When evaluating the performance of a business, one of the first things you want to know is how profitable it is.  From an accounting standpoint profit is a more complex calculation than simply taking revenue and subtracting operating costs.  Items such as depreciation and amortization attempt to capture the loss in value over time of assets the business owns.  However, while these items impact profits “on the books”, they don’t represent actual cash leaving the business.  For MLPs, this is where Distributable Cash Flow (DCF) comes into play.

Distributable Cash Flow – Cash is King

Since MLPs are yield oriented investments, investors are primarily concerned with how much cash the business is generating.  More precisely, we want to understand how much cash is potentially “distributable” to the partnership in a given period.  Therefore, we need to make adjustments to net income to reverse any of the accounting items that distort cash flow.  The calculation can be seen below.

The acronyms ‘MLP’ and ‘PTP’ are frequently used interchangeably, but there is a subtle difference.  A Master Limited Partnership (MLP) is technically just a business structure legally recognized in the tax code (it is not necessarily a publicly traded entity).  A Publicly Traded Partnership (PTP) is any partnership that is publicly traded like a stock (not necessarily an MLP).

I often get asked about benchmarks for gauging MLP performance (similar to the S&P 500 for the broader equity market).  The de facto standard is the Alerian MLP Index which tracks 50 of the largest master limited partnerships in the energy industry.  Performance data is available under the NYSE ticker AMZ and AMZX (tracks combined price and yield).  You can view data for the MLP index on Yahoo! Finance by entering ‘^AMZ’ in the ‘get quotes’ box.

As millions of barrels of oil continue to spill into the Gulf of Mexico, the U.S. is beginning to look at viable alternatives to offshore drilling.  This is a good thing for infrastructure MLPs, because  the logical choice is to increase the use of natural gas as an energy source.  More gas demand means more gas moved through pipelines, which means higher profits for these businesses.

As investors become increasingly aware of the higher yields offered by MLPs, financial institutions are pushing to offer more in the way of investment options.  Exchange Traded Funds (ETFs) are the latest investment vehicle to be offered in this space.  As reported by ETFtrends.com, two funds filed with the SEC in June to offer MLP ETFs:  ALPS Advisors and Van Eck Global.

From time to time I like to post links to MLP investor information which I have found useful.  One site that seems to have a good deal of current info is the National Association of Publicly Traded Partnerships website.  In particular, the investor conference slides that they publish are a good way to stay updated on the latest and greatest in the MLP space.  I have included a link to the 2010 investor conference slides below.

Master Limited Parternship 2010 Investor Conference Slides

Everyone knows that the last several years have been rough for Wall Street.  The stock market weathered one of the worst recessions in U.S. history, leaving many investors discouraged and confused.  We witnessed the cataclysmic failure of longstanding financial institutions and the subsequent bailout of the banking system by the federal government.  What a nightmare.

MLP Investments Emerge as Winners

Despite all of the turmoil, master limited partnerships have remained solid long term investments.  While MLP indices have had their fair share of volatility, they have performed well thanks to a favorable tax structure
and outstanding yields.  In fact, the Alerian MLP Index sports a 10 year total annualized return of around 18% vs. a depressing -0.7% for the S&P 500!  Not too shabby given the recent economic situation.

The Future of Energy MLPs

As far as the future goes, one thing seems almost certain: the U.S. demand
for energy should continue to grow over time.  I expect energy MLPs will continue to prosper as this trend continues.

The National Association of Publicly Traded Partnerships has posted an excellent presentation which covers the basics of MLPs.  I encourage everyone to read this document, as it contains updated, important information related to investing in master limited partnerships.  You’ll find it an easy read and a fairly comprehensive piece of work (including good examples regarding taxes, etc.).  As always, consult your tax advisor before you invest in MLPs to ensure you are getting the most out of your investments.

There are many things which make energy Master Limited Partnerships (MLPs) attractive investments.  However, some of the advantages of these investments are overlooked.  Of course, the most prominent is that MLPs aren’t plagued by the same double taxation that afflicts dividend paying stocks (tax is not paid at the entity / “corporation” level).

However, here are three additional benefits that are also often overlooked:

MLPs are also regulated by the Securities and Exchange Commission (SEC)

Just like stocks, MLPs are under the watchful eye of the SEC.  This means they must also file annual and quarterly statements just like stocks of a public corporation, as well as notify investors of any material changes which affect the business.

MLPs must comply with Sarbanes-Oxley

Again, like publicly traded corporations, MLPs must comply with the enhanced accounting rules set in place by the Sarbanes-Oxley act.

MLPs offer a unique opportunity

Because they are currently overlooked by large institutional investors, the market for MLPs has room to grow.  In fact, it is estimated that less than 10% of large institutions own MLP assets.

In the wake of one of the toughest recessions in US history, many believe the market has undergone a  long-term paradigm shift (and there is much in the way of data to support this).  While this may be true for stocks, the underlying fundamentals which make investing in midstream Master Limited Partnerships (MLPs) attractive continue to endure.

Tackling the Initial “So What” Question

When evaluating investments, I like to start with a pessimistic approach and ask “So What”?  If I can’t come up with a compelling answer quickly, then I know I’ve got a problem.  So when I came across investing in MLPs I was surprised that the initial, basic argument was easy to formulate (even in this economy):

• The demand for energy in the US will continue to grow (forecasts agree)
• Midstream MLPs (e.g. pipelines) are required to transport commodities to meet this demand
• This demand is relatively inelastic (regardless of commodity price, demand for service remains)
• Barriers to competition are very high (sure, I’ll just build a pipeline real quick and compete…)

So, this gets us past our initial “So What” and the basics (Warren Buffett would be proud).  In my next post, I’ll drill down further and show you how other existing factors make MLPs even more attractive from an investment perspective.