Master Limited Partnerships (MLP's), 2: Top Picks

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In last week’s article, we introduced master limited partnerships (MLP’s) as a potentially good investment for those seeking fixed income opportunities that may also create capital gains. In particular, we recommend focusing on the oil and gas pipelines. Indeed, some of the stronger and more growth-oriented pipeline partnerships could readily double their distributable cash flow over the next decade. Let us consider which of these publicly traded stocks is most appealing at this time.

Since the recent market bottom in MLP’s (approximately December 2008), there have been two stages of recovery. In the first stage, investors poured into the larger, better capitalized and more liquid MLP’s, such as Plains All American LP (“PAA,” $47.36) (all quotes as of market close 8/12/2009) and Enterprise Products Partners LP (EPD). In the second stage, somewhat riskier MLP’s (have greater commodity price sensitivity, lesser size, or weaker balance sheets) have led the charge. These included Markwest Energy Partners (“MWE,” $21.99), Regency Energy Partners (“RGNC,” $16.64) and NGLS.

Some of the top-performing MLP’s have more than doubled in price per share since the market bottom. The biggest standouts were in natural gas gathering and processing. Generally, the trading opportunity has passed for many of these assets, though many still have merit for long term investment. Our recommendations are based on an investment horizon of five to ten years and would be most suitable for those looking for a quasi-fixed income investment with capital gain potential.

Among oil and refined products pipelines, Sunoco Logistics Partners LP (stock ticker: SXL, $56.41 per share) deserves attention. Besides pipelining, SXL also terminals, stores, and markets crude oil and refined products, primarily in the Eastern United States. Some of its facilities are linked with refineries of Sunoco Inc. (“SUN”), the giant integrated oil company. Sunoco Logistics’ market capitalization is about $1.82 billion, which is large, though not so much so as competitors such as Boardwalk Pipeline LP (“BWP,” $23.00), with $4.41 billion of market capitalization. The distribution yield of Sunoco Logistics is 7.40% currently (distribution yield equals annual dividend per share divided by price per share). Sunoco Logistics’ balance sheet and cash flow generation can readily sustain its current distributions and, in the future, increase them.

Among the more stable plays in natural gas gathering and processing, I like Williams Partners (“WPZ,” $20.31), which has a market capitalization of $1.3 billion. WPZ also fractionates and stores natural gas liquid (NGL). Its balance sheet is strong and it does not face a problem with rollover of short-term debt. Its distribution yield is currently a stout 11.90%. Second quarter earnings will be negatively affected by a one-time adverse event: the nationalization of its Venezuelan natural gas facilities by the Hugo Chavez regime. The partnership was founded in 2005 and its headquarters is in Tulsa, Oklahoma. Similarly, I like El Paso Pipeline Partners (“EPB” $18.85), which also benefits from a strong balance sheet. El Paso’s assets include pipeline and storage facilities in Wyoming, Colorado and Utah. El Paso shows strong momentum in cash flow growth and has a market capitalization of $2.2 billion. To exemplify our investment thesis—that cash is king in this market—El Paso is currently purchasing an additional 18% interest in Colorado Interstate Gas Company from El Paso Corporation for about $215 million. Jim Yardley, CEO and President of the general partner of El Paso Pipeline Partners LP, says that the acquisition will be immediately accretive to cash flow available for distribution. The dividend yield is currently 6.90%.

It is comforting when an MLP is presided over by a potent and well capitalized parent company with midstream assets. This is true of El Paso Pipeline (parent: El Paso Corp, “EP”), Williams Partners (parent: Williams Companies, “WMB.”) and Sunoco Logistics Partners (Sunoco Inc.). Generally, the parent company will be the general partner of the MLP, will own 2% of its shares and may float some midstream assets down to the MLP, taking back additional stock. The parent will also have an inherent interest in keeping the MLP solvent, as a failure at that level would raise questions about the creditworthiness of the parent.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Master Limited Partnerships (MLP's), 1: Introduction

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

If your investment requirements include current income, but you also seek capital gain potential, one promising vehicle to consider is Master Limited Partnerships (MLP’s).

MLP’s have a treatment under the US tax code that is analogous to (the more familiar) Real Estate Investment Trusts (REIT’s). This treatment is intended to prevent double taxation at the corporate and the individual level, so long as entity restrictions are rigorously followed. In fact, the compound rate of return on MLP’s as a class has surpassed that of REIT’s since 1990. However, as with REIT’s, there are tremendous differences in operating models and investment objectives within the MLP group.

MLP’s are publicly traded; there are currently about 70. They are bought and sold on US stock exchanges. Such MLP’s must make public filings with the SEC and comply with federal securities laws. The stock price, depending on investor sentiment, can be more or less than the book value of assets per share. MLP’s are not yet widely followed on Wall Street, which allows inefficiencies in valuation to occur more readily.

An MLP is a tax pass-through entity. If an MLP follows the restrictions embodied in the Tax Reform Act of 1986 (and subsequent implementing regulations), there is no federal tax due at the MLP level. Instead, each partner receives an allocated share of the partnership’s taxable income (if any). One of the restrictions is that 90% of the entity’s income must be obtained through the transportation or storage of natural resources, including oil, gas, oil distillates, coal, fertilizer, timber and paper.

The general partners in an MLP manage its business and receive “incentive distribution rights” (IDR’s). These provide motivation for the general partner to manage the business well and grow its dividends. The public shareholders of an MLP are limited partners and have limited liability. The incentive splits vary and deserve close attention.

MLP’s have diverse business models. Some explore for oil and gas. Some gather and process natural gas. I particularly favor MLP’s whose major assets are oil and/or gas pipelines. These are long life assets.[1] They are straightforward to understand. These pipeline partnerships bear a resemblance to regulated utilities in certain ways, but MLP’s generally offer more upside.

One advantage of pipeline MLP’s is economies of scale, also called “operating leverage.” The business profit margin tends to increase as their business grows in size. This provides a significant barrier to entry by competitors. A second advantage is that their revenue is not keyed directly to the price of oil and gas, but rather to the supply and demand for these products. A third advantage in many cases is inflation protection; with federally regulated interstate pipelines, revenues generally are inflation-protected through linkage with the federal Producer Price Index (PPI).

Next week: analysis and recommendation of specific MLP’s.

[1] A caution to investors: in the case of some MLP’s, particularly including oil and natural gas production, the distributions may represent in part a depletion of a fixed asset. The economic depletion of most pipeline assets is so slow that that economic depletion per year is relatively insignificant. As a different consideration, those distributions attributed to return of principal as to tax accounting are not subject to U.S. income tax.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.