MLP Q4'18 Distribution Coverage... Now Featuring Payout Ratios!

Summary

• Today, we look at MLP distribution coverage and payout ratios to help a broader investor base analyze and compare MLPs with other investment options.
• Improving distribution coverage metrics should give investors comfort around the ability of MLPs to afford their distributions.
• Payout ratios should be viewed in the context of the MLP sector’s generous yields and the fact that MLPs do not pay federal taxes.

By Stacey Morris

Last week's piece recapped 4Q18 distribution trends for midstream MLPs, and this week we look at the ability of MLPs to afford those distributions. Historically, when exploring this topic, we have only focused on distribution coverage, which compares distributable cash flow (DCF) generated in a period to distributions paid. Today, we are incorporating payout ratios in addition to distribution coverage metrics. Why? Distribution coverage is an example of MLP jargon that is admittedly less than user-friendly. As we discussed in our 2019 outlook video, we see generalists or new investors entering this space as a potential catalyst for MLPs. The least we can do is start providing data in a format that is more familiar to generalists and widely used across investments. To analyze distribution coverage trends and payout ratios, we focus on the constituents of the Alerian MLP Infrastructure Index (AMZI).

Higher distribution coverage sometimes comes at a cost

Distribution coverage for the constituents¹ of the AMZI Index has generally improved over the last two years. The 4Q18 average coverage ratio of 1.4x is a noticeable step up from the 1.2x average from the same quarter in 2016. Notably, of the 22 names with coverage ratios below, 17 MLPs have coverage ratios of 1.2x or better in 4Q18, compared to only 11 names in 4Q16.

Why has coverage improved? For some MLPs, improved coverage has resulted from distribution cuts. While some names cut prior to 4Q16 (read more), we have denoted in the chart those MLPs that cut between the two periods presented. Other companies have not cut their distributions but have higher coverage due to their focus on self-funding equity, including Enterprise Products Partners (EPD) and MPLX (MPLX), for example. Still others have seen coverage decrease as distributions to unitholders have grown significantly, including Antero Midstream (AM), EQM Midstream (EQM), Phillips 66 Partners (PSXP), and Shell Midstream (SHLX). For these names, decreasing coverage is to be expected. Holly Energy Partners (HEP) and DCP Midstream (DCP) stand out with the lowest coverage for 4Q18. HEP guided to full-year 2019 coverage of 1.0x, with higher coverage anticipated in 2H19 due to tariff escalators built into contracts. For its part, DCP had a $10-15 million one-time impact in the quarter related to a third-party line strike of the Sand Hills pipeline, and results were negatively impacted by the weakness in crude and NGL prices in 4Q18.

Overall, coverage looks comfortable for AMZI constituents. While distribution cuts have been painful in recent years, we believe the cuts for the group of MLPs shown are largely behind us. Improving coverage ratios should give investors more peace of mind when it comes to the ability of these MLPs to pay their distributions.

MLP payout ratios represent a wide range

Typically, payout ratios compare dividends to earnings, but for this exercise, we compared distribution payments (including payments for preferred units and payments to the general partner where applicable) to operating cash flow to calculate the payout ratio. Why not use earnings as the denominator? Earnings are less meaningful for MLPs given typically elevated depreciation expense due to hefty investment in growth projects. Using earnings would distort the picture, and it would seem that MLPs were paying out more cash than they were generating. We acknowledge that this is a shortcoming in making MLPs truly comparable to other investments with payout ratios based on earnings, but a payout ratio based on operating cash flow is likely more helpful than distribution coverage alone. Additionally, to provide more context and cut through potential quarterly noise or seasonality for some MLP businesses, the table below includes full-year 2018 payout ratios in addition to the 4Q18 values.

To further clarify, the distribution coverage calculated above compares the distributable cash flow generated in 4Q18 with the distribution based on 4Q18 performance but paid in 1Q19. The payout ratios below compare the operating cash flow generated in the quarter with the distribution paid in the quarter. In other words, for 4Q18, the payout is based on the distribution paid in 4Q18 related to 3Q18 performance.

While there is a broad range among constituents, payout ratios overall look fairly comfortable based on the average of 65% for 4Q18 and 73% for the year. Keep in mind, the yield on the AMZI Index as of Friday was 7.68%. The payout ratios likely seem high compared to other industries, but other industries have more modest yields and have to pay taxes. If we take utilities as an example, 2018 payout ratios based on dividends and operating cash flow averaged only 30% for the 28 constituents of the S&P 500 Utilities Index, and the yield for the index was only 3.47% as of Friday.

Unsurprisingly, the companies with low coverage tend to have high payout ratios, but there are other nuances to the data as well. DCP stands out for having payout ratios in both periods that exceed 100% but has incentive distribution rights (IDRs) in the high splits², preferred units, and has not cut its distribution - all of which leads to a larger numerator. We discussed specific 4Q18 headwinds for DCP above. Crestwood Equity Partners' (CEQP) payout ratio exceeded 100% in 4Q18, but was below 100% for the full year. CEQP does not have IDRs, but it does have preferred units. NGL Energy Partners (NGL), which is at the high end for full-year payout ratios, has two classes of preferred units and IDRs. On the other hand, Plains All American (PAA) has a relatively low payout ratio, but PAA cut its distribution twice and has kept it flat since. Clearly, each company has its nuances. Payout ratios are likely to shift over time as distribution policies change, new projects come on-line, assets are bought or sold, etc. As such, today's post sets a baseline for payout ratios that we will update in the future.

Bottom Line

Improving coverage ratios should give investors comfort around the ability of MLPs to afford their distributions. Payout ratios may look high relative to other sectors but should be viewed in the context of the sector's generous yields and the fact that MLPs do not pay federal taxes. With solid fundamentals and expectations for growing cash flows as projects are brought on-line, there is certainly potential for these metrics to continue to improve.

Footnotes:

¹ The table shows constituents as of the December 21, 2018, quarterly rebalancing. Not all constituents shown were in the index for 4Q16.

² High splits refer to the point where the General Partner is earning the highest percentage on incremental distributions.

Disclosure: © Alerian 2019. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers.

Stacey Morris is the Director of Research at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Ms. Morris engages with the investment community to increase awareness of the Alerian Index Series and support broader understanding of the role that midstream assets play in North American energy markets. Ms. Morris was previously the Investor Relations Manager for Alon USA Energy, overseeing investor communications for the corporation and its variable distribution MLP, Alon USA Partners. Prior to Alon, she covered the integrated majors and refiners at Raymond James as a Senior Associate in the firm's Equity Research Division. Ms. Morris graduated summa cum laude with a Bachelor of Science in Business Administration from Stetson University, and is a CFA charterholder.