MY FAVORITE BORING INDUSTRY
is suddenly trendy. For nearly 10 years I have been pointing out the appeal of oddball securities called master limited partnerships. They have unusually high yields around 6% today and impressive growth prospects since payouts can increase by 8% annually. That income is even more attractive given the special tax advantages of MLPs. And because they don't track the overall market, they're wonderful risk reducers for any portfolio.
Readers who shared my enthusiasm are happy indeed: Over the past 20 years, pipeline MLPs have consistently outperformed the Standard & Poor's 500 often by 2 to 1. And the gains just keep coming: In 2004, total returns for MLPs were 23%, while the S&P 500 was up 11%. Despite rising interest rates, this year MLPs are still beating the market.
The charm of MLPs used to be threefold: They were difficult to understand, institutions couldn't own them, and brokers were nervous about selling them. Those obstacles are eroding. Four new closed-end funds eliminate the tax complications that used to scare off many MLP investors. The funds have attracted nearly $2 billion and trade at a rare premium to net asset value. What's more, last October, Congress made it possible for conventional mutual funds to own MLPs.
Investors are piling on. Hiland Partners, an unremarkable natural gas gathering system in Oklahoma, went public in February at $22. Shares jumped 30% in a month. In early March, more than 500 people showed up at an MLP investment conference in New York. Women from hedge funds clicked away on BlackBerrys, and I sat next to a guy who runs money for Paul Allen. Over cocktails, I met a would-be mogul who leases space on a pipeline from Texas to Mexico. He got into MLPs after a stint selling tennis shoes in Russia.
You never make big money buying what other people are eager to own, so the salad days of MLPs may be gone. But being in the spotlight isn't all bad. Over time, all the new interest is likely to push MLP yields down closer to the 4 or 5% payouts on REITs and utilities. That adjustment (similar to a stock getting a higher P/E multiple) should make MLPs a safe haven as interest rates rise.
In what follows, I'll tell you about my favorite partnerships. I'll also explain closed-end MLP funds. But first, a brief review. The law allows certain companies, mostly in the energy sector, to operate as publicly traded partnerships. They have exchange listings, just like normal corporations, but they pay no taxes and pass along income (or losses) directly to investors known as limited partners.
MLPs maximize their tax advantages by owning long-lived assets that generate lots of depreciation-mostly long-distance pipelines, but also riskier things like gathering systems (pipe that connects to wells), storage tanks, even barges. Partnerships also pay out nearly all of their cash flow. But thanks to those depreciating assets, most of these distributions are considered a return of capital. That means you generally aren't taxed on MLP payouts until you sell, or until your total income exceeds your initial investment.
Tax breaks are neat, but not a reason to own MLPs. The attraction is their unusual mix of income, safety and growth. Pipelines are fee-for-service businesses. There are long-term contracts and long-lived assets. Commodity risk is minimal. Kinder Morgan, for example, gets $1.35 to move a barrel of gasoline to Phoenix from Los Angeles regardless of whether oil prices are $25 or $50.
Internal growth is modest-what with rate increases and incremental demand, maybe 2 or 3% a year. But it's possible to boost payouts much more quickly by making acquisitions. Consider the numbers: The cost of capital for most MLPs (what they need to pay to raise money by selling bonds and issuing stock) is under 7%. Midstream energy assets such as pipelines and storage tanks, meanwhile, sell at prices that provide operating yields of 10 or 12%.
|Master limited partnerships offer high yields, dividend growth and tax advantages.|
|Partnership (Ticker)||Principal Assets||Price
|General Partner (Split)**|
|Gathering, pipeline, propane||32.05||33-18||5.5||Management, Investors (50)|
|Diversified||27.01||28-20||5.9||Dan Duncan (25)|
|Propane||33.75||34-21||5.6||Management, IPO Filed (50)|
|Pipelines, CO2, terminals||43.58||44-33||6.8***||Public Company, Ticker KMI (50)|
|Oil pipelines, terminals||39.62||41-30||6.2||Management, Paul Allen (25)****|
|Prices as of 3/4/05.
* Consensus estimate for the next three to five years.
** Split is the percentage of incremental earnings paid to the general partner.
*** Dividend payable is stock, not cash.
**** Current split is 25%; maximum is 50%.
DATA: COMPANY REPORTS; RESEARCH WIZARD 4.0 FROM ZACKS INVESTMENT RESEARCH
That's a fat opportunity gap, which exists for two reasons. Since their payouts are tax-exempt, MLPs can raise money cheaply. And the sellers, mostly integrated energy companies that have used up their depreciation, want to invest in other things like drilling new wells.
Total MLP assets are around $50 billion, barely 20% of the property that could be converted to MLPs. So moderate growth could continue for decades. Since MLPs distribute so much cash, they need to borrow and sell new shares in order to make an acquisition. This gives outside investors de facto veto power on every deal. So far knock on pipe that discipline has kept MLPs from overpaying.
MLPs are set up so that a general partner manages the business and may own as little as 2% of the partnership. Initially, partners were big energy companies that created MLPs when they sold off assets. But now outside investors (Paul Allen, Carlyle Group, Lehman Brothers) have moved in. The take, known as a "split," can be as high as 50%. Lower is better because high splits raise the cost of capital, making it harder for a partnership to grow but not impossible. Kinder Morgan's payout has tripled since it began paying 50% splits in 1998.
The MLPs in my table look particularly attractive. In January, Energy Transfer acquired a Texas pipeline with a choice position in a booming natural gas reservation. Enterprise, where Dan Duncan has a near-40% stake, just cemented a merger with pipeline owner Gulf Terra, making it the most thoroughly integrated MLP. Plains, meanwhile, links oil producers in the Gulf and Canada with midwestern consumers. It also has little floating-rate debt, a plus if interest rates move higher. Inergy is a propane distributor. That's a risky, seasonal business. But it's the industry's class act, making smart acquisitions. The company is also shopping for a pipeline, potentially a transforming deal.
|For Fund Investors|
|Access to MLPs without the tax confusion.|
|Fund (Ticker)||Share Price||Premium to NAV (%)||Yield
|IPO Date||Offer Price ($)|
|Prices as of 3/4/05.
Given its record, you'd think Kinder Morgan would command a premium. But investors worry about CO2 operations (squeezing oil out of old wells in the San Juan Basin), which account for 20% of profits. This brings exposure to energy prices. Kinder, however, protects itself with financial instruments known as hedges. Note, too, that I prefer Kinder Morgan Management, which pays dividends in the form of stock and trades at a discount to Kinder Morgan Partners.
Closed-end MLP funds offer diversification and professional management plus two extras. Investors get the tax deferral of an MLP, but receive plain-vanilla dividends. So on Apr. 15 there's a familiar 1099 form, not the more complicated partnership K-1 schedule. That means the funds also qualify for tax-exempt IRA and 401(k) accounts.
Because MLP funds pay taxes, they should yield less than a do-it-yourself MLP portfolio. But, like closed-end bond funds, the MLP funds try to offset that disadvantage by borrowing to leverage their assets. They can also invest in private placements and other nonpublic obligations.
It's hard to differentiate this early in the game. But the table includes my take on each fund's style. Tortoise seems the most conservative. It was the first MLP fund, the brainchild of David Schulte, whose Overland Park, Kan., investment company has nearly two decades of MLP experience. The Kayne Anderson fund also has seasoned managers. But they're from Wall Street, with a more aggressive strategy (and incentive fees to match). Fiduciary Asset Management in St. Louis runs the two middle-ground funds. James Cunnane, the strategist there, learned the ropes handling MLP accounts for wealthy individuals.
Final tips: MLP Web sites are worth perusing, as is www.ptpcoalition.org. And watch the difference between the price of an MLP fund and the net asset value. I get nervous if the premium gets much past 10%. To see the NAV, type the ticker symbol into the stock quote box in a financial Web site, then insert an "X" before and after the ticker. Not all sites offer this function, but one that does is finance.yahoo.com.