In my last post I described what I consider the worst case scenario for MLPs in the event that their tax favored status ends overnight. Today I want to look at a few of the upsides of such an event. Yes, I do think there are upsides to ending the MLP tax favored status. I can think of four upsides right away; incremental share demand, potential higher valuations, expanded business opportunities, and pricing power. Lets look at each of these possibilities.
While the MLP sector has enjoyed strong and increasing investor demand over the years the tax complications and tax risk has kept many investors away. An ending of the tax break for MLPs would lead to a large incremental demand for shares from several sources. First, many individual investors simply don’t want to deal with the tax complications of K-1 filings or take the risk that the tax advantage goes away thereby hammering share prices. Also, besides a few special share classes, also for tax reasons (UBTI income) MLPs are not suitable investments for retirement accounts. On the institutional side, mutual funds and pension funds, are not large owners of MLPs for similar reasons to those of individual investors. And lastly, no MLPs are included in any of the major indexes like the S&P500. They are not allowed to be. All of these would be the source of incremental share demand for the MLPs, especially the large caps. For example, consider ETP or KMP. ETP has a market cap of $34B and KMP has one of $22B. For the S&P500 index the average market cap is $23B. ETP and KMP would be candidates for the index after the tax change. Choosing an example mid tier S&P500 company, CHK, lets look at the volume of shares traded. CHK has a market cap of $17.8B and its average daily volume is 10.5 million shares. ETP and KMP, with larger market caps, have average daily volumes of 1.3M shares and 0.75M shares respectively. After a tax change, as normal operating companies, EPD and KMP could be added to the index. Needless to say this would lead to more demand for shares in the companies. In short, incremental demand from individuals, institutions, and potentially indexes would be a positive catalyst for MLP post a tax change.
The next potential upside for MLPs post a tax change is higher valuations. The tax complications and risk keep a lid on valuations. The best comparison I can make to MLPs is the utility sector. The company structures, stability of cash flows and dividends, and regulatory environment are very similar. Taking a look at the utility sector, using the utility sector ETF, XLU, we can compare valuations to the MLP sector. The XLU trades at a dividend yield of about 4% and the MLP sector, using AMZ, trades at a yield of about 6%. That’s about a 33% premium for XLU vs AMZ. That’s remarkably similar to the US corporate tax rate of 35%. Coincidence? Maybe but probably not. Post a tax change MLPs would most likely trade at higher valuations than they do today, a big reason of which would be the incremental share demand I described in the first paragraph.
A third potential upside for MLPs from a tax change would be potential new business opportunities. Today, to qualify for MLP status MLPs are limited to businesses that have to do only with energy and energy infrastructure. With an end to the MLP tax status MLPs could potentially pursue other types of infrastructure projects. For example, several MLPs have expressed interest in pursuing water pipelines. And a few have even sought regulatory approval for water pipelines that are related to energy projects.
The last potential upside is the pricing power that MLPs have. Actually, I think this is more of a mitigating factor. One of the core strengths of MLPs is their economic moats. Because of the huge upfront capital investments and lead times required to build energy infrastructure MLPs are able to enter long term contracts, 10-20 years, with their customers. Also, these contracts tend to be predominantly fee based and not subject to commodity price movements. This dynamic leads to strong competitive positions – once a $1B pipeline is built someone is not going to come along and build another $1B pipeline right next to it to compete. In the event of a tax change, where the economic returns of projects go down suddenly, the MLPs would be in a position to renegotiate the contracts with their customers. The impact of the tax change would not just be born by the MLPs but also by their customers, the energy exploration and development companies. I’m not saying the MLPs could make up all the impact but they could certainly offset some of it.
In summary, there are some potential upside catalysts to an MLP tax change. While there is no doubt that in the short term such a change would be painful to existing shareholders it is not all bad. I showed in my previous post, the downside impact is not as bad as it appears on the surface and here I describe a few potential positives from such a change. I don’t think such a tax change is a risk anytime soon, probably not until late 2013 at the earliest, and even then it is only a small risk. But its always good to be prepared and think about the potential consequences of such an event.
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