If you're an income investor who strives for stable, high-yielding assets, then you should be looking at master limited partnerships (MLPs). Particularly right now, MLPs can be terrific investments -- their yields are exceptional, averaging nearly 7% and well above the average yields for utility stocks (about 4%), real estate investment trusts (REITs) (3.5%) and the S&P 500, which only yields about 2%.
MLPs are designed to pay the bulk of their income to investors and have a big advantage in that they pay no corporate tax, which greatly lowers the cost of capital. Because MLPs are not subject to double taxation (meaning profits are taxed at the corporate level and the shareholder level), a higher distribution amount can be paid to unit holders.
Of course, distributions from these investments aren't guaranteed, so it's important to focus on safety and yield when shopping for an MLP. Here are the main safety factors I consider:
- Distribution coverage from cash flow. The key metric for MLPs is distributable cash flow (DCF), which is the amount of cash available for distributions. Net income is less important, because many MLPs report net losses (due to high depreciation expenses), but still produce substantial cash flow. I also note whether distributions are paid from operations and not from debt or equity offerings.
- Conservative balance sheet. In a weak economy, companies that have high debt levels and looming debt maturities are the most risky. For this reason, I prefer MLPs with modest debt. I also check whether the MLP is complying with all debt covenants, since a default can negatively affect the distribution.
- Frequent increases in the distribution. There's no better predictor of MLP safety and future growth than a consistently rising payout. I also look for strong re-investment in the business.
With this in mind, here are three MLPs that warrant high scores for safety and distribution growth. Like the majority of MLPs, all three of them store and transport oil and natural gas...
1. Plains All American Pipeline L.P. (NYSE: PAA)
Plains owns a diversified portfolio of pipelines, terminals and processing facilities that move energy between Canada and the United States. The MLP transports roughly 3 million barrels of crude oil, refined product and liquefied petroleum gas a day. Plains has a $14 billion market value and ranks 87 among Fortune 500 companies.
In 2011, Plains spent more than $3 billion for acquisitions and is on track to complete nearly $1 billion of expansion projects by the end of 2012. In addition, Plains recently closed the $1.7 billion purchase of BP's Canadian natural gas liquids (NGL) business. The effect of all this is apparent in distributable cash flow, which rose in the first six months of 2012 to $732 million, up 47% from a year earlier. That was enough to cover the distribution payments of $328 million more than twice over.
Since its IPO 14 years ago, Plains has returned 19% annually and raised the distribution 137%, including an 8.4% increase in August to a $4.26 annual rate.
2. Enterprise Products Partners L.P. (NYSE: EPD)
This MLP is the largest publicly-traded energy partnership in the United States and ranks 62 among Fortune 500 companies. Enterprise owns pipelines and processing facilities that transport natural gas, natural gas liquids (NGLs), crude oil, refined products and petrochemicals. Enterprise shares are up more than 13% year-to-date and 15 of the 17 analysts covering it rate this MLP a "buy."
Enterprise is taking advantage of increasing global demand for plastics by building the world's largest polymer-grade propylene (PGP) production facility. PGP is the petrochemical feedstock used in plastics manufacturing. This facility is scheduled to become operational by 2015 and Enterprise has already pre-sold 75% of the plant's capacity under long-term, fee-based contracts.
This MLP's distributable cash flow improved 70% to $2.5 billion in the first six months of 2012 from a year earlier and provided 2.3 times coverage of the distribution. Long-term debt is conservative at $13.3 billion and roughly 51% of capitalization.
Enterprise has grown its distribution 8% a year since its 1998 IPO. The last increase was 5% in June to a $2.54 annual rate, marking 32 consecutive quarters of distribution growth.
3. Magellan Midstream Partners L.P. (NYSE: MMP)
Magellan owns the nation's longest refined petroleum products pipeline. In the past decade, it has invested nearly $2.5 billion in acquisitions and joint ventures to expand its system. Most recently, it announced a joint venture with Occidental Petroleum (NYSE: OXY) to build a 400-mile long oil pipeline, with plans to spend $500 million on growth projects during 2012.
Completed projects contributed to 11% growth in distributable cash flow to $260 million during the first six months of 2012. Coverage of the distribution was generous at 140%. Long-term debt is a bit high at $2.1 billion, but still manageable at 57% of capitalization.
Distributions have grown 259% since its 2006 IPO and Magellan raised payout by 12% in June to a $3.77 annual rate. Management targets 18% distribution growth for 2012 or double its previous 9% growth target, and another 10% hike in 2013.
Risks to consider: Most of the typical MLP distribution is classified as a return of investment, rather than income, so you don't pay taxes on that portion until you sell your units. But when you do sell, they'll be taxed at the ordinary income rate, not as capital gains. In addition, MLPs require special tax forms. MLPs that operate in more than one state (and most do) are usually subject to different tax regulations in each of them. Seeking advice from a tax professional is generally a good idea with MLPs.
Action to take --> For distribution safety, it's hard to beat Plains or Enterprise. These MLPs have provided exceptional long-term returns, fueled by consistently rising distributions. Magellan is a bit riskier due to its relatively short history and greater financial leverage, but still a strong choice for investors seeking higher rates of distribution growth.