distribution does not necessarily relate to the firm's income generation. Instead, cash distributions are based on the MLP's distributable cash flow (DCF) which is analogous to free cash flow for a C Corp. However, a part of these distributions are considered reductions in your cost basis and therefore create a deferred tax liability that becomes due upon sell.
There are additional aspects of investing in MLPs that many consider as drawbacks. MLPs by structure and law are, for the most part, operating in the energy sector. Consequently, if an investor includes several MLPs in their portfolios, they are exposing themselves to concentration risk by overweighting the energy sector. However, it is possible to include select MLPs that are not directly exposed to oil and gas price volatility to accomplish a modicum of diversification. With oil and gas prices recently in a freefall, concentration risk has been accentuated which has simultaneously exposed the volatility risk derived from a lack of liquidity because of the relatively small size of the overall MLP market.
Another risk associated with investing in MLPs stems from the fact that they typically distribute most of their income to investors. Therefore, the typical MLP is heavily reliant upon taking on debt and/or raising equity to fund future growth. Consequently, MLPs are, by their nature, more dependent on the health of the capital and debt markets in order to fuel future growth. Of course, higher debt implies higher risk and raising equity is dilutive to existing shareholders.
Additional drawbacks that are often cited regarding MLPs are their complicated capital structures coupled with what many believe is a lack of standard accounting rules for reporting important financial metrics. This accounting standard shortfall is most vividly revealed with how many MLPs adopt differing approaches to reporting their maintenance capital expenditures required to maintain and operate the assets they own. This makes MLPs extremely tricky to value on an apple-to-apples basis.
Finally, since MLPs are concentrated in the energy sector which is divided into three major components, so are MLPs. Each of these major components possesses different levels of risk that the prospective investor should carefully evaluate.
Upstream MLPs participate primarily in exploration and production. Therefore, many consider upstream MLPs to be the most heavily exposed to the commodity price volatility of oil and gas. Therefore, I personally consider these the most risky MLPs to invest in.
Midstream MLPs typically are involved in the transportation, storage and marketing of crude or refined petroleum products. Since much of their business is done by contract, this component is less exposed to the volatile pricing of oil and gas. This is also the largest segment of the MLP population.
Downstream MLPs typically are involved in the refining, marketing and distribution of oil and gas products. As one of the smallest segments of the MLP universe, I personally prefer investing in major publicly traded international oil companies such as Chevron (NYSE:CVX) or Exxon (NYSE:XOM) in lieu of their MLP counterparts.
Later, I will provide specific fairly valued examples of MLPs from each of the major energy components. As a bonus, I will also include one example from the non-oil and gas energy sector coal.
The Advantages of Investing in MLPs
Up to this point, the reader might ask, with all these drawbacks why should I even consider investing in MLPs? The answer to my way of thinking is simple and straightforward. The primary reason to consider MLPs is their capacity for generating significant levels of current and cumulative total income. Consequently, they might be especially appropriate for those in retirement that need the maximum amount of income they can get on their portfolio commensurate with a reasonable level of risk.
On the other hand, MLPs have only been around since the late 1980s which coincides with a long and steady decline of interest rates. Therefore, prudent prospective investors need to consider what might happen to MLP performance during a rising interest rate environment which they have never operated under. However, even though many MLPs depend heavily upon borrowing to sustain their current distribution, in a potentially rising interest rate environment it will still come down to the spread they can earn on those borrowed funds.
To put this into a different perspective, MLPs offer the potential to raise the overall yield of an income portfolio when included as part of an overall diversification strategy. In the same vein, long-term historical total cumulative dividend income (distributions) potential has been extraordinarily large relative to your typical dividend income paying stocks, or the overall market as represented by the S&P 500. Consequently, even though there is a potential deferred tax liability, the amount of income that an MLP can produce is still significantly greater.
Simply stated, investing in MLPs is all about the massive amount of income distributions they can generate, at least in my humble opinion. To be sure, there are certain MLPs that also produce exceptional capital appreciation as well. Nevertheless, I believe the primary allure of investing in MLPs is for their income distributions. Consequently, as I will express in more detail later, when attempting to ascertain fair value for an MLP, I have found the relationship of price to the company's dividends (distributions) to be a key.
Additionally, I feel it's only fair to state that I do not consider myself an expert in evaluating MLPs. Frankly, I consider them extremely difficult to analyze due to their complex capital structures and the lack of clear reporting standards that I referenced earlier. Therefore, when I screened the universe of MLPs looking for fair value, I relied heavily on the F.A.S.T. Graphs fundamentals analyzer tool for guidance.
For the most part, I searched for those MLPs with the most stable historical records of distributable income. But most of all, I looked for MLPs whose price was low relative to their dividend (distribution) history. My logic was simple; since I am primarily attracted to MLPs for their dividends (distributions), it only made sense that their yields would be highest when their prices were below the dividend (distribution) line. Conversely, when their price is aberrantly above their dividend line, overvaluation logically seemed manifest.
Therefore, when I later present and highlight specific MLPs, I will only present F.A.S.T. Graphs showing dividends and price. I think the reader will discover that the correlation between price and dividends is profound and simultaneously represents a strong proxy and reflection of valuation. Although this approach may not be widely utilized throughout the industry, whether coincidence or not, it seems to have value when looked at in real-world situations.
The Current Energy Market: Risk or Opportunity?
It should be no surprise to any reader that the energy sector is currently in a crisis of sorts as it relates to the recent price collapse of oil prices. Since MLPs are primarily energy sector investments, it should also be no surprise that many MLPs have also recently been under pressure price-wise. Consequently, it should also be no surprise that many MLPs are currently trading at historically low valuations. However, this begs the question as to whether this is a short-term anomaly or a long-term opportunity.
If you believe that low oil and gas prices are temporary, then MLPs and other energy stocks might be of great interest to you. However, if you believe we are entering a long-term and therefore more permanent period of low oil and gas prices, you might consider today's apparent low valuations to be illusions. Personally, I see today's energy market as a great long opportunity to invest in select energy holdings at attractive valuations. Nevertheless, as it relates to MLPs, for many of the reasons expressed earlier, I suggest that great caution and careful due diligence is in order.
48 MLPs That Appear Attractively Valued Today
I screened the entire universe of MLPs one company at a time looking for consistent distribution histories and fair value. Of the more than 100 companies that I looked at, I offer the following 48 research candidates that met my criteria for consistency and fair valuation. However, the reader should note that many of the names on the following lists are relatively new, and many are small. Nevertheless, after reviewing each of them individually, I felt that this group was interesting and worthy of inclusion.
To put this in perspective, I offer a few excerpts and the following link to an article in Barrons by Michael Aneiro on February 15, 2014 titled "Master Limited Partnerships: It's Time to Get Picky." For those interested in understanding MLPs better, I highly recommend following the link and reading the entire article.
"The MLP universe - which in 2000 had 18 companies with a collective $14 billion in market value - now has 113 companies with some $460 billion. The vast majority operate in the energy and natural-resources industry. Most are infrastructure companies, in the business of storing or transporting oil, natural gas, and other forms of fuel. The energy industry calls these businesses "midstream."
"Investors have fueled the boom in MLPs with their passion for income. MLPs offer high payouts, averaging 5.7% today, and have been some of the most reliably high-yielding investments in recent years. Those payouts are a result of the partnerships' tax-advantaged structure; MLPs distribute a high percentage of their profit to shareholders, who are able to defer much of the tax owed on distributions."
Highlighted MLPs from Each Energy Component
As previously promised, I have highlighted three midstream MLPs as I consider these the most conservative and appropriate for retired investors. Additionally, I have highlighted one upstream MLP, as I consider this the most risky. On the other hand, the MLPs with the highest current yields are also found in this energy component. However, this might simultaneously say something about the risk of upstream MLPs. I also included one downstream MLP because I not only found it interesting, but I simultaneously felt it illustrates a great example of the importance of fair valuation. Finally, I included one MLP from the coal sector.
Most importantly, as it is with the entire list above, these are offered as research candidates and not specific recommendations. As I pointed out throughout the article, MLPs are complex and potentially risky investments. Therefore, I highly suggest that no decisions be made without conducting a more comprehensive research and due diligence.
Midstream Highlighted Research Candidates
"AmeriGas is the nation's largest propane company, serving over 2 million residential, commercial, industrial, agricultural and motor fuel propane customers from over 2,500 distribution locations in all 50 states."
And to repeat what I stated above, I am only presenting historical F.A.S.T. Graphs showing dividends and price. The light gray dividend line on the graph sitting above the blue shaded area is offered as a fair value proxy or reference line. What I believe the graph illustrates is that there is a high correlation between an MLP's stock price and its dividend (distribution). Stated over simplistically, when the price is below the gray line, the MLP appears undervalued; when the price is touching the gray line, sound valuation is indicated; and finally when the price is above the gray line, overvaluation exists.
In the AmeriGas Partners LP example below, we see a profound example of how price and dividends (distributions) have correlated and reflected valuation since 2001. Clearly, the most opportune time to invest in this MLP has been when the price is below the gray line, as it is today. Moreover, when the price is below the gray line, the dividend yield (distribution yield) of the MLP is indicated at optimum levels. The bottom line is that price follows dividends (distributions).
When you examine the performance associated with the above graph, the true allure and value of investing in MLPs becomes vividly clear. A simple one-time $10,000 investment on 12/29/2000 has generated $21,661.60 of cumulative total dividends paid versus only $2,298.69 versus an equal investment in the S&P 500 over the same time frame.
Additionally, because this specific MLP was undervalued at the beginning of 2000, it simultaneously produced more than double the capital appreciation that the S&P 500 generated. This all leads to a total return that is approximately 3 times greater than an equal investment in the S&P 500 over this time frame.
Targa Resources: (NYSE:NGLS)
"The Partnership is a leading provider of midstream natural gas and NGL services in the United States that was formed in October 2006 to own, operate, acquire and develop a diversified portfolio of complementary midstream energy assets. The Partnership is engaged in the business of gathering, compressing, treating, processing and selling natural gas and storing, fractionating, treating, transporting and selling NGLs and NGL products.
The Partnership operates in two primary divisions: (I) Natural Gas Gathering and Processing, consisting of two segments - (A) Field Gathering and Processing and (B) Coastal Gathering and Processing; and (II) NGL Logistics and Marketing, consisting of two segments -Logistics Assets and Marketing and Distribution."
One of the primary reasons that I highlighted Targa Resources was because I feel it offers a clear lesson on valuation. For example, beginning in the fall of 2011, Targa Resources' stock price became clearly disconnected from its dividends (distributions), in other words, significantly overvalued. Although this lasted for a couple of years and most likely lead to investor complacency, since August of 2014, Targa Resources' stock price moved swiftly and severely back to fair valuation. Today, I would consider it a sound buy, but not an especially undervalued buy.
Once again, I direct the reader's attention to the substantial dividend (distribution) outperformance of Targa Resources versus the S&P 500. Even though this MLP was technically overvalued upon its initial IPO, capital appreciation also exceeded the S&P 500.
ONEOK Partners, L.P.: (OKS)
"ONEOK Partners, L.P. is one of the largest publicly traded master limited partnerships and is a leader in the gathering, processing, storage and transportation of natural gas in the U.S. and owns one of the nation's premier natural gas liquids [NGL] systems, connecting NGL supply in the Mid-Continent and Rocky Mountain regions with key market centers."
ONEOK Partners, L.P. represents a second example that clearly reveals the MLP price and dividend (distribution) relationship, and simultaneously offers a lesson on the importance of valuation. Clearly, the most opportune times to invest in midstream MLPs are when their price sits at or below the gray dividend (distribution) line.
Once again, we discover substantial dividend (distribution) outperformance versus the S&P 500. Additionally, we also see significant capital appreciation performance as well. I believe this midstream MLP example, as well as the two that preceded it, clearly illustrate why I prefer MLPs that operate in the midstream energy component.
Upstream (exploration and production) Research Candidate
Perhaps the most prominent and widely recognized upstream MLP is Linn Energy (LINE). However, it has also suffered one of the most severe price drops over the last two years, and has performed horribly price-wise since August of this year. On the other hand, this drop in price has led to an extraordinarily high yield exceeding 17% per annum. This MLP pays monthly distributions, and maintained its current distribution rate for the most recent month.
Linn Energy, LLC:
"Linn Energy has grown from a handful of natural gas wells in 2003 to a top-15 independent U.S. E&P company with approximately 6.4 Tcfe of proved reserves in producing U.S. basins as of Dec. 31, 2013.
Linn became the first publicly traded independent oil and natural gas limited liability company (LLC) in January 2006. Since then, the company has consistently paid the distribution to unit holders for 32 quarters and grown to an enterprise value of more than $19 billion.
Linn now has approximately 1,600 employees spread across more than two dozen locations in the United States. Headquartered in Houston, Texas, the company's core focus areas are the Rockies, the Mid-Continent, the Hugoton Basin, California, the Permian Basin, Michigan, Illinois and East Texas."
Of course, the real question that needs to be asked is whether or not this company will continue their high distribution rate, or will they be forced to cut distributions in the future. From the perspective of price, I doubt that a distribution cut would cause much damage from today's low levels.
But since I have stated that MLPs should be bought for their significant income producing capacity, a distribution cut would be problematic. Frankly, there are strong positions taking both sides of Linn Energy's future distribution potential. Consequently, I suggest checking out the numerous articles available on Seeking Alpha as part of your further due diligence. I've included a few of the most recent ones found here, here, here, and here.
Calumet Specialty Products Partners, L.P. (NASDAQ: CLMT)
"Calumet Specialty Products Partners, L.P. is a leading independent producer of high-quality, specialty hydrocarbon products and fuel products in North America.
We are headquartered in Indianapolis, Indiana and own facilities primarily located in Louisiana, Wisconsin, Montana, Texas and Pennsylvania. We own and lease additional blending and storage facilities, primarily related to production and distribution of specialty products, throughout the United States ("U.S.").
Our business is organized into two segments: specialty products and fuel products. In our specialty products segment, we process crude oil and other feedstocks into a wide variety of customized lubricating oils, white mineral oils, solvents, petrolatums, waxes and asphalt. Our specialty products are sold to domestic and international customers who purchase them primarily as raw material components for basic industrial, consumer and automotive goods. We also blend and market specialty products through our brand Royal Purple.
In our fuel products segment, we process crude oil into a variety of fuel and fuel-related products, including gasoline, diesel, jet fuel and heavy fuel oils.
In connection with our production of specialty products and fuel products, we also produce asphalt and a limited number of other by-products."
I chose to highlight Calumet Specialty Products Partners, L.P. for a couple of reasons. First of all, it represents an example of a downstream MLP that might actually benefit from lower oil prices. Secondarily, it also offers insights into valuation and investor psychology. Upon its IPO in 2006, the MLP's stock price rose dramatically until the spring of 2007. However, the Great Recession soon brought investors back to their senses.
Nevertheless, in spite of high early valuation, Calumet Specialty Products Partners, L.P. generated significant income distributions far in excess of the S&P 500. However, the headwinds of overvaluation greatly impacted capital appreciation to the extent that it underperformed the S&P 500.
As a follow-up to my perspectives on the importance of valuation, I offer the additional price and dividend (distribution) graph starting when the MLP was significantly undervalued. When you review the performance of the same company over a different time frame and with better valuation, the results are extraordinary.
When purchased at low valuation, Calumet Specialty Products Partners, L.P. produced almost 10 times as much income as the S&P 500. Interestingly, thanks to low valuation, it also produced more cumulative total income than it had over the longer time frame when it was overvalued. Better capital appreciation also resulted because of low beginning valuation.
Specialty MLPs: COAL
Alliance Resource Partners, L.P.: (NASDAQ:ARLP)
"Alliance is a diversified coal producer and marketer with significant operations in the eastern United States. We have mining operations in Kentucky, Indiana, Illinois, West Virginia, and Maryland.
Strategically located operations, abundant long-lived reserves and appropriate acquisitions have provided us solid growth opportunities since we began operations in 1971 as MAPCO Coal Inc. As a result, Alliance is now the third-largest coal producer in the eastern United States.
Our customer base includes major utilities and industrial users. Coal is the energy source used by utilities to fuel approximately 45% of the electricity generated in the United States of America each year. In 2012, more than 90% of our sales tonnage was dedicated to electric utilities that have long-term contractual relationships with us.
As of February 1, 2013, we had 4,345 full-time employees, including 4,091 employees involved in active mining operations, 86 employees in other operations, and 168 corporate employees. At year-end 2012, we had $1.96 billion in assets and had generated $2.03 billion in total revenues for the year.
Alliance was the coal-producing industry's first publicly-traded master limited partnership."
As previously promised, my final MLP highlight is Alliance Resource Partners, L.P. Although coal is still included in the energy sector, it is not as directly related to oil pricing. Also, I believe this MLP represents a quintessential example of the price and dividend (distribution) correlation that I personally utilize to determine fair valuation on MLPs. Note how price follows the distribution line, and how it subsequently returns back into alignment after it goes above or below the line.
When reviewing the performance of Alliance Resource Partners, L.P., the incredible income producing prowess of MLPs becomes vividly revealed. A single $10,000 investment in this company on 12/29/2000 generated just under $40,000 of total cumulative income versus only $2,238 for a similar investment in the S&P 500. Capital appreciation was also significant leading to a very impressive total return. With that much income, you could pay a lot of taxes when you sell and still be far ahead.
Summary and Conclusions
MLPs can be very attractive income investments for retirees. Although there are issues with including them in qualified plans, the prodigious amount of income they are capable of producing might be worth it to some investors. With this article, I attempted to demonstrate just how lucrative MLP investing can be. However, I simultaneously attempted to demonstrate that investing in MLPs is not without risks. Perhaps more importantly, the risks associated with MLPs can be quite different than the risks associated with investing in blue-chip dividend stalwarts.
Finally, the current stress in the energy sector has created extraordinarily low valuations on many MLPs. Of course, that is assuming that over the long run oil and gas prices stabilize and perhaps even return to more normal and higher levels. On the other hand, MLPs are difficult to analyze and evaluate for many of the reasons I stated in the article. Therefore, comprehensive research, due diligence and careful monitoring is more important when investing in MLPs than most other asset classes. Caveat emptor.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: The author is long ARLP at the time of writing.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.