Arguably the biggest advantage of investing in MLPs is the favorable tax structure these businesses enjoy. MLPs are partnerships which pass through the majority of earnings from the business to investors in the form of quarterly cash distributions. Sounds like a dividend, right? Exactly – distributions are very similar to dividends.

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.

As we saw in our last post, Distributable Cash Flow is the amount of cash an MLP could pay out to investors in a given period.  However, a well managed business balances future cash requirements with giving investors a return on investment today.  As a result, not all DCF is paid out to unitholders – some is retained to fund expansion or to ensure that the partnership does not have to reduce distributions in the future.

As an investor, this is what we want – a business which generates more cash than required to provide investors a solid ROI. We can measure this with a metric called the “Coverage Ratio”:

In general, we want DCF to be about 1.2 times the amount of the actual cash distribution.  In other words, DCF should be about 120% of distributions.

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 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.

We recently posted an entry outlining the importance and calculation of distributable cash flow (DCF) when evaluating MLPs.  In a nutshell, DCF represents what the MLP could have paid out in cash to unitholders had it chosen to do so.  However, while investors want to see cash distributions grow over time, they also want to see the MLP managing cash responsibly as well.  That is, they want to feel confident that the firm is maintaining reasonable levels of cash “coverage” so it can continue to grow the business moving forward.  The “coverage ratio” is the de facto standard for measuring this and is calculated by:

Typically, investors want to see a coverage ratio of anywhere from 1.2 to 1.5 in addition to growing quarterly distribution payments.

Whether you are dealing with stocks or MLPs, one thing is clear: cash is king. 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.

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