By Brian Nelson, CFA
We understand that to many dividend growth investors the dividend/distribution isn’t everything–it is the only thing. That’s why we spend a considerable amount of time assessing the health and growth potential of dividends/distributions. To us, a master limited partnership’s (MLP) distribution is inherently risky. One of my former colleagues at Morningstar, Jason Stevens, emphasized in an April 2013 research piece on the group what Valuentum has been telling investors for a while:
Another implication of MLP distribution policies that is important to understand is the impact of high distribution payouts on MLPs’ capital spending. Unlike corporations, which can use retained earnings and excess cash for growth purposes, MLPs retain very little of the cash generated each quarter, requiring MLPs to go hat in hand to the capital markets in order to raise cash for new investment. This forces a measure of capital discipline on management teams, as the market is unlikely to subscribe to debt and equity offerings for MLPs that fail to create value. It also means that MLPs virtually require capital market access to grow.
At the core, for an MLP’s distribution to be sustained and to grow, the market must continually fund the firm with new capital (equity or debt). This is why in every one of the 16-page reports of an MLP on our website, you’ll see us highlighting that an MLP is inherently dependent on the capital markets.
In the event of a credit crunch or in a situation where new capital is not available—think Boardwalk Pipeline (BWP)—an MLP’s distribution will face pressure (if not taken off the table altogether). Our job at Valuentum is not to frighten you about your investments; it is to make sure that you are aware of not only the opportunities—but also the risks behind them. An informed investor is simply a better investor.
As it relates to Energy Transfer Partners (ETP), a holding in the Dividend Growth portfolio, we spend a lot of our time looking at the MLP’s distribution coverage ratio (at the bottom of the table below). The distribution coverage ratio is a lot like Valuentum’s Dividend Cushion ratio in that it looks at cash flow coverage of a firm’s distribution. The Dividend Cushion ratio, however, expands the analysis to consider a firm’s net debt/cash position and, for MLPs in particular, future equity issuance (which is a core component of an MLP’s business model)–as access to the capital markets is critical.
In Energy Transfer Partners’ case, the distribution coverage ratio expanded to 1.10x in the second quarter from 1.03x in the same period a year ago. Similar to how one might interpret the Dividend Cushion ratio, the higher the ratio above 1, the better.
Image Source: Energy Transfer Partners
Valuentum’s Take
We think that for investors to take on the risk of MLPs, a good mix of corporates should also be included in the portfolio. The systematic credit risk of a portfolio of only high-yielding MLPs and REITs—both structures inextricably tied to the health of the capital markets—is very high and borderline imprudent.
In the event where capital markets face challenges, we would expect the price of MLPs and REITs to face considerable pressure as higher discount rates are applied to their respective future free cash flow streams. Such an assessment excludes the perhaps more ominous concept of interest-rate risk. As the nominal interest rate of fixed-income investments approaches the distribution yield of many MLPs and REITs, we would expect shares of MLPs and REITs to sell off to more appropriately price such risks of their operations (and the option of pursuing alternative equally-yielding or even higher-yielding investment vehicles).
All things considered, we’re not expecting a scenario that would systematically challenge the business structures of MLPs and REITs anytime soon. However, the very real scenario of Boardwalk Pipeline should highlight that the risks of MLPs are not to be taken lightly. For us, we’re comfortable holding Energy Transfer Partners in a diversified Dividend Growth portfolio of high-yielding corporates. The MLP’s distributable coverage ratio of 1.10x is solid. Kinder Morgan Energy Partners (KMP) is another MLP we hold in the Dividend Growth portfolio. These are two MLPs that we’re willing to take on the risk of their respective business structures to capture the elevated yield. At the time of this writing, Energy Transfer Partners yields 6.6% while Kinder Morgan Energy Partners yields 6.9%.
Appendix: Understanding Various Measures of Cash Flow
Free cash flow to the firm (FCFF) or enterprise cash flow: the estimated cash flows that accrue to all stakeholders (equity + debt + preferred). The measure equals earnings before interest (EBI) less net new investment NNI). Total debt and total preferred is subtracted from the present value of future enterprise cash flows (FCFF) to arrive at total equity value. Free cash flow to the firm is a measure calculated for equity valuation purposes. Free cash flow to the firm includes cash generated organically for future investment purposes, cash generated that is stored on the balance sheet, cash paid for interest and on preferred dividends, and cash returned to shareholders in the form of dividends and share buybacks.
Cash flow from operations (CFO, OCF): This is an accounting item found on the cash flow statement. It is typically calculated by adding depreciation and amortization to net income and accounting for changes in working capital. Cash flow from operations is the source of cash earnings of the company. Total capital expenditures (maintenance + growth), found in the cash from investing section on the cash flow statement, are subtracted from cash flow from operations to arrive at traditional free cash flow (FCF).
Free cash flow (FCF): Cash flow from operations less total capital expenditures (maintenance + growth). This is a non-GAAP measure that is followed by most analysts and presented by most management teams within press releases and corporate presentations. This is a great short-hand measure to assess free cash flow conversion, earnings quality, free cash flow yield, and a variety of other analytical considerations. For general corporates, dividends are paid with free cash flow (or from cash held on the balance sheet in periods where free-cash-flow shortfalls occur).
Distributable Cash Flow (DCF): This is found in MLP structures and is typically calculated as cash flow from operations less maintenance (sustaining) capital expenditures. MLPs typically use distributable cash flow in the numerator of the distribution coverage ratios they publish. Distributable cash flow is subject to a variety of estimates regarding sustaining capital expenditures and is not a complete measure of free cash flow as it does not consider the growth capital expenditures that are used to drive future expansion in cash flow from operations.
Discounted Cash Flows (DCF): Though sharing the same abbreviations as distributable cash flow (immediately above), the measures are completely different. Discounted cash flows represent the present value (discounted) enterprise free cash flows (FCFF) of an entity and are summed up to derive, in part, the total value of the equity of a firm. Discounted cash flows are not found anywhere else, except within the valuation context of a firm.
Note: For master limited partnerships–which generate 90% or more of their income from activities related to the production, processing and transportation of oil, natural gas and coal–investors should be cognizant that they have different tax consequences for different investors, so please be sure that you are aware of such items.