The Rise And Fall Of The MLP

2/8/2016


What a difference a year makes.

From the end of 1995 through the end of January 2015, a period stretching more than 19 years, master limited partnerships trounced the S&P 1500 Index. The Alerian MLP Index's 19-year total return of 1,487% more than quadrupled the S&P 500 Index's 360% return. Even excluding the MLPs' rich dividends, the Alerian index won, gaining 343% versus the S&P 500's 224%. 

However, in the year ended January 2016, the MLP index fell 42%, erasing much of that outperformance. Since June 2006, when the Alerian index launched, it has returned 92%, only slightly above the 87% return of the S&P 500.

So, what happened to the MLPs?

About 75% of the 112 MLPs in our Quadrix research universe operate in the energy sector, and the energy MLPs account for 78% of the group's total market capitalization. So, the weakness in energy stocks — and the uncertainty surrounding the viability of North American oil and gas at today's low prices — explains much of the underperformance.

Assessing MLPs' appeal

The average MLP yields 7.8%, not because it targets such yields or has beefed up dividends in recent months, but because its share price has plunged. Over the last year (in most cases the 12 months ended September), the average MLP saw it sales fall 2% and per-share earnings 8% — not as bad as the typical energy stock in Quadrix, but far worse than the average outside the energy sector. Analysts expect an average profit decline of 4% for MLPs over the next year, with many of the targets looking optimistic.

MLPs VERSUS ENERGY SECTOR
Master
Limited
Partnerships
Energy Sector
(Including MLPs)
Quadrix
Universe
Number of companies
112
396
4,851
Total market cap. (in billions $)
322
2,484
31,308
% of companies in energy sector
75
100
8
% of market cap. in energy sector
78
100
8
Average dividend yield (%)
7.8
3.3
1.7
Dividend growth
Most recent quarter (%)
(1)
(12)
2
% cutting dividend, last 12 months
17
17
6
1 year (%)
6
(3)
3
5 years, annualized (%)
8
1
3
Average 12-month growth
Sales (%)
(2)
(13)
5
Per-share earnings (%)
(8)
(25)
0
Operating cash flow (%)
12
(11)
2
Average expected EPS growth
Next 12 months (%)
(4)
(16)
5
Next 5 years, annualized (%)
6
4
13
Average total returns
1 year (%)
(40)
(43)
(15)
3 years, annualized (%)
(15)
(23)
1
10 years, annualized (%)
6
(6)
1
Average trailing valuation ratios
Price/earnings
16
15
19
Price/sales
2.0
1.7
2.3
Price/operating cash flow
4.7
4.7
10.6
Average Quadrix scores
Momentum
44
32
50
Value
65
60
50
Quality
49
37
50
Financial Strength
52
43
50
Earnings Estimates
40
30
50
Performance
30
31
50
Overall
51
39
50
Note: Quadrix scores are percentile ranks, with 100 the best.

MLPs have averaged 8% annual dividend growth over the last five years, but that growth has slowed. In the most recent quarter, the average MLP paid out 6% more than in the year-earlier period, and 17% have cut their dividend over the last year. In contrast, just 6% of the stocks in our Quadrix universe paid out less than in the year-earlier period. Given the lack of profit growth, we don't expect MLPs' dividends to rise much in the year ahead, and additional cuts would not be a surprise. Nothing spooks income-oriented investors like dividend reductions, and if MLPs start cutting their dividends en masse, carnage could ensue.


What is an MLP?

MLPs trade on indexes like stocks. However, they are not stocks, but partnership units. Before you buy one, read on to learn how they differ from stocks:

• On average, the MLPs in our Quadrix universe yield 7.8%, the kind of dividend that in a typical stock would start us searching for what troubles have made it so cheap. But MLPs can pay robust distributions because their corporate structure gives them tax breaks if they generate 90% of their cash flows from "qualifying sources," such as natural resources, commodities, or real estate.

• Nearly 70 MLPs began trading in the five years ended April 2014, during which period the Internal Revenue Service broadened its interpretation of qualifying sources, opening up MLP status to companies that provide support services for drillers, and some that transport or store alternative fuels and industrial gases. The IRS suspended applications for MLP status in 2014, then in May 2015 proposed new rules that seemed to tighten the focus back toward energy companies, allowing regulators wide leeway. Since then, the IRS may have backed off on the changes, and as of yet no official rules have taken effect.

• MLP investors must go through an extra step at tax time. They will receive a K-1 form that breaks down the distributions, which may include returns of capital taxable at the individual-income rate.

• While MLPs report operating income like other companies, analysts typically gauge their operating performance using distributable cash flow, or operating cash flow minus capital spending and payments to the general partner. We present a shorthand version of DCF in the table below.

• A few of the stocks we classify as MLPs aren't partnerships, but limited liability companies that opt to be taxed like partnerships. Investors should treat them all the same way.


Relative to the rest of the Quadrix universe, MLPs look fairly cheap, averaging Quadrix Value scores of 69. The average MLP trades at 16 times trailing earnings and 34% below its five-year average. Of course, such valuations make sense in the wake of the massive sell-off.

Most energy MLPs operate in such midstream businesses as transportation and storage, which are supposed to be less sensitive to energy prices. However, recent declines in sales and profits call into question the conventional wisdom. Plenty of MLPs are somewhat price-sensitive, and if those low energy prices drive a lot of producers out of the market, the MLPs could take additional hits on the volume side.  Don't count on a bounceback to old valuation ratios in the year ahead.

MLPs earn decent Quadrix scores. They average Overall ranks of 51, with 44 in Momentum and a solid 65 in Value. Quadrix has historically worked well for MLPs — companies in the top one-fifth for Overall score outperformed the average MLP by an average of 3.1% in rolling 12-month periods over the last decade. The Value score proved particularly effective, with top scorers delivering average outperformance of 6.6%.

Unfortunately, many of the highest scorers are small-caps too tiny for the Forecasts to consider.

THE BEST MLPs
Below we present all MLPs rated A (above average) in our Alternative Income Watch List (www.DowTheory.com/Go/Alt). The A ratings compare each company to other MLPs, not the broad universe; few would warrant an A rating on our Monitored List. The 12-Factor and Reranked Overall scores compare MLPs to each other.
------ Dividend Growth ------
Distributable
----- Cash Flow -----
--------------- Quadrix Scores ---------------
Company (Price; Ticker)
Div.
($)
Yield
(%)
Last
Quarter
(%)
Last
Year
(%)
Last 5
Years
(Annual.)
(%)
In Millions,
Last 12
Months
($)
12-Month
Growth
(%)
Value
Overall
12-
Factor
Reranked
Overall
Alliance Holdings
($18; AHGP)
3.84
21.4
8
10
15
502
18
100
60
90
81
Ciner Resources
($22; CINR)
2.23
10.0
9
36
NA
81
(16)
94
96
NA
NA
DCP Midstream Partners
($19; DPM)
3.12
16.3
3
5
5
245
50
88
52
82
66
Enbridge Energy
($18; EEP)
2.33
13.0
5
4
3
(1,055)
NA
79
73
89
76
EQT Midstream Partners
($68; EQM)
2.84
4.2
23
25
NA
NA
NA
60
85
61
77
Genesis Energy
($27; GEL)
2.62
9.7
11
11
11
(192)
NA
81
89
95
91
Magellan Midstream
($63; MMP)
2.96
5.0
16
18
14
558
(12)
45
89
71
71
Spectra Energy Partners
($44; SEP)
2.50
5.7
8
9
7
63
NA
65
94
66
86
Star GasPartners
($8; SGU)
0.38
4.9
9
7
5
127
48
93
90
96
93
Note: Quadrix scores are percentile ranks, with 100 the best.     NA Not available.

 


The curious risks of MLPs

MLPs are not technically stocks, as discussed in a story on page 4, but they do trade like stocks. While we don't recommend any MLPs on our buy lists, our Top 15 Utilities portfolio (www.DowTheory.com/Go/Top15) features three — EQT Midstream ($68; EQM), Spectra Energy ($44; SEP), and Star Gas Partners ($8; SGU).

As a group, MLPs face some risks common stocks do not:

Potential law changes. For nearly two years, the Internal Revenue Service has been considering changes in what kinds of companies can obtain MLP status. While traditional energy MLPs probably won't lose their status, the uncertainty adds risk to the group.

Dividend cuts. Any company that pays a dividend might choose to cut or eliminate that payment, but the problem becomes more acute with MLPs. While publicly traded partnerships are not obligated to distribute the bulk of their cash flows to investors, most do it to make the units more appealing. Such a policy benefits investors in good times, but what happens when a company that typically pays out most of its cash flows suffers a downturn in business? That problem has already manifested itself. MLPs' dividend growth has slowed, and in the most recent quarter the average MLP paid out 6% more than a year ago.

Interest rates. In general, rising interest rates don't favor stocks with high yields, as the rise in rates may drive investors away from equities and toward bonds. Interest rates haven't risen enough for bonds to compete with many MLPs, but as rates keep rising, we could see investors bailing out — particularly if they perceive MLPs as especially risky.

Energy exposure. Much of MLPs' revenue comes from long-term delivery or storage contracts with energy producers. Sounds like a steady revenue stream. But what happens when producers cut back, or run into financial difficulty? Such counterparty risk probably contributes to MLPs' market weakness.

Stampedes. Because so many MLPs operate energy-related businesses, the whole group tends to pitch and yaw together. It's tough to diversify within the group, and a slump in one MLP often accompanies slumps in many others.


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