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MLP Relative Valuations

By Elliott H. Gue on Jul. 30, 2014

Financial journalists and media pundits are fascinated by the concept of absolute valuation, especially after a prolonged rally in the stock market.

Using metrics like price to earnings (P/E) or enterprise value to EBITDA, they attempt to divine whether the S&P 500 is cheap or expensive relative to historical norms. Unfortunately, there are almost as many valuation measures as there are financial pundits.

Energy-focused master limited partnerships (MLP) have handily outperformed the S&P 500 and most energy stocks over the past three, five and 10 years.


Source: Bloomberg, Energy & Income Advisor

This impressive performance often prompts investors to ask whether MLPs are overvalued and too expensive to buy.

And although many energy-focused MLPs have raised their payouts considerably over the past five years, price appreciation has outstripped distribution growth in many instances, compressing yields.

At the end of March 2009, the Alerian MLP Index yielded north of 8.5 percent; today, this capitalization-weighted basket of 50 prominent master limited partnerships yields 5.3 percent.

But investors shouldn’t assume that all MLPs are overvalued; the largest publicly traded partnerships account for a disproportionate share of the Alerian MLP Index.

These five blue-chip MLPs sport a weighted average yield of 4.6 percent, pulling down the Alerian MLP Index’s current return.

Not only have investors largely discovered these well-established midstream MLPs, but these large-cap names also figure prominently in JPMorgan Alerian MLP ETN (NYSE: AMJ) and other popular exchange-traded products that offer one-stop exposure to this security class.

Accordingly, large-cap MLPs are disproportionately affected by inflows to these fund products.

Although the absolute valuation of the Alerian MLP Index provides ample fodder for pundits, investors should look to relative valuations to identify favorably priced names in this security class that could outperform the broader market.

Consider that 19 of the Alerian MLP Index’s 50 constituents yield more than 7 percent. And this popular index omits more than 50 publicly traded partnerships, including many recent initial public offerings and underappreciated small-cap names that can deliver differentiated returns.

Selectivity is critical. So far this year, Natural Resource Partners LP (NYSE: NRP) takes the crown as the worst-performing name in the Alerian MLP Index, having lost 18 percent of its value. Meanwhile, the index’s top performer, Phillips 66 Partners LP (NYSE: PSXP), has soared by more than 85 percent.

Investors willing to buy individual MLPs and look beyond the established, large-cap names can outperform dramatically and score above-market yields.

A Framework for Relative Valuation

Yield and distribution growth are the main ingredients of MLP valuations.

To tempt investors, MLPs with little or no growth potential must offer a higher yield. In contrast, MLPs with a large slate of organic growth projects or the potential to purchase assets from their general partners (drop-down acquisitions) often sport lower yields.  

Any valuation framework is a rough guide to an inefficient market; however, this graph plotting indicated yield and the Bloomberg consensus estimate for three-year distribution growth serves as a good starting point.  


Source: Bloomberg, Energy & Income Advisor

The thick blue line on the graph represents a best-fit curve between yield and anticipated distribution growth for 45 MLPs. Yield and growth expectations exhibit a tight correlation, and most MLPs included in the study hew closely to the line.

MLPs located above the thick blue line appear relatively cheap; these names offer higher yields and the potential for solid distribution growth. Meanwhile, MLPs below the line are relatively expensive on the basis of yield and growth potential.

Investors shouldn’t invest blindly in the “cheap” MLPs on this graph. In some cases, these stocks trade at a discount for good reason. However, this simple valuation exercise can unearth gems that the market has overlooked in its fervor for larger, established names.

Here are two simple strategies that can help you identify overlooked MLPs that trade at attractive valuations.

MLP Initial Public Offerings

Many MLPs outperform the Alerian MLP Index in their first few years as publicly traded partnerships. Of the 15 top-performing MLPs thus far in 2014, 11 went public in 2012 or 2013.

This phenomenon isn’t an anomaly. Many fledgling MLPs receive scant attention from individual investors and Wall Street analysts when they make their public debuts. Brokerage houses involved in these transactions are prohibited from providing research coverage on these names for a “quiet period” after the IPO.

And until an MLP disburses its first full quarterly distribution, most financial and brokerage websites will list the yield as zero percent; these names rarely appear on the screens run by individual investors.

However, investors willing to dig deeper and monitor S-1 registration filings can identify MLPs soon to come public and assess their distribution and growth prospects. These filings contain a wealth of information and cash flow projections that can help you identify likely yields and growth rates long before the crowd bids up the stock.

In addition, as we explained in the Sept. 13, 2013, issue of Energy Investing Weekly, The Lowdown on MLP IDRs: Incentive or Impediment, the general partner (GP) receives incentive distribution right (IDR) as compensation for managing the assets of the MLP.

The general partner’s cut of an MLP’s incremental cash flow increases once the partnership’s distribution reaches certain predetermined milestones. This structure incentivizes the general partner to pursue strategies that drive distribution growth at the MLP level.

When an MLP first goes public, the general partner’s cut of the partnership’s cash flow is relatively low, facilitating rapid distribution growth, which, in turn, drives price appreciation.

V-MLPs

Most MLPs establish a minimum quarterly distribution (MQD) at the time of their initial public offering.

These pass-through entities’ partnership agreements usually include strong incentives for the general partner to at least maintain this MQD. For example, many general partners own subordinated units in the MLP that, for a specified period, don’t receive a full quarterly distribution unless common unitholders receive the MQD.

Variable-rate MLPs (V-MLP) operate on fundamentally different principles than traditional MLPs and offer a completely different investment proposition.

Over the past three years, the universe of investable V-MLPs has grown significantly, with nine new names completing IPOs over the past 3.5 years.

The group’s appeal to income-seeking investors should be clear: The average V-MLP offers a yield of 8.7 percent, compared to 5.3 percent for the Alerian MLP Index.

Whereas traditional MLPs privilege reliable cash flow and distribution growth, V-MLPs make no effort to hedge their exposure to commodity prices or economic conditions.

Instead, V-MLPs pay the vast majority of their cash flow to unitholders in the form of a quarterly distribution–minus modest reserves to cover expenses and maintenance. These publicly traded partnerships deliver distribution coverage of 100 percent each quarter, but their payouts will vary depending on the performance of their underlying business.

Although some V-MLPs own midstream infrastructure such as pipelines and terminals, the steady cash flow generated by these assets represents a relatively small portion of their earnings before interest, taxes, depreciation and amortization (EBITDA).

Most V-MLPs own and operate downstream assets such as refineries or chemical plants–industries where earnings fluctuate with commodity prices and exhibit greater volatility than in the midstream segment.

When V-MLPs’ underlying businesses are in the sweet spot, these names can deliver big-time gains and stratospheric yields of 20 percent to 30 percent; however, if business conditions deteriorate, it’s not unheard of for a V-MLP to omit its quarterly payout entirely.

Check out our Free Video explaining our strategy for investing in V-MLPs.

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