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?

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.

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.

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.

…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)

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.

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).

Related Links:

Standard & Poors MLP Primer

MLP unitholders, however, only pay taxes when they receive a dividend payment (called a “distribution”).  Further, MLPs can defer paying taxes on the majority of the distribution until the units are actually sold.  Not bad, eh?

Always Know the Downside

Don’t forget to do your research.  In some cases, MLP unitholders may have to pay taxes in each state where the partnership operates.  I strongly encourage everyone to consult a tax advisor before attempting to invest in these vehicles.  They can be great investments only if you do the research and follow the rules.