Beat the New Tax Increases With These 3 MLPs

Wednesday, January 30, 2013 - 4:00am

by Lisa Springer

Because of new higher tax rates on dividends and capital gains for upper-bracket earners this year, it's more important than ever to choose investments that are worth holding for the long-term and that grow their dividends. The best way to offset the negative effects of these new tax hikes is through a rising dividend, which also offers inflation protection and support for the share price.

Consider the example of a stock yielding 5% with a $100 share price and $5 per-share dividend. An increase in the dividend tax rate from 15% to 20% reduces this stock's after-tax income to $4 per share from $4.25 ($5 - 20% = $4). But if the stock also grows its dividend by a 5% annual rate, then income quickly rises despite the tax hike. Within five years, this stock will be paying a $6.38 per-share dividend that yields after-tax income of $5.11. That's considerably more than the $4.25 per share of income collected initially at the 15% tax rate. 

Growth in $5 dividend climbing 5% a year

A great place to look for rising dividends is among energy master limited partnerships (MLPs). These companies typically provide energy-related services under long-term contracts that generate the reliable cash flow necessary for a growing dividend.

The strength of MLP dividends became apparent during the recession when household names such as General Electric (NYSE: GE) and Pfizer (NYSE: PFE) were forced to cut dividends. In contrast, most MLPs maintained payouts during the downturn, even as energy prices collapsed. MLPs that own midstream assets such as pipelines are especially resilient since their mostly fee-based income is largely insulated from energy price changes. 

Similar to real estate investment trusts, MLPs are required to pay at least 90% of their income as distributions to their limited partners, the unitholders. These payments are only taxable when the units are sold (ownership in an MLP is in "units" rather than shares). This is why investors should buy and hold the units for long periods or even through retirement, when retirees typically move to a lower tax bracket. [Stocks like these are what Carla Pasternak, chief investment strategist of High-Yield Investing, calls Retirement Savings Stocks.]

To pick the best MLPs for a buy-and-hold strategy, I focused on companies that have strong operating performance, consistent distribution growth and solid distribution coverage. Taking into account the new higher dividend tax rate, I gave distribution growth a larger weighting than the current yield

These three MLPs measured up on all three fronts, making them great Retirement Savings Stocks. You can buy the shares today and expect to collect a rising distribution in the future. 

1. Oneok Partners LP
Yield: 5%
Oneok Partners (NYSE: OSK) owns major natural gas liquids (NGL) pipelines that connect producers in the mid-continent and Rocky Mountain regions with end-markets in other regions. The company's pipelines carry nearly one-fifth of the gas exported from Canada to the United States
New pipeline projects that came online last year fueled a 27% year-over-year rise in Oneok's earnings per unit to $2.38 during the first nine months of 2012. EBITDA, a key cash flow metric for MLPs, improved 16% to $979.3 million in the first three quarters of 2013 from $842.1 million a year earlier. 
Oneok has another $4.2 billion of expansion projects planned through 2014, including pipelines serving the Bakken Shale, and Canadian Woodford and Granite Wash energy plays, which can drive future gains. In addition, Oneok has a $2 billion backlog of announced natural gas and NGL infrastructure projects.
This MLP has increased distributions 6% a year for five years and 20% since 2011. At present, Oneok pays an annual distribution of $2.74 a unit, yielding almost 5%. Cash flow coverage of the distribution is solid at 145%. Oneok aims to grow distributions 10-15% a year and EBITDA 17-21% annually through 2015.


2. Magellan Midstream Partners LP
Yield: 4%
Magellan Midstream Partners (NYSE: MMP) owns the longest refined petroleum pipeline in the United States, with access to more than 40% of the nation's refining capacity. The company owns more than 9,600 miles of pipeline, 50 terminals and 80 million barrels of petroleum storage capacity.
Magellan's growth will come from $1.3 billion of new investments in crude oil pipelines, particularly in the Permian Basin, where it's just beginning to tap into the Permian crude oil boom. The company's Permian assets are slated to become operational in mid-2013. 
During the trailing 12 months ended in September 2012, Magellan's earnings improved 29% to $392 million from a year earlier, while EBITDA rose 11% to $599 million from $540 million in the same period. Per-unit distributable cash flow was $2.17 and provided more than 130% distribution coverage.
Magellan has increased its distribution 43 times and at a 12% annual rate since 2001. The last increase was in January to a new annualized rate of $2 per unit, yielding about 4%. The company targets a 10% distribution growth in 2013.


3. Sunoco Logistics Partners LP
Yield: 4%
Sunoco Logistics Partners (NYSE: SXL) owns a geographically diverse portfolio of pipelines, terminals and crude oil marketing assets. The company owns 5,400 miles of crude oil pipelines located mainly in Oklahoma and Texas, terminal facilities on the Texas Gulf Coast and a 2,500-mile pipeline of refined product. Sunoco's general partner is owned by Energy Transfer Partners L.P. (NYSE: ETP).
The MLP's earnings per unit climbed 61% to $3.14 during the first nine months of 2012. EBITDA jumped 76% to $555 million from $379 million in the same period. Cash flow coverage of the distribution was impressive at 240%.
Sunoco's growth will likely be driven by new projects coming online in 2013 and 2014. These include a Permian Basin pipeline connecting West Texas producers and Gulf Coast refiners and an Allegheny pipeline linking Midwest refiners with markets in Ohio and Pennsylvania.
This fast-growing MLP has delivered six straight quarters of positive earnings surprises and 31 consecutive quarters of distribution hikes. The latest distribution increase was a 5% hike in January to a new annualized rate of $2.07 a unit yielding about 3.5%.

Risks to Consider: As I've said before, MLPs are pass-through entities that transfer profit or losses to individual unit holders, who pay taxes at their ordinary income rate. Because MLPs pay the majority of their earnings to unit holders, these companies typically rely on debt or equity financings to fund growth initiatives.

Because of depreciation, the Internal Revenue Service considers most of the MLP's distribution as a return of capital, so it's not taxed in the current year. Instead, this portion of the distribution isn't taxed until units are sold. Return of capital also reduces the cost basis in the MLP. 

Action to Take ---> My top pick for distribution growth and safety is Sunoco Logistics Partners. Magellan and Oneok are also strong picks for investors who prefer a higher yield and are willing to accept a more modest distribution growth.

P.S. -- If you're looking for a smarter, safer, and more profitable approach to income investing than you may be following now, then you need to know about Retirement Savings Stocks. Simply put, if you're looking for a second income stream for your retirement, then it's the only way to go. Find out more in this special presentation.

Lisa Springer does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.