Is There More Value in the Pipeline for MLPs?

Note: We're re-featuring this article, originally published on Dec. 15, 2010, as part of our Retirement Income Week.

Master limited partnerships have been on a tear over the last year, with Morningstar's MLP Composite Index up 33% over the trailing 12 months through Jan. 25 versus a 20% gain on the S&P 500. The MLP Focus Index consists of the 20 MLPs in our coverage universe trading at the greatest discount to our risk-adjusted fair value estimates. It's up 36% over the trailing 12 months. Looking across our MLP investment landscape, the space looks fully valued, if not perhaps a touch richly valued. Given this outlook, are there compelling reasons to initiate new MLP positions currently?

We think that for certain types of investors, the answer to this question is a resounding yes. Given that current distribution yields average around 6.5%, and that our outlook calls for close to 5% average annual distribution growth, MLPs continue to offer attractive total return prospects. For income-oriented investors, MLPs remain one of the more attractive opportunities in the market, offering high yields backed by stable and growing cash flows.

While none of the MLPs in Morningstar's coverage currently provide enough of a margin of safety, in our opinion, to earn our 5-star rating, we continue to like the business models, assets, and management teams that generate strong cash distributions. MLPs tend to occupy market niches that provide structural competitive advantages, helping most MLPs in our coverage to earn either narrow or wide economic moat ratings.

MLP business models focus on how best to utilize hard assets such as pipelines, processing plants, storage terminals, and gathering systems. In our view, one of the strongest business models in the space arises when an MLP seeks to integrate its assets into a single economic system. Networks of pipelines, connected together and fed by gathering systems and processing plants, offering access to multiple markets and storage facilities, all help MLPs deliver excess returns year after year by earning economic rents along each link of the midstream value chain. We think that business models such as those of  Enterprise Products Partners (EPD) and  Energy Transfer Partners  are excellent examples of this dynamic in the natural gas space. In the crude oil and refined products space,  Plains All American (PAA) consistently leverages its transportation and storage assets to generate excess returns.

Long-haul pipelines, in our view, tend to be wide-moat assets that consistently earn economic returns in excess of their capital costs thanks to high barriers to entry, high upfront capital costs, and regulatory approvals needed to develop competing projects. We think MLPs such as  Magellan Midstream Partners   and  Boardwalk  have built solid businesses based on long-haul pipes. Magellan's refined pipeline and terminal network provides unmatched connectivity to Midwest refineries and end markets, and investments in strategic crude oil terminals and pipelines allows Magellan to generate strong returns on both sides of the refinery. Boardwalk's legacy natural gas pipelines and storage, coupled with significant new pipelines that knit its system into a single network, provide excellent market access for Texas and Gulf Coast natural gas producers and provide a diversity of supply options for utilities.

In thinking about management teams, we like how the MLP funding model forces a degree of discipline. Managers must go hat in hand to debt and equity markets to fund expansions, and historical success at putting capital to work generating excess returns helps to lower the cost of capital. Because of this dynamic, and the tendency of MLPs to pay out the vast majority of available cash as distributions, management teams tend to be conservative with their capital. But not necessarily with their vision--we think MarkWest's approach to building gathering and processing assets in partnership with specific producers has led to a strong position in the emerging Marcellus shale, and  ONEOK Partners'  focus on natural gas liquids has led to a dramatic transformation from its legacy natural gas pipeline beginnings.

In our view, each of these MLPs deserves to be on investors' watchlists. The combination of solid business models, attractive assets, and focused management helps MLPs generate stable cash flows, pay consistent, and rising, cash distributions, and set the stage for future growth. MLPs have certainly taken advantage of investor appetite for both debt and equity, raising roughly $20 billion in debt and $13 billion in new equity so far this year. Much of this capital will go to new projects that, by our estimates, will generate returns well in excess of capital costs, paving the way for distribution growth during the next several years. And despite the run in MLP stock prices, we think there's likely room for additional growth.

In our minds, the ongoing shift from conventional oil and gas production to resource plays targeting shales and tight sands will continue to drive midstream capital expenditures for the foreseeable future. As producers develop new regions, new infrastructure must be placed into service, and MLPs have demonstrated remarkable consistency in developing new projects that bake in economic profits. On the refined products side, we continue to see oil majors putting infrastructure assets up for sale, and MLPs are the likely buyers. We expect both of these trends to continue, and we'd expect our fair value estimates to rise to the extent that new projects and acquisitions exceed the capital expenditure and return assumptions currently embedded in our models.

Given their visible growth profile and their demonstrated ability to earn returns in excess of their cost of capital, we're bullish that MLPs as a sector are likely to continue to outperform the market over time. And while, in our view, MLPs do not offer significant discounts to their fair value currently, we believe that the income and total return prospects offered by MLPs are likely to continue to appeal to investors.