Income-seeking investors all too often pick the master limited partnerships (MLP) in their portfolios based on their distribution yields, ignoring critical factors such as the underlying business, growth potential and valuations relative to their peers.
There’s nothing new under the sun. In a March 1987 article published in the Wall Street Journal, Barbara Donnelly wrote: “Investment bankers specializing in [master limited] partnerships say that in order to be competitive an issue must offer a current return of 9 percent to 10 percent.”
Twenty-five years later, it’s still all about the yield for many investors, especially as retiring baby boomers shift their focus from accruing assets to transforming accumulated savings into a reliable income stream.
However, as my colleague Elliott Gue observes in Investing in MLPs: Yield vs Distribution Growth, publicly traded partnerships that grow their distributions over time generally deliver superior total returns than those that offer only a high yield.
Moreover, taking profits on a MLP that has generated a big chunk of its upside from price appreciation entails less of a tax burden than a position that has generated most of its return through distribution accumulation.
Prospective investors should also understand the extent to which an MLP’s relationship with its general partner can enhance or impede its growth prospects.
These days, initial public offerings of recent vintages are often structured so that the parent can monetize its MLP-qualifying assets and achieve the high splits as quickly as possible to maximize its cut of the cash flow. (See MLP Basics: Incentive Distribution Rights Explained.)
Combined with an understanding of an MLP’s underlying business and growth prospects, valuation can help you decide which publicly traded partnerships to add to your portfolio.
This week, we’ll start from the bottom and look at the five MLPs that exhibit the lowest prices to earnings before interest, taxation, depreciation and amortization (EBITDA).
There are few surprises among these bottom dwellers, many of which are smaller-cap MLPs with checkered pasts or limited upside.
Among this auspicious group, Seadrill Partners LLC (NYSE: SDLP) appears the most interesting, largely because weak day-rates for deepwater drilling rigs could prompt its parent SeaDrill (NYSE: SDRL) to accelerate the pace of drop-down transactions to the MLP. These assets would need to operate under contracts that are at least three years in length.
That being said, prospective investors would need to keep a close eye on any impending contract expirations and be ready to exit when the pipeline of potential drop-down transactions looks ready to dry up. And with SeaDrill owning 39 percent of the MLP’s outstanding float, the parent could look to monetize its stake at some point, sending the stock lower.
Elliott and Roger on Oct. 29, 2018
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