The Dark Side Of MLP Investments - Revisited

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Includes: AMID, ENB, EPD, ET
by: Jussi Askola
Summary

Opportunities are abundant in the MLP sector, but you must be really careful to not step on a landmine.

Dilutive growth, "fake value”, and biased investment reports are among the common reasons that lead to poor investment decisions.

With a strict selection of the best MLPs, most of the landmines can be avoided and investment performance can be materially improved.

We discuss one of our current top picks among MLP investments.

In a recent article entitled "The Dark Side of MLP Investments," we lay out the investment thesis for MLPs in today’s market:

  1. Contrarian Opportunity: Valuations are at historic low levels due to a multi-year bear market that originated from the crashing commodity prices in 2014.
  2. Improving Fundamentals: While share prices kept on dropping, the fundamentals of the sector have greatly improved with MLPs moving to the self-funding model and reducing leverage.
  3. Defensive Business model: Most midstream MLPs own a significant number of regulated, demand-pull assets with long-term contracts. Additionally, commodity risk is minimized by the fixed fee volume-dependent nature of these contracts.
  4. Strong Growth Prospects: Not only have these businesses been steadily growing their EBITDA over the past few years, but it's now just beginning to translate into strong distribution growth.
  5. High Yield and Upside: The average dividend yield is at close to 8.5% and as capital flows back to the sector, valuation multiples are expected to expand back towards historic norms.

Higher yield combined with high growth and upside is a recipe for spectacular investment results. However, as you have probably heard the saying:

"There ain't no such thing as a free lunch."

And with MLPs, investors have to be particularly cautious in their selection as there exists a "Dark Side" to the sector with:

  • Self-interested and dishonest management teams.
  • Higher volatility and significant disparities in performance.
  • And lack of dedicated investment research.

Today, in an effort to take this discussion even further, we add three more issues to the list. Over the years, we have found that (1) “fake value”, (2) dilutive growth, and (3) biased investment reports are leading reasons for poor investment decisions.

The "Dark Side" of MLPs is a real thing, and if you want to avoid stepping on a landmine, you better be aware of the following issues and know how to dodge them:

#1 Fake Value

There exists large disparities in valuation multiples between different MLPs.

  • MLP A may trade at 6x Cash flow…
  • While MLP B trades at 10x Cash flow.

Many investors are quick to suppose that MLP A is undervalued here, when in fact, it could well be overpriced relative to MLP B. Investment research is relatively rare in this sector and analysts are quick to jump to conclusions.

In reality, there are a lot of valid reasons that can lead to a lower cash flow multiple and concentrating the analysis on the valuation can be very dangerous. Most often discounted valuations are well-justified in the MLP space with specific companies using (1) excessive leverage; (2) suffering greater commodity risk; and/or (3) not acting in the best interest of the investors.

Many MLPs are “seemingly” cheap when you look at their valuation, but really they are nothing more than overleveraged time bombs that should be avoided at all cost. We like to call it “fake value”.

A notorious example here is the case of American Midstream Partners (AMID). Back in 2018, the company attracted a lot of investors due to its unusually high dividend yield and low valuation multiple relative to peers.

Just one year later, many investors got a taste of what "Fake Value" really is:

AMID investors suffer losses

However, a prudent investor would have seen numerous red flags signaling the impending distribution cut as it suffered from excessive leverage, dilutive equity issuances, poor management execution, and mistreatment from its general partner.

Don’t let a low valuation seduce you. More often than not, the discount is well-justified in the MLP space.

#2 Dilutive Growth

Just like any other public company, MLPs want to grow to achieve greater scale and notoriety. The issue here is that often this growth may not be beneficial to investors. In many cases, it is actually quite the opposite if this growth comes at the cost of dilution.

We regularly see MLPs take on new investments to grow an ever-larger portfolio. However, there is no benefits in doubling the cash flow if you also double the unit count – leading to stagnant or declining cash flow on a per-share basis.

In reality, the management teams are eager to grow the portfolio is order to justify higher fees and/or salaries. We call this behavior: “empire building” and it is the main reason for underperformance in the MLP sector. Earlier we mentioned AMID, which would have a perfect example of that.

To avoid the cost of dilutive growth, we suggest that you stick to:

  • MLPs that have high insider ownership.
  • Avoid MLPs that have not moved to the self-funding model yet.
  • Trust but verify.

If an MLP suddenly starts raising more equity, but its share price is at a very low level (high yield and/or discount to NAV) - this is a good indicator of pain ahead.

#3 Biased Research Reports

Finally, investment research on MLP opportunities is rare and its objectiveness is often questionable. I have found that MLPs are always eager to get attention from investors and will often directly reach out to analysts (including me) in an attempt to sweet talk them into giving a positive review of the company.

By sweet talk, I do not mean anything more than a phone call or invitation to an event, but nonetheless, it will often have an impact (generally positive) on the analyst's views who may then write a biased investment report.

Since we represent ~600 REIT & MLP investors at High Yield Landlord, we are often directly approached by MLP management teams who wish we would give them a positive review. We always welcome discussions, but we are also very careful to not let any biases influence our thinking. We suspect that this is not the case for everyone. (Disclosure: the objective of High Yield Landlord is to streamline our MLP research process to the public and allow interested members to emulate our strategy.)

Even worse than some sweet talk, there exists an entire industry of "company-sponsored research" in which MLPs will pay analysts to produce and distribute "independent research" on their companies. It should be clear to everyone that it leads to sizable conflicts, and while it's strictly forbidden on the Seeking Alpha website (fortunately!) - it remains a common practice in the research industry.

An MLP Opportunity in June 2019

A good MLP opportunity is one that trades at a discount to fair value, but most importantly:

  1. Does not seek expansion at the cost of dilution.
  2. Is conservatively financed.
  3. And well managed in the shareholder's best interest.

This is a sector where you need to be very selective to maximize returns and avoid landmines. As an example, for every investment that we make, we reject about 10 other alternatives:

Source: High Yield Landlord Selection Process

Right now, Enbridge (ENB) strikes us a no-brainer. ENB is actually structured a C-Corp to avoid K-1s at tax time, but it is otherwise equivalent to other MLP entities.

The company is a "blue-chip” that trades at a reasonable valuation – with a sector-leading track record and solid growth prospects. When you can get quality on the cheap, there is no reason to go for the riskier and more speculative options in our opinion.

ENB is the market leader with an enterprise value that is even greater than the popular: Energy Transfer (ET) and Energy Product Partners (EPD).

ENB best in class

source

It has managed to grow its cash flow during all market conditions including the financial crisis and the commodity price collapse:

ENB resilient cash flow

source

Most importantly, this cash flow growth has translated into a fantastic dividend track record for investors:

ENB dividend track record

source

  • The dividend yield is currently at near all-time highs at 6.2%.
  • The company has recently achieved self-funding status.
  • The BBB+ balance sheet is among the best in the industry.
  • Its top-tier mission-critical assets and scale give it a strong moat.
  • It enjoys very stable, recession-resistant cash flows that is set to grow at roughly 5% per year in the long run.
  • Combining the growth outlook with the current yield, the total return potential is in the double digits.

We were able to build a position at a ~10% lower share price, but even now, the company remains very opportunistic.

It's by targeting this type of high-quality undervalued MLPs (and other real asset investments) that we aim to outperform markets - all while earning higher dividends. As of today, our Real Asset Portfolio has a 7.2% dividend yield with a conservative 68% payout ratio. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x cash flow - providing both margin of safety and capital appreciation potential.

Source: High Yield Landlord Real-Money Portfolio

Closing Notes: MLPs Are Wonderful (if you pick the right ones…)

Priced at a deep discount to the broader market, there's no doubt that there exist some lucrative opportunities in the more obscure and less crowded MLP sector. You must, however, exercise very prudent attention to your selection as return disparities can be massive.

To illustrate this point, consider that passive market indexes earned 8-10% over the past decades, whereas the average individual investor earned only 2.6% per year over the same time frame:

Clearly, the average investor does NOT know what they are doing. They are consistently making the wrong decisions, trading too much, and stepping on (NYSE:MLP) landmines.

Disclosure: I am/we are long ENB. 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.