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A Simplified Take on MLPs

Thu, 11 Jul 2013

Morningstar's Matt Coffina and Connie Hsu put master limited partnerships in layman's terms but note few values currently exist among these energy firms.

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Video Transcript

Matt Coffina: For Morningstar StockInvestor, I am, Matt Coffina. I am joined today by Connie Hsu, who is an equity analyst covering the midstream energy sector for Morningstar, and we are going to talk about master limited partnerships.

Connie, thanks for joining me.

Connie Hsu: Thanks for having me.

Coffina: So briefly for investors who might be less familiar with this area, what is a master limited partnership?

Hsu: A master limited partnership is a publicly traded partnership, that's similar to a corporation except they don't pay any corporate tax. Instead they pass through all of their income to their MLP investors, who then pay tax on that income at their own individual marginal tax rates. So in order to qualify for the special tax status, MLPs have to generate 90% of their income from energy-related activities essentially, and their mandate to their investors is to sustain and grow cash distributions to their investors.

Coffina: And just to be clear, MLPs are not appropriate for a lot of tax-deferred accounts, just because of the special tax situation?

Hsu: Right. I think past a certain level, I think it's $1,000 of unrelated business taxable income, they are going to have to pay tax regardless of whether they are held in tax-deferred accounts.

Coffina: We've found that the relative cost of capital is an important determinant of an MLP's competitive position and its future growth prospects. Why is that?

Hsu: A lot of that is actually a function of the MLP structure. So because MLPs are tasked with growing and sustaining their distributions, they often pay out almost all their distributable cash flow in the form of distributions to their investors. So because of that, any time they want to grow if they want to build a new pipeline or acquire a new pipeline, they have to constantly access the equity and debt markets. So generally speaking, the lower the cost of capital, the greater their ability to grow.

Coffina: And one of the main differentiating factors between different MLPs is their general partner interests and the incentive distribution rights that they owe to their general partners. So could you explain, in layman's terms, what are general partner incentive distribution rights?

Hsu: Sure. MLPs are generally set up with two types of partners. There are the general partners that are actually running the partnership, running the business, and initially they're entitled to about 2% of income and distributions earned. And then there are limited partners that are typically composed of the public investor base, and they are getting 90% of distributions and 90% of income initially.

To incentivize the general partners to grow cash flow and grow distributions, through these incentive distribution rights they are entitled to a growing share of the total cash distribution pie, basically once they hit certain distribution targets. So as the LP distribution approaches the first target, say it's a $1, the general partner gets 2% of the total distribution pie. Past that $1, it will get 15% of the incremental growth in distributions and then past the next target, say it's $1.50, the general partner will get 25% of the incremental growth and so on until it gets to a 50% split between the general partner and the limited partner.

Coffina: Just focusing on the limited partners, do any of them stand out as having a relatively attractive cost of capital, and do any of them stand out as having a relatively unattractive cost of capital?

Hsu: Yes. As a function of these incentive distribution rights, we have generally found that the firms that don't have to pay these incentive distribution rights tend to have the most competitive and lowest cost of equity capital. And these firms--Magellan Midstream Partners, Buckeye Partners, Enterprise Products Partners, MarkWest Energy Partners--over the last few years have all taken the initiative to effectively buy out these IDRs. It basically reduces their cost of equity capital to adjust the distribution that they are paying out to LP unit holders plus projected growth.

And then on the flip side there are firms that do have IDRs, and as these IDRs are increasing over time, the firms are starting to take initiatives such as forfeiting their IDRs in tandem with particular deals in order to reduce their cost of capital.

Coffina: Are there any particular names you would call out that have those relatively high incentive distribution rights?

Hsu: Yes. Kinder Morgan Energy Partners at this point is in the high splits. They are paying out about half of their incremental distribution growth to their general partners. Energy Transfer Partners is also paying a significant amount to their general partners.

Coffina: Valuation is obviously also an important consideration for investors. Do any of the MLPs look particularly undervalued right now, or is there anywhere that you would recommend investors look?

Hsu: Well broadly speaking I think the MLP sector might be fairly valued at this point. They have come down a bit since the Fed has signaled some tapering or a potential rise in interest rates. They have come down, but they have also bounced back pretty quickly, as well. So, at this point no individual names necessarily jump out as being that attractive. The names that do have higher yields right now tend to have quite significantly more risk, as well.

Coffina: Great. Thanks for joining me, Connie.

Hsu: Thanks, Matt.

Coffina: For Morningstar StockInvestor, I am Matt Coffina.

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