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MLP 101: An Excellent Master Limited Partnership Primer

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.

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3 Things You Didn’t Know About MLPs

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.

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Midstream MLPs Remain Attractive Investments

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.

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MLPs - Ready for a Steady Climb Upward?

It’s no secret that the US economy and Wall Street are in the throes of a major recession.  As a write this, the S&P 500 is down 37% in the last year, unemployment has skyrocketed above 8%, and the government continues to struggle with the fallout from the subprime lending nightmare.  The Master Limited Partnership universe has also suffered losses, with the benchmark Alerian MLP Index down about 35% over the last 12 months.

However, in my opinion, now is the time to start formulating an asset allocation plan for the next 5 years.  While the outlook for the economy does not look promising, I think the market has weathered the worst part of the storm (that’s not to say there won’t be some smaller rain clouds to come).  I also think that, liquidity issues aside, MLPs can be a beneficial part of that plan (if investors understand the tax implications).  So, stay tuned, and keep your eye on the ^AMZ index (already up 14% YTD) - I think there is fair (or at least “better”) weather ahead.

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Why the Rich Get Richer

Ken Fisher is one of my favorite columnists and a well respected writer for Forbes magazine.  His personal investing mantra, while deceptively simple, goes something like “the key to being a successful investor is to know something that others don’t know”.  Well, ok - that seems pretty basic, right?  We’d all like to know what others don’t know.

Personally, I think it is more about taking the time to learn what others won’t or choose not to learn.  Take the Master Limited Partnership for example - one of probably the least understood, yet most tax efficient investment vehicles available to the public.  The wealthy typically benefit from these investments because they have the luxury of private-client wealth managers and estate planning (i.e., they are fortunate enough to “know what others don’t know”).  However, the average Joe (like you and me) can also benefit in the same way.

MLPs and Estate Planning

So, why do the rich just keep getting richer?  Money that rolls from generation to generation, besides benefiting from the power of compounding interest, also grows through good estate planning.  That means making sure the estate is structured in the most tax efficient manner possible.  MLPs are excellent vehicles for this - why?  Per Investopedia’s article titled Discover Master Limited Partnerships:

“MLPs can be used to gain current income while deferring taxes…This can be taken one step further when an MLP investment is used as a vehicle for estate planning.  When an MLP unitholder dies and the investment is transferred to an heir, the cost basis is reset to the market price on the transfer date, eliminating any accrued tax liability caused by return of capital.”

How’s that for tax efficient?  When you die and pass on any LP units to your heirs, you effectively shield them from taxes by resetting their accrued liability to zero.  Not too shabby, eh?

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Barron’s: Pipelines, Infrastructure to Shine in Downturn

Barron’s published an interesting interview with Jay Rosenberg, manager of the First American Global Infrastructure fund.  According to Rosenberg, pipelines and infrastructure related companies are attractive in the current economic environment because they offer stable cash flows.  Specifically, Rosenberg says:

…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…

Related Links:

Barron’s Article (subscription may be required)

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2 Metrics MLP Investors Must Understand

The Master Limited Partnership is a tax efficient, cash generating machine.  In the MLP model, the majority of cash generated in a given period is passed directly through to investors.  However, some cash is retained in order to fund future projects or growth.  Understanding the difference between how much was paid out to investors and how much could have been paid out is key.

Distributable Cash Flow (DCF)

Stock investors typically use a metric called “Free Cash Flow” as a gauge of a company’s ability to generate cash (after adjusting for expenses relating to maintaining its assets). This cash can then be used to fund additional projects or pay out dividends. Similarly, MLP investors use Distributable Cash Flow (DCF) as a measure of cash available to distribute to unitholders or fund growth.

Calculating DCF is fairly simple, and involves working backward from Net Income on the Income Statement and adding back accounting related items. Remember that accounting items like depreciation and amortization are typically subtracted from income to represent the loss of value of different assets over time. However, they don’t really have anything to do with generating cash, so we want to make sure we add them back to net income. The calculation is:

The Coverage Ratio

So, now we know how to calculate Distributable Cash Flow (which represents what we could pay to investors if we wanted to).  However, it’s always a smart idea to retain some of the cash generated to fund future growth or as an emergency fund.  Thus, the amount actually paid out (the actual distributed amount) will typically be less than DCF.  As a general rule, we like to see the ratio of DCF to the actual distribution to be greater or equal to 1.3.  This ratio is referred to as the “coverage” ratio and is calculated as:

Coverage Ratio = Distributable Cash Flow / Actual Distributed Cash Flow

In our example above, if we have $225 million in DCF, we would likely actually distribute around $173 million to investors to maintain a coverage ratio of 1.3x.

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MLP Focus: Enterprise Products Partners, L.P.

One of the largest MLPs in existence today is Houston based Enterprise Products Partners.  As measured by enterprise value, EPP is second only to MLP bellwether Kinder Morgan at $21 billion.  However, from a liquidity standpoint (the ability to trade LP units on the open market - a key concern of many investors) it bests Kinder Morgan with an average of 560K units traded daily.

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.

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Why MLPs Continue to Grow Cash Distributions

The Master Limited Partnership (MLP) has two key components.  At the core of the MLP is the General Partner (GP), which actually runs daily operations (e.g., physical management of a pipeline, billing, accounting, etc.)  Limited Partners (LPs), on the other hand, are passive investors in the business and have no part in daily operations.  The goal of the GP is to grow cash distributions (similar to a stock dividend) to the LPs and, since most MLPs operate in the energy space, these distributions tend to grow steadily over time. (more…)

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S&P on the MLP

Standard & Poors has a pretty good article on its website outlining the basics of MLPs. Of particular interest is the low correlation of MLP returns with those of stocks and bonds.  For those not familiar with asset allocation theory, combining investment classes that have low correlations with each other is a good way to remain diversified.  Further, it can allow you to boost returns while actually lowering portfolio risk.

Related Links:

Standard & Poors MLP Primer

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