Midstreams Are Finally Ready To Shine Over The Next 12 Months

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Includes: AMLP, BPL, EPD, ET, MLPA
by: Jim Kimmelman
Summary

Most MLPs have hit their turning point.

Don't let a K-1 scare you off.

Several options of funds and tickers to reward you.

Two important MLPs Energy Transfers (ET) and Enterprise Product Partners (EPD) both reported record cash flows within the last week. This along with the buyout of Buckeye Partners (BPL) and a 28% one day gain are showing there is money in this sector. After 4 years of bearish action and sentiment on the sector, it is finally ready to move.

In 2014, this sector was completely different than the structure today. Companies were over-leveraged with huge project lists. After they hit the max on the debt market because more debt would drop them below investment grade, they started issuing units. This diluted existing holders and increased the cost to maintain the distributions.

Many partnerships over the last few years had to restructure, sell assets to deleverage, or cut distributions. Now they are looking at completing the process to fund growth without the dilution or massive debt. What EPD calls self-funding which they announced they would start doing in October 2017. Since then, an investor is probably frustrated with price action. I even invested too early in this new MLP business model. The commitment to the new model is there as Kelcy Warren of ET stated:

"So we'll start with this. We made a commitment to the rating agencies to get to a certain number that we'd been very vocal about that and that we're going to honor that commitment."

A long term investor should view this new strategy as less risk with a steady income. With the growth in volume of the US energy market, cashflow will increase.

So why is this sector turning the corner? As I alluded to, 2 of the largest partners. I will start with Enterprise Products.

In Q1, they increased EBITDA by 17% to $1.63 billion, which gave them a 1.7x coverage. Even with the move to self-funding they have growth the distribution for 20 consecutive years. Albeit a small amount in the past few years because of the switch to self-funding. Part of the increase in distributable cash flow is from lower interest rates and less leverage. EPD has a leverage ratio of 3.4x. This makes them one of the safest bets in the sector.

Energy Transfer like Enterprise recorded record EBITDA up 39% from a year ago. They have higher leverage ratios which they have not fully disclosed. They are targeting a 4-4.5x leverage ratio which they have alluded to meeting that goal by years end. This quick deleveraging is from a 2.07x coverage of the distribution. Based on their conservative guidance of $10.7 billion for 2019, I see starting in Q1 of 2020, a steady increase of distribution increases.

So, why does this matter to cause an improved sentiment in the sector? No investor can ignore huge earning beats when companies are deeply undervalued. EBITDA beats will likely continue for most MLPs throughout 2019 because of the large increases in oil and natural gas production in the United States. These companies are less sensitive to commodity prices and excel with increased volumes.

Additionally with the buyout of BPL and a 28% one day gain shows that the sector is massively undervalued. The assumption that IFM Global Infrastructure Fund overpaid is unfounded. In the next 12 months I could see some other undervalued MLPs scooped up. This M&A action will likely push up other values of smaller MLPs.

K-1's are a large complaint of many investors which there are 2 decent fund options (AMLP) and (MLPA). K-1's do not make me feel bad for my tax guy (myself). They take a little extra time to enter in to Turbo Tax, but no reason to avoid a sector. If it is I will discuss the best 2 options that do not issue K-1s but offer exposure to the best companies in the sector.

AMLP and MLPA are very similar in their fund holdings and structure.

As you can see, the top 4 holdings are nearly identical. The remainder are similar in weighting and both funds hold roughly 25 partnerships.

The funds are set up as C-Corps which they pay 21% income tax which can make them lag the overall index in terms of price. Because of this, they pay qualified dividends which reduces your back end taxes. This can cause a 21% +15% for a total of 36% tax on income. When you hold the partnerships instead the tax rate is dependent on your individual, the amount of capital put in, the partnerships income or loss. Overall, for most investors it is less than 36% as the funds are.

Expense ratios are on the higher side but acceptable at .85% for AMLP and .45% for MLPA.

In conclusion, the sector is ripe to finally reward unit holders as most companies have converted to their new matured business model. I project MLPs will outperform the S&P 500 over the next 1 and 2 year period. For any holders, I would continue to DRIP until units reach an acceptably priced level. I still prefer to handle the K-1s and invest directly into the partnerships.

Disclosure: I am/we are long ET EPD. 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.