Master Limited Parternship 2010 Investor Conference Slides

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.

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.

Luckily, according to the National Association of Publicly Traded Partnerships this is not the case.  Per the NAPTP:

…a memo circulated by an investment firm that was based on the Tax Policy Center analysis described below but like other summaries we have seen, neglected to include the all-important word “financial”.   The investment firm has admitted that this was an error.   Therefore, it continues to be true that the only matter involving PTPs on which the President-elect has taken a public position is his cosponsorship of legislation–which has gone nowhere–to tax PTPs which are investment advisors as corporations. We have no reason to believe that he has taken any position with regard to other PTPs.

So, looks like we’re in the clear for now.  The only publicly traded partnerships Obama has considered are “financial” in nature.  In my opinion, it just doesn’t make sense to go after MLPs.  It is in the best interest of the nation to promote building and maintaining quality energy infrastructure – the tax benefits of master limited partnerships encourage this.

Investors in Master Limited Partnerships, however, are finding themselves in a much more favorable position.  MLP distributions are not actually considered dividends.  In fact, they dodge the tax bullet in this case because they are considered a tax-deferred return of capital.  So, hold on to your hats – with yields between 7 – 10% MLPs may soon become as popular as the ETF.

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.

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).