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By Matthew Coffina, CFA and Connie Hsu, CFA | 07-02-2013 02:00 PM

A Simplified Take on MLPs

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.

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.

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