A Ranking Protocol For The MLP Space

There are unique aspects of Master Limited Partnerships ("MLP") that warrant a more specialized approach when it comes to comparing various MLP investment choices:

• As a Limited Partner ("LP") unitholder you need to remain cognizant of the amount of cash flow that is being paid to the General Partner ("GP") under the Incentive Distribution Right ("IDR") structures.
• The amount of the LP distribution that is effectively tax deferred varies across the space.
• The Distribution Coverage Ratio ("DCR" = Trailing Twelve Month ("TTM") Distributable Cash Flow divided by TTM Limited Partner and General Partner Distributions) is a relative indicator of the safety of the distribution (i.e. if it is less than 1.0x that is a red flag).
• The DCR is also a relative indicator of potential forward distribution growth (all else being equal an MLP with a consistently higher DCR can more comfortably grow its distributions).

One approach to using MLP specific analysis and ratios involves the following:

3YR FYAT: The 3 Year Forward Yield After Tax ("3YR FYAT") is calculated by projecting the forward distributions after tax for each MLP taking into account the estimated growth rate of their distributions and the estimated portion of the distributions that will be tax deferred and for simplicity sake assuming the highest tax bracket (35% for now, I do know that will change unless Congress extends it before year end, but for now the assumption remains flat at 35%, also the potential end of those tax cuts is comparatively less detrimental to MLP investors when compared to the larger relative increase in C-Corp cash dividend tax rates). The sum of the projected distribution stream after estimated taxes is then divided by the current LP unit price.

Valuation Coverage Ratio ("VCR"): The VCR compound ratio is calculated by taking the Total Enterprise Value ("TEV" = total equity market cap plus total debt less cash) divided by Adjusted EBITDA (TTM EBITDA less the TTM General Partner distributions = "ADJ EBITDA"), and then dividing that result (the "TEV Multiple") by the Distribution Coverage Ratio, so VCR = (TEV/ADJ EBITDA)/DCR.

3YR FYAT/VCR Ratio: This compound ratio is calculated by taking the 3YR FYAT times 100 and dividing that by the VCR ratio.

Example Calculations

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What VCR Means

The VCR essentially measures the cost in valuation for an MLP's distribution coverage. A lower TEV Multiple equates to a better/more favorable valuation and generally speaking the higher the DCR the better. A lower numerator is better and a higher denominator is better so, just like a golf score, the lowest relative VCR within an MLP peer group is the "best" and the highest is the "worst." And in a big picture sense the ratio is somewhat comparable across the MLP universe, keeping in mind that the resulting VCR number is most impacted by changes in the DCR and it is most comparable within an MLP peer group. Here's how the Valuation Coverage Ratios look for the Natural Gas & NGL Pipeline segment, this peer group includes Boardwalk Pipeline Partners, L.P. (BWP), El Paso Pipeline Partners, L.P. (EPB), Enterprise Products Partners L.P. (EPD), Energy Transfer Partners L.P. (ETP), Kinder Morgan Energy Partners L.P. (KMP), Kinder Morgan Management LLC (KMR), ONEOK Partners, L.P. (OKS), Spectra Energy Partners, L.P. (SEP), TC Pipelines L.P. (TCP) and Williams Partners L.P. (WPZ):

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So looking at the chart you can see that EPD has the lowest/best VCR and ETP and BWP are the two highest/worst. Both ETP and BWP have DCRs less than 1.0x which effectively increases their VCR making them look relatively worse compared to the rest of their peer group. EPD has a very high DCR (2.25x) which is why they have the lowest VCR (EPD's VCR is benefiting from approximately $1.9 billion of proceeds from asset sales and related transactions, if you back that benefit out EPD's VCR is ~11.3).

What 3YR FYAT/VCR Means

The theory for this next compound ratio is that it takes into account the projected after tax yield and adjusts for the effective LP enterprise valuation cost for the MLP's distribution coverage ratio. Again as a compound ratio the absolute levels are less important and they should primarily be viewed on a comparative basis within an MLP segment peer group. A higher 3YR FYAT/VCR ratio is better and could be driven by the now 3 key inputs:

1. An MLP could have a very high projected after tax yield, possibly driven by a very high projected distribution growth rate and/or differing estimated tax deferrals on the distributions.
2. An MLP could be trading at a comparatively low Total Enterprise Value to ADJ EBITDA multiple, so MLPs without a high IDR burden have an advantage since ADJ EBITDA is after the GP distributions.
3. An MLP could have a very high Distribution Coverage Ratio.

So now in the 3YR FYAT/VCR ratio rankings an MLP that does not have the highest forward yield and is expensive on an TEV/ADJ EBITDA basis could still be better ranked than its peers if it has a very high Distribution Coverage Ratio (intuitively that seems reasonable, the market would place a higher valuation on a safer expected distribution stream). Here are the current 3YR FYAT/VCR ratios for the Natural Gas & NGL Pipeline segment:

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On this metric, TCP is ranked first, so relatively speaking within the peer group TCP's forward yield is a pretty good relative value after taking into account its TEV/ADJ EBITDA multiple (the third lowest in the group) and its DCR (at 1.41x it is the fourth highest in the group, or third highest if you adjust EPD's). EPD is the second highest on this metric which is still being driven mainly by their very high DCR, but again if you back that $1.9 billion asset sales proceeds benefit out EPD's 3YR FYAT/VCR is 1.27, which is more in line with KMP's 3YR FYAT/VCR of 1.29. BWP is again at the bottom driven mainly by its DCR being less than 1.0x.

Limitations

Anything that involves projecting future numbers (i.e. three years of after tax distributions) is always limited as the future is always uncertain so any projected metrics should be viewed with some healthy level of skepticism. The estimated tax deferral percentage is also a rough estimate and can change over time depending on the specific MLP's capital expenditures, acquisitions, etc. Additionally, the growth assumptions are subject to review and changes based on any new data that comes out about a given MLP. The 3YR FYAT/VCR is a compound ratio so it is not a cut and dry scale for comparison versus say Debt/EBITDA, i.e. a 3YR FYAT/VCR ratio of 6.0 is not necessarily twice as good as a 3YR FYAT/VCR ratio of 3.0, whereas Debt/EBITDA of 6.0x does mean that it is twice as high as a company with Debt/EBITDA of 3.0x.

Conclusion

The 3YR FYAT/VCR ratio is one MLP specific metric that can be used as a tool to rank, compare and determine the "best" projected yielding investment within an MLP segment peer group.

Natural Gas & NGL Pipeline Segment Peer Data

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Disclosure: I am long KMR, KMI. I currently have an open limit order to add to KMR at lower prices. I may add to any current positions and may start new positions in any of the tickers shown over the next 72 hours.