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By Jeremy Glaser | 05-17-2011 04:22 PM

Why Have MLP Shares Been Faltering?

Morningstar DividendInvestor editor Josh Peters explores the recent softness in MLP stocks and shares his pick for the best value in the sector today.

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. Investors looking for yield have recently looked to master limited partnerships as a place to find it, but the stocks are off about 10% from their highs. I am here with Josh Peters, editor of Morningstar DividendInvestor, to see what's happening in this space and if there are values that have been uncovered.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, let's talk a little bit first about MLPs. For investors who may not be familiar with them, can you give us just a quick overview of what these companies are and why they might be different from a regular company?

Peters: Sure. MLP stands for master limited partnership. Technically, these companies are not corporations. They are organized as partnerships, in which you would own units of limited partner interest. It sounds kind of cumbersome. I mean, it really represents equity and equity stake in a business, much like a common stock does for a corporation. But they are structured for tax purposes as partnerships, so that the taxable income of the partnership just flows right down to the tax returns on individual investors reporting. The income isn't been taxed at the level of the partnership itself. The government created this type of structure or sanctioned this type of structure for some very specific lines of business back in the 1980s. Most of that relates to energy logistics, such as moving energy around through pipelines, storing it through terminals, associated activities like that.

Glaser: So let's take a look at the stocks today. They've been off somewhat substantially from their highs. What do you think is driving that movement?

Peters: Well, there are a couple of different factors. The market for MLPs started to get a little bit nervous a couple of weeks ago when a major news organization reported that perhaps some staffers in the Treasury Department working on an overhaul generally of the corporate tax code were looking at removing some of these treatments for what they call just a broad brush of pass-through entities, which is remarkable because this isn't just MLPs. This could be any type of joint venture. It could apply to hedge funds. It could even apply to law firms, other professional organizations, even law firms that employ lobbyists perhaps. It applies to any type of a corporate structure where the income isn't being taxed at the corporate level but instead is being allocated down to the individual owners of the business.

Looking at that, I actually went through the trouble of talking with Mary Lyman, who is head of the National Association of Publicly Traded Partnerships in Washington. She tells me basically there is no mandate in Congress to actually change MLP taxation. I mean, this isn't something that floated along just in the last couple of years as a tax loophole. It's been an established part of the tax code now for 25 years. And it does serve a real purpose in that the government created this structure in order to incentivize investment in pipelines, in storage terminals, and energy logistics, and to support infrastructure needs of the economy as a whole. Certainly, it doesn't look like there's much risk of anything happening between now and the next election, but even after that, all of these pass-through entities are pretty well embedded in the tax code. You can call them a special interest, if you like, but special interests have what they have for reasons, and in this case, you're touching not just MLPs but a very large swath of different types of businesses. So, that was one of the things that first got into investors' minds.

Glaser: Was there anything on a more fundamental level that's been driving these stocks?

Peters: Well, from my perspective, this news about tax code threats, which at some point down the line could become very real, is something to watch. It's not something we think is an imminent risk, but that kind of reminds people, yes, these are not bonds. And there's no FDIC guarantee; they are equity investments in a business. They tend to be very conservative businesses, but they are not risk-free. And at that point, people start wondering, "Well, what's been happening to prices?" And we saw that MLPs were trading at record levels, and valuations were trading at right around the past high levels in terms of distribution yields and price/cash flow multiples. And that kind of sets you up for something of a fall.

I mean, they've performed so well during the last five years, 10 years, or 15 years as a group that investors, I think, perhaps got a little bit ahead of themselves in terms of the prices that they were willing to pay.

Glaser: Oil prices have also come down off their highs. Is that something that would affect the MLPs?

Peters: Actually, it's very interesting. It probably is not going to have much, if any, fundamental impact on pipeline cash flows or distribution increases. I mean, those are all pretty much, not maybe on auto-pilot, but they tend to operate in a pretty narrow band. You don't see plus and minus 10% changes in the usage of energy even though you see now plus and minus 10% in terms of the price of energy all the time. So, that's not really something that's concerning.

Unfortunately, you've got, what I will call, more technical factors in the market that you have hedge funds, commodity-oriented funds, other types of institutional money, some fast money, and some hot money, that specialize in this very large energy sector. Those are some of the owners of MLPs even though those aren't necessarily bets; in fact they're very poor bets on the direction of energy prices. And if those folks are now facing say margin calls, because they have long oil positions that they're having trouble supporting, you can't always sell what you want, so you maybe wind up selling what you can. And in that case, you could wind up with some dumping of MLP units, and who buys them?

If hedge funds are selling MLPs, then it's really up to the traditional individual investors who are looking for those 5%, 6%, or 7% types of yields, who wind up doing the buying. They do come to market. I've seen this many times now in the last couple of years with MLPs. I mean, if there's somebody who wants to get out of lots of these in a hurry, they are going to fall, but it takes a while for the ordinary investors to sort of step up to the plate and recognize now there's a little bit of additional value on the table. Maybe it's a better time now actually to be a buyer because the seller isn't selling because these companies have suddenly gone bad. They just had other reasons that may have had nothing to do with the MLPs themselves to sell. So I actually think that the correlation between oil prices and MLP unit prices makes no sense, but it actually does a better job of explaining why the units are down than anything else.

Glaser: So if the units are down as much as they are, has it created any opportunities?

Peters: It's made it a little bit better. The group is not quite as overvalued as it was a couple of weeks ago relative to our fair value estimates. I'd say that you're getting into the area now where perhaps as a group they are more or less fairly valued, and I think that these units can be very solid holds when you're owning them at or around fair value over the long run. In some cases, I've continued to hold on to MLPs even as they got kind of expensive because one of the key benefits in addition to those big upfront yields is that a lot of these pipelines have regulatory regimes that directly link their revenues to inflation. So you get just this terrific inflation hedge from an enterprise like say Magellan Midstream Partners, symbol MMP.

As for current buys, the only ones that I now think of as having become cheap enough to buy--and this is partly because they have been frankly some of the laggards relative to the rest of the MLP group during the last year or so--are Energy Transfer Partners and Energy Transfer Equity. Energy Transfer Partners now yields quite a bit over 7%, with one of the highest yields in the MLP area. It hasn't been growing its distribution during the last couple of years as it has made some acquisitions and had a lot of construction projects. Some of the business, a smaller slice that is a little bit sensitive to commodity prices, has been under some pressure, but looking ahead, we see distribution growth resuming.

Energy Transfer Equity actually owns the general partner stake in Energy Transfer Partners as well as another partnership called Regency Energy Partners. The yield is lower, a couple of percentage points lower, but the growth rate, because it is allowed to collect incentivized distribution based on the growth of the underlying partnerships that it controls, actually leads us to expect double-digit distribution growth going forward.

So, I'm not going to say these are the best MLPs from a business perspective. They are cheap relative to the other ones for some reasons, most notably the lack of distribution growth. But we're looking ahead and seeing that situation and that level of performance improving during the next couple of years.

Glaser: Josh, thanks for the tips.

Peters: Thank you, Jeremy.

Glaser: From Morningstar, I am Jeremy Glaser.

 

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