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Published:
February 11, 2009
To spur the development of vital energy
infrastructure assets, Congress essentially granted MLPs an exemption
from federal income taxes. But favorable tax treatment is only one
reason why income investors have flocked to this group.
Could the attraction also lie in their highly stable business models? Or
their outsized, double-digit yields? Or their ability to hike
distributions +8-10% per year like clockwork?
Yes.
Heads We Win, Tails You Lose
The vast majority of MLPs operate in the energy business. Specifically,
these companies own and operate networks of long-lived assets ranging
from pipelines to liquefied natural gas (LNG) terminals, which they use
to transport, process and store crude oil, natural gas and
petrochemicals.
In short, these critical "midstream" functions serve as a vital link in
the chain enabling oil/gas producers to get their products from the
ground to the market. And this business has some highly attractive
features:
Aside from routine maintenance, pipelines and other facilities don't
require much in the way of ongoing capital expenditures and can stay in
service for decades.
Most companies have staked out different territories, and since
overlapping pipelines are rare, competition tends to be minimal in many
regions.
Unlike other sectors, disruptive new technologies and product
obsolescence aren't much of a threat -- pipelines aren't going out of
style anytime soon.
In general, MLP income is based largely on the volume of oil and gas
flowing through the system, not the prices of the underlying
commodities.
Pipelines that cross state lines are often regulated at the federal
level, with rates tied to the Producer Price Index, so tariffs ratchet
higher over time to match inflation.
Because MLPs aren't involved in the actual production and sale of
commodities, many pipeline owners care little whether crude slides to
$25 or springs back to $100. As long as oil and gas are flowing through
the system, the company responsible for moving it is well-compensated
for its services.
Not too many industries can count on inelastic demand, natural barriers
to entry, strong operating leverage, and (to one degree or another)
insulation against fluctuating prices. So it's not surprising that MLPs
are famous for their ability to generate highly stable and predictable
cash flows in both good times and bad.
And just like utilities, these mature companies have little need to
retain profits and usually return them to shareholders (technically
known as "unitholders" in partnership lingo) as fast as they take them
in. In fact, with their "pass-through" structure and light capital
spending requirements, MLPs typically distribute about 90% of their cash
flows each quarter -- and in this case, Uncle Sam doesn't take a cut of
the proceeds.
The Tortoise and the Hare
As we've seen lately, commodity prices can fluctuate wildly from day to
day -- or even minute to minute. But demand for crude and natural gas is
fairly level and increases at a slow, but steady pace each year. Most
experts agree that the world's oil consumption (which now stands at 85
million barrels per day) will go right on increasing at a +1.25% annual
clip over the next 20 years.
That
might not sound like much, but
consider that most MLPs are also
busy making acquisitions and
pursuing growth initiatives. By
expanding pipeline systems and
taking other such steps, firms can
rake in more cash even if product
volume remains flat.
More cash to the company means a
rising stream of dividend
distributions for investors. Over
the past decade, MLPs have parlayed
gradually rising demand, built-in
inflation adjustments and billions
in expansion projects into
dependable +8-10% average annual
distribution increases.
As you can see from these widely
held MLPs (which are commonly found
in nearly all MLP funds), those
steady increases can really add up
over time.
|
Company |
2006 Dist. |
2007 Dist. |
Current Dist. |
5-Yr. Div.
Growth Rate (CAGR) |
Current Yield |
|
Magellan
Midstream (NYSE:
MMP) |
$2.29 |
$2.49 |
$2.81 |
+12.9% |
8.2% |
|
Enterprise
Products (NYSE:
EPD) |
$1.80 |
$1.92 |
$2.12 |
+8.2% |
9.6% |
|
Energy Transfer
(NYSE: ETP) |
$2.01 |
$3.19 |
$3.57 |
+22.6% |
10.3% |
|
Plains
All-American
(NYSE: PAA) |
$2.87 |
$3.28 |
$3.57 |
+10.3% |
9.4% |
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Salute the General
Cash-generating machines like
Enterprise Products Partners
have increased distributions by
nearly +50% over the past five
years. Meanwhile, since its IPO
in 2001, Magellan Midstream
Partners has raised its
dividends for an impressive 30
quarters in a row. Over that
span, investors have watched
their annual payments surge more
than +150%.
While an impressive track record
is nice, it's what's on the
horizon that matters most.
Fortunately, most MLPs have
multiple projects cooking that
should drive cash flows
significantly higher once they
come online. These growth
initiatives are welcome news for
companies like Enterprise and
Magellan -- but it's the general
partners in charge of these
firms that really stand to be
showered with cash.
As you may be aware, partnership
status comes in two flavors:
limited partner (LP) and general
partner (GP). The GP typically
handles all of the day-to-day
business operations and in
return gets a cut of the
distributions that are dished
out to the limited partners. As
an incentive to get the most out
of the company's assets, the GP
is paid on a sliding scale that
ratchets upward along with
payouts.
These incentive distribution
rights reward general partners
with a fatter slice of the pie
over time. To see this in
action, look no further than
Magellan. The firm's limited
partners just received a +9%
year-over-year dividend hike
last quarter. Meanwhile, the
general partners were treated to
an increase of +22%, more than
double.
Typically, GPs trade at a
premium because of their faster
growth. But today, many are
attractively priced and have
similar or even higher yields
than their underlying LP.
The Price Is Right
I would be remiss if I didn't
mention that for all their
benefits, MLPs can create some
headaches at tax time.
Distributions are usually a
mixture of net income and a
return of capital (an allowance
for depreciating assets). In
general, the portion deemed a
return of capital simply reduces
your tax basis and isn't taxable
until the shares are sold. For
more information, this
primer might help.
Fortunately, those who invest in
this sector through a fund
rather than individual stocks
can bypass most of these
complications and receive a
streamlined 1099-DIV form
instead of a K-1 partnership
statement. Still, you may want
to consult your tax advisor
before investing.
In any case, it's easy to see
why MLPs are prized for their
unique mix of stability, income
and growth. And after this
historic sell-off, there has
arguably never been a better
time to invest in this
attractive sector.
As you can see from the table
below, valuations have been
pushed lower and lower, allowing
MLP yields to rocket into
uncharted territory.
I
can't think of a more opportune
time to check out some of the
attractive closed-end funds that
specialize in MLPs.
Nathan Slaughter
Editor
Half-Priced
Stocks
About Half-Priced Stocks
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About Nathan Slaughter
Nathan Slaughter has developed a long and successful track
record over the years by investing primarily in deeply discounted securities. He
uses advanced discounted cash flow techniques, along with a host of fundamental
research, to uncover quality stocks that are trading well below their actual
intrinsic value.
Nathan's previous experience includes a long tenure at
AXA/Equitable Advisors, where he provided comprehensive investment advisory
services to small businesses and high net-worth clients. He also honed his
research skills at Morgan Keegan, where he performed asset allocation,
retirement planning, and consultative portfolio management services.
Several years ago Nathan switched gears and decided to devote
his time exclusively to financial analysis and writing. He has since published
hundreds of articles for a variety of prominent online and print publications,
and he now writes exclusively for StreetAuthority.com.
Nathan's educational background includes NASD series 6, 7, 63,
& 65 certifications, as well as a degree in Finance/Investment Management.
He currently resides in Shreveport, LA with wife Julie and sons Aidan and Riley.
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