Yield, Value, Safety And Complications With MLPs

by: John D. Thomason

This is a continuation of the series of searching for stocks suitable for an income portfolio, this time, focusing on Master Limited Partnerships (MLPs). In this article, I will deviate a bit from the approach of the prior articles in the series, in that the emphasis will be educational, to define MLPs, and highlight some of the differences between these entities and regular corporations. I will identify numerous resources that explain MLPs in considerable detail. Many investors are probably avoiding this asset class because of the complexities, which is understandable, but this is unfortunate, as MLPs have been some of the best-performing income investments available the last several years. Even though this article is targeted towards investors who are new to MLPs, long-time investors may realize a benefit as well, if they were not aware of some of the resources identified. After presenting an overview and references, I will then present a high-level comparative analysis of twelve MLPs, six of the largest, and six others selected to illustrate some of the different types of MLPs. I will then conclude with recommendations.

In the interest of full disclosure, note that I am not a financial professional, nor am I certified in any way as a financial advisor. I am an independent, individual investor focusing on dividend-paying stocks exclusively.

An MLP consists of a general partner [GP] and multiple limited partners [LPS]. The general partner manages the operation of the partnership, and typically holds a 2% equity ownership. The limited partners provide capital through the purchase of partnership units, usually have no role in the operation of the partnership, and receive quarterly payments defined as distributions, rather than dividends. All MLPs discussed in this article are publicly traded partnerships (PTPs), which trade on U.S. stock exchanges. These are Limited Liability Companies (LLCs) that have chosen partnership taxation, which means they do not pay income taxes directly, as corporations do; they are pass-through entities, with taxes paid by the investors' owning units in the partnership. The unit-holders are the limited partners, which are similar to shareholders of a C-corporation. The taxes paid by the limited partners are per their pro-rata share of the income, deductions, and so on of the partnership's business activities, which are detailed for them annually on a K-1 form, which is in lieu of a 1099.

MLPs were first authorized in 1981, and further defined and limited in 1987. The only firms allowed to be established as MLPs after 1987 are those involved in natural resources activities or real estate. With the exception of a few holdovers involved in financial services or real estate, most MLPs today are involved in energy-related industries, with the majority of these engaged in oil and gas storage, processing, and transportation, referred to as midstream energy operations.

MLPs are attractive investments for income investors for several reasons:

  • Most MLPs are committed to paying out "all available cash" to unit-holders. While the definition varies, it generally is all income not required to conduct business and maintain the facilities. The partnership agreement usually incentives the general partner to have the MLP pay out as much as possible to the limited partners, via incentive distribution rights. Note that the tax status of MLPs, unlike REITs, has nothing to do with how much they must pay out to the unit-holders.
  • Because of the foregoing, the managements of MLPs must be very disciplined regarding capital for expansion, either via organic projects or acquisitions. Funding for expansion can only come from secondary offerings of new units or from debt. Either way, success in raising funds requires that a case be made for the planned expansion.
  • Distributions to unit-holders are largely tax deferred, with the tax liabilities for the unit-holders, as defined by the annual K-1s sent out each year, being substantially less than the cash received from distributions, at least in the early years of ownership.

Incentive Distribution Rights [IDRs] allotted to the GP are a common feature of most MLPs. The partnership agreement will define a Minimum Quarterly Distribution [MQD], and at the lower distribution levels the GP will typically receive a payment equivalent to 2% of the total payout being made, while the LPs will receive 98%. The agreement will also define several tiers above the MQD, and will specify that the GP will receive a higher percent of the incremental increases of the payout, as the LP distributions are increased through the defined tiers, up to a maximum of as much as 50%. This is positive in that the GP benefits as the LPs benefit from distribution increases, but negative in that as distributions extend into the higher tiers, the business must generate more and more income to be able to increase the payouts to the LPs. At the maximum, to distribute an extra dollar to the LPs, the partnership must generate an extra two dollars of income, since 50% of the additional distribution will go to the GP. For this reason, some mature MLPs have acquired their GPs and eliminated IDRs. An investor contemplating an MLP investment needs to know if IDRs exist, and where the current distribution level is in comparison to the IDR tiers established by the partnership agreement. The IDR details are often available in the annual 10K filings.

A key metric for MLPs is Distributable Cash Flow [DCF], which is essentially net income with non-cash expenses, primarily depreciation, added back in, and maintenance capital expenditures (MCE) subtracted back out. MCEs are the outlays required to keep the facilities maintained, and do not include expansion projects. While most MLPs now report DCF and MCE, there are differences in how these are arrived at from one MLP to the next. DCF is key, as it determines what can be paid out as distributions, and the relationship between DCF and the current distribution level determines the distribution coverage ratio. This ratio is comparable to the inverse of the dividend payout ratio for a C-corporation, being expressed, for example, as 1.10x, which would indicate that the payout is supported 100%, with a 10% margin for error. As one would expect with a charter to pay out all available cash, MLP coverages are tight, with coverage ratios ranging from less than 1.00x to no more than 1.50x, with most closer to the lower end of that scale. An investor in an MLP needs to know the coverage ratio, and if it is deficient, what the outlook is for improvement. Sometimes the MLPs will report a coverage ratio, and analyst reports are another source. For investors desiring to dig deeper, I will subsequently identify a Seeking Alpha series that expands upon the topic.

The values on the annual K-1 form break out the LP's share of all income, expenses, and so on, for the tax reporting year, which must then be integrated into the investor's tax return. The tax owed will depend on the individual investor's tax situation. Distributions received are not the source of reportable income, but rather are considered a return of capital. Thus they subtract from the investor's initial cost basis, and a larger taxable gain will result when the units are sold. This is all applicable to MLPs held in regular, non-retirement accounts. As for retirement accounts, such as IRAs, MLP activities do not affect taxes any more than a regular stock, with one exception; if the investor is allocated more than $1000 in income characterized as Unrelated Business Taxable Income [UBTI] from all MLPs held in an account in a given year, a tax is levied on the excess, even though the units are held in an IRA. The UBTI is shown on the K-1. For this reason, investors are cautioned against holding MLPs in IRAs.

All of the preceding is at a very high level. I will now list resources where more detailed explanations can be found on all of these topics and more.

The first website to review is sponsored by the National Association of Publicly Traded Partnerships [NAPTP], http://naptp.org. Start with the front page, then select, from the menu on the left, PTP 101. From there, review selections MLP Basics, Basic Tax Principles, and PTPs in Retirement Accounts. After this, select Presentations and Primers. The first selection on this page, NAPTPs MLP 101 presentation, is another overview. Next, there are two excellent, very detailed documents that can be downloaded as PDF files and retained; Credit Suisse MLP Primer - Part Deux, and Wells Fargo MLP Primer, 4th Edition: Everything You Wanted To Know About MLPs, But Were Afraid To Ask. The Credit Suisse document has the most thorough explanation of IDRs I have seen, and the Wells Fargo document has an excellent discussion of DCF. You will know more about MLPs than most investors after reading these two documents. The Tax Guide to Master Limited Partnerships from Forbes, also shown on the page, is also worth a read.

Another useful website is Alerian.com, which maintains several MLP indices. The website lists all indices and constituents, ETFs and ETNs based on the indices, plus a selection, MLP News, that offers up current news relating to MLPs.

MLP Hindsight, by Hinds Howard, offers an excellent glossary of MLP and Energy Industry terms, plus a news roundup.

MlpInvestor.com offers occasional news of interest, plus provides links to Mlp Blog, and archives of previous articles, by date.

Miller Howard Investments, Inc, offers an interesting perspective on MLPs in retirement accounts. Select the Additional Insight menu option, and then select MLPs in IRA/Keough Accounts to get a PDF article on the topic.

There are many Seeking Alpha authors writing about MLPs every day. Enter an MLP ticker symbol in the Enter symbol, author, keyword box to get a list of articles on SA related to the symbol.

There are two SA contributors that have authored several articles relating to aspects of MLPs that are very informative and detailed. I recommend these articles be reviewed before moving forward with an MLP investment.

First, contributor Ron Hiram began a series of articles in December 2011 focusing on DCF of MLPs. Recall that DCF is calculated differently by the various MLPs, if it is reported at all. Ron has developed a methodology to determine what he defines as "sustainable" DCF, which can then be used to determine the safety of the distributions. He has produced 28 articles, as of this writing, covering many of the most popular MLPs. This series will take an investor to a level of understanding of DCF beyond the basics. Here is a link to Ron Hiram's SA Profile, from which a list of the articles can be selected.

Finally, regarding MLPs and taxation, both in regular accounts and in IRAs, contributor Reel Ken must be acknowledged. This author addresses other topics besides MLPs, so I have listed below six of his key MLP articles:

The second article in the list above deserves special mention. In it, the author made a case for the risk of a substantial increase in UBTI upon sale of units that had been held for some time inside an IRA. The impact could be significant, such that an investor that, prior to selling, had little risk of exceeding the $1000 UBTI threshold, could suddenly and unexpectedly be over the threshold. The article generated a huge number of comments, and the author has responded extensively with thoughtful, reasoned, and supported responses. My advice is to read the article and every last one of the comments before deciding whether you agree with the central point of the article, or not. By way of clarification, I must point out that I also have an article out on the topic, which I wrote just before the Reel Ken article came out. In it, based on the published resources I had relied upon, I stated that I felt that small investors with small MLP positions in their IRAs did not need to be concerned with UBTI. I have since come around to agreeing conceptually with Reel Ken that this is an exposure. It very well may become more of a concern in future years, as the IRS pursues tax compliance and revenue enhancement ever more aggressively. I concur that for all but the smallest accounts, the UBTI risk on sale of units should be considered.

Now, I will present the results of reviewing twelve MLPs. The MLPs are listed below, along with the business focus, market cap, month / year of the first distribution, and recent price with yield:

Enterprise Products Partners (NYSE:EPD) - Midstream, Infrastructure / Natural Gas, $45B-Large Cap, 10/1998, $52.99, 4.82%.

Kinder Morgan Energy Partners (NYSE:KMP) - Midstream, Infrastructure, $28B-Large Cap, 10/1992, $84.58, 5.68%.

Williams Partners (WPZ) - Midstream, Infrastructure / Natural Gas, $18B-Large Cap, 11/2005, $54.50, 5.60%.

Plains All American (NYSE:PAA) - Midstream, Infrastructure, $13B-Large Cap, 11/1999, $80.81, 5.17%.

ONEOK Partners (OKS) - Midstream, Infrastructure / Natural Gas, $12B-Large Cap, 01/1994, $55.30, 4.59%.

Energy Transfer Partners (ETP) - Midstream, Infrastructure / Natural Gas, $11B-Large Cap, 09/1996, $47.96, 7.45%.

NuStar Energy (NYSE:NS) - Midstream, Infrastructure, Refining, Asphalt, $4B-Mid Cap, 07/2001, $57.60, 7.60%.

Martin Midstream Partners (NASDAQ:MMLP) - Midstream, $.8B-Small Cap, 01/2003, $33.63, 9.07%.

BreitBurn Energy Partners (BBEP) - Upstream, E&P, $1.3B-Small Cap, 02/2007, $18.00, 10.06%.

Exterran Partners (EXLP) - Midstream, Natural Gas, Equipment & Services, $.9B-Small Cap, 02/2007, $20.67, 9.53%.

Amerigas Partners (NYSE:APU) - Downstream, Propane, $3.7B-Large Cap, 08/1995, $39.50, 7.72%.

Penn Virginia Resources Partners (NYSE:PVR) - E&P, Coal and Natural Gas, $2B-Mid Cap, barely, 01/2002, $25.42, 8.03%.

The review findings are presented in two tables below: Table1A covers the large, mature, and safest MLPs, all of which are focused on midstream energy businesses; Table1B presents the same data for several newer, smaller, higher-yielding MLPs, from several energy sub-sectors.

The data shown covers the key MLP metrics of IDR status and Distribution Coverage Ratios, plus the overall debt levels, valuation metrics, ratings, and distribution history. Conspicuously absent are metrics involving GAAP earnings, which are not as relevant for MLPs, with their high levels of non-cash charges against earnings. The IDR, coverage ratio, and ratings data sources are identified in the entries, and all other data was obtained from the MSN Money website.

While MLP prices dipped along with all stocks during the recent financial crisis, MLP distributions fared much better than most other dividend payers. Per the Wells Fargo document referenced above from the NAPTP website, all 20 Pipeline MLPs maintained or increased distributions during the period, and only 16 out of 74 MLPs reduced or suspended distributions. This record is all the more remarkable when you consider the high payout levels of MLPs.

The largest, strongest MLPs, namely all of the MLPs in Table1A except Energy Transfer Partners, have seen huge price increases since 2009. New buyers probably will not see this type of price appreciation going forward. Still, even at these elevated levels, yields are better than most stocks, and future distribution increases are likely, even if at a slower pace than in recent years.

A brief synopsis of each MLP evaluated is now presented:

Enterprise Products Partners - Top of the line, and priced accordingly, with the yield slipping under 5%. If it should drop back into the $45 to $48 range, I say jump on it.

Kinder Morgan Energy Partners - Also top of the line, with a slightly higher yield. The planned acquisition of El Paso Corp (EP) later this year is a positive, although it complicates the evaluation. Also, this MLP has a three-level organization structure that is more complex than most. The price has declined recently from the low $90's to around $83. This MLP is a solid buy below $80.

Williams Partners - A winner any way you look at it. This MLP has also dropped back slightly from the recent highs, to $57 or so; buy under $55 whenever possible.

Plains All American - Another great MLP. Unfortunately, a steady rise evolved into a rocket ride beginning in November 2011. It may never come back down to the early November 2011 levels around $65, it may be worth $80 or more, it may go on to even greater heights - but the value investor in me just cannot bear to pay what would be required to acquire units of this MLP today.

ONEOK Partners - Same situation as Plains All American. It would be a great acquisition in the low $40s, but not at current levels.

Energy Transfer Partners - Distributions have been flat since 2008, which explains why this MLP has not rocketed up in price like the preceding MLPs. Now may be a good time to buy, in the middle $40s. An April 2012 Credit Suisse analyst report opines that "Long-Term Value Outweighs 2012 Headwinds", and states that modest distribution growth should resume after 2012. I agree, and with a current yield over 7%, waiting should not be too painful.

NuStar Energy - The recent earnings results were not good, but not all that bad either, with several initiatives in the works to improve things going forward. The recent drop in the price may be more attributable to this head-scratcher of a statement in the earnings press release: "Distributable cash flow available to limited partners covers the distribution to the limited partners by 0.55 times for the first quarter of 2012." A Credit Suisse analyst report that came out afterwards projected that full-year distribution coverage ratios for NuStar will be 1.01x in 2012, 1.07x in 2013, 2014, and 2015, and 1.10x in 2016. I believe NuStar is a buy here, under $55, although it is definitely higher up on the risk spectrum.

Martin Midstream Partners - This firm features a somewhat diverse set of operations in the Gulf Coast region, with a great yield. There is not much confirmation available in the way of analyst coverages, but an experienced investor with an ability to review the financials might see this as a buy, although the debt level seems high. I have no opinion to offer on MMLP.

BreitBurn Energy Partners - As goes oil prices, so goes BreitBurn. This MLP offers a terrific yield at the current price, around $18.50. Upstream MLPs are by definition higher risk than midstream, but for investors willing to shoulder the risk, BreitBurn is a buy at current levels.

Exterran Partners - This MLP occupies a niche as the dominant provider of natural gas compression services. The present low price environment for natural gas is impacting the firm, at least indirectly, by reducing demand for the services provided. The dependence of the distribution on GP cost caps due to expire in 2013 is a concern, although the caps are likely to be extended in some form. Upon a drop below $20, this MLP would be very enticing, with a yield over 10%. My thinking is to consider this MLP upon a market decline, while keeping a close watch on results. I personally do not believe natural gas is going away as a fuel; someday the price will rise above today's depressed levels.

Amerigas Partners - The largest propane MLP just got larger, with acquisition of propane assets from Energy Transfer Partners. Amerigas is a buy at current levels, unless you believe cold winters will never return.

Penn Virginia Resources Partners - This MLP focuses primarily on coal properties, although it does have some natural gas gathering and processing operations. Coal is the fossil fuel everyone loves to hate, but it is not going away anytime soon, either. The best time to have bought this MLP was in early April, in the $22 to $23 range. If it drops back down to those levels, I would buy again, like I did then.

There are alternative ways to benefit from MLPs without having to deal with the tax complexities, either through funds, ETFs, ETNs, or even with individual GP stocks that are not MLPs. Foremost in this latter category is Kinder Morgan Inc (NYSE:KMI), which will benefit as KMP grows and increases distributions going forward. The reference resources provided discuss these alternatives at length.

My final conclusion: whether through ownership of MLPs directly, or via some of the proxy techniques, I believe an income investor should have some exposure to MLPs in his/her portfolio.

Disclosure: I am long (APU), (BBEP), (NS), (PVR), (ETP).