Dividends Take a Double Tax Hit

So what’s the difference? Investors in a public company that pays dividends pay taxes twice. That’s right: twice. They are taxed once at the corporate level when the company pays taxes, then again when they pay taxes on dividends they receive. Ouch. Sounds like uncle Sam fares pretty well in that situation.

Distributions Avoid Double Taxation

Investors in MLPs, on the other hand, pay taxes only once on the cash distributions they receive from the partnership. Because the partnership’s goal is to pass on most of its earnings to unitholders, it is not taxed at the “corporate” level. This amounts to what is essentially a tax efficient “shield” for MLP investors.  Given that the rate of tax on stock dividends will likely rocket to almost 40% in 2013, this makes MLP distributions look pretty attractive moving forward.

MLP Investment Continues to Grow

Investment in MLPs continues to grow over time. In fact, the Alerian MLP index hit a historical high of 390.02 in April of this year. That translates into a very robust 5-year annual return of roughly 17%. While the index is currently hovering around 349, this still represents tremendous long term growth (especially given the current economic climate).

The Future is Unconventional Reserves

But the bigger story here is the continued long term potential for growth in the MLP space. Unconventional oil and gas reserves are the future of domestic energy in the United States. New technologies for extracting oil and gas from shale will drive demand for infrastructure (namely pipelines). In fact, INGAA analysts estimate over $200 billion in new natural gas infrastructure will be built by 2035. That means big returns for MLP investors moving forward.

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.

As a result, some pipeline companies (which actually have limited exposure to these prices) have unduly suffered.  For example, Crosstex Energy LP (XTEX) has fallen over 70% since July – even though it has continued to grow cash distributions to investors.  While it had a rough 3rd quarter due to major Hurricanes, at a price of $8 Crosstex has a whopping 25% distribution yield!  However, I like to see a coverage ratio close to 1.3x – Crosstex is below this benchmark with a coverage of around 1x.  Still, bottom line is the same – the market is likely undervaluing some of these companies as commodity prices fall.

…we are generally much more focused on those companies that transport petroleum — both crude refined products — and natural gas. But they do so in a way that is very contractual in nature and where their earnings don’t fluctuate very much based on the volumes that they are shipping. The company that best typifies what I’m talking about would be Enbridge (ENB), in particular because of the contractual nature of its gas load. Another company that we like in is Kinder Morgan …whose institutional shares (KMR) we own. Kinder Morgan has a fantastic portfolio of pipeline assets but also has some of the best unique storage assets in the US…

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Overview

Like many of its peers, EPP is focused on providing midstream energy services to natural gas, natural gas liquids (NGL) and crude oil producers and consumers.  Its primary method of doing so is its extensive network of pipelines (both offshore & onshore) which span over 35K miles in length.  However, a key differentiator is its ability to tie import / export of NGLs with domestic and international consumers.  In fact, NGL has become a very profitable business for EPP, with over half the partnership’s gross operating margin derived from NGL pipelines and services.

The Numbers

Investors like consistency, fiscal conservatism, and cash – and EPP seems to fit the bill with all 3.  The partnership has grown cash distributions to LP unitholders at an annual growth rate of 9% per year since 1999, and grew total assets at a 39% CAGR during the same period.

Jan – June 2008 operating margins grew at a double digit pace vs. 2007 with strong performance across all pipeline business segments.  Further, distributable cash flow (DCF) grew 41% in 1H ’08 vs. 1H ’07 to $730 MM, and the amount of retained DCF grew over 4X to $212 MM.  This gives the partnership a comfortable coverage ratio of around 1.47.

In Sum

I don’t issue buy or sell recommendations for any type of security.  However, I like EPP and will continue to watch this company as it pursues more projects and grows in the midstream energy space.

However, the GP has an added incentive to grow cash distributions to LP investors.  Why?  While the GP typically only has a 2% initial stake in the business, their share of cash distributions can grow significantly once they reach a predefined threshold.  For example, the GP may only get 2% of cash distributions up to $0.30 per LP unit, but beyond this point their claim may jump to 15% and sometimes can grow to 50%!  Therefore, it is in the interest of the GP to continue growing distributions to LP investors (and is why you rarely see MLPs shrink the cash distribution).

A good analogy is, unsurprisingly, an actual toll road.  It doesn’t matter if 100 Honda Civics use the road or 100 Aston Martins – the same toll is collected and, consequently, the same amount of revenue.