It’s a good time to update the valuation for one of my favorite sectors for income investors and retirees, MLPs. MLPs had another great year in 2011, especially during Q4. The sector returned 14% for the year vs 2% for the SP500. I’ll spare everyone the suspense buildup of the next 600 words or so and say that I think that the sector is slightly overvalued on a short term basis but many individual MLP names are offering good value. On a longer term view the sector is still very compelling. As I write this on Jan 13, 2012 there is a bit of a sell off going on in MLPs so far in Jan which I think is quite a healthy thing and will most likely present some good entry points for investors looking to add funds to this sector. Lets look at some details of MLP valuation right now.
Overall, the best relative valuation metric for the MLP sector is its yield spread to the 10 year treasury. I’ve shown this chart many times in the income investor dashboard. Here is the MLP spread and also the ones for investment grade bonds and for high yield bonds, two sectors that often compete for funds with MLPs.
These charts show the MLPs still offer a good value relative to their historical values and relative to corporate and high yield bonds. On a short term basis however the sector look a bit frothy. Lets look at a recent chart of AMJ, the main MLP ETF.
As the AMJ chart shows. MLPs have had quite a run from the Oct 2011 lows. A pull back is well in order. I would love to see a pull back to at least the 50 day SMA or the lower bollinger band. Even a pull back to the 200 day SMA would not be a shock but I think its unlikely in the current environment.
Just like the overall market I don’t invest in the MLP index. I think individual MLP names are much better investments than the index. In individual names the stories of value can be quite different. For example, in 2011 the best MLP performer was EVEP with a gain of over 70% while the worst performer was NKA with a loss of over 50%. I like to use the magic formula to value any income investment. Basically, I rank investments on total return and calculate total return as the sum of the current dividend plus dividend growth. I’ve done this for a list of MLPs that I follow. See below. The dividend growth numbers come mostly from the companies themselves and in some cases analyst estimates in cases where the companies don’t provide estimates. Right now the general partners of the MLPs are offering better value than the limited partner shares.
Based on this type of analysis I rotated some of my MLP holdings in Q4 of last year. I sold KMP and rotated into KMI and I also sold ETP and rotated into some ETE and also initiated a position in WMB and VNR. All else being equal I’m always looking for higher total returns. There are always key individual situations in each company that can provide investors even better investments than that suggested by total return forecasts alone. For example, I chose KMI because the pending acquisition of EP is going to provide an even better dividend boost this year than forecasted. I chose WMB because of the spinoff value of WPX plus I think they’re sandbagging their long term forecasts. And finally I chose VNR also because I think growth will be much better than expected as they grow their market cap via future acquisitions.
In summary, in the short term MLP valuation appears over extended but the sector offers good long term value and very solid fundamentals. General Partners also appear to be offering better value than the limited partner counterparts.
Disclosure: long EPD, KMI, VNR
13 Comments
J Carroll · January 14, 2012 at 8:50 am
Paul, I also did the KMP/KMI comparison, but, being about 20 years older than you, decided to stay with KMP for the higher current yield. Wonder if you could comment on the age break-point where one values current income over income growth potential? Thanks.
libertatemamo · January 14, 2012 at 11:35 am
Hey J, good question but a tough one. I think its a highly individual decision. But I’ll tell you how I think about it. For me, if I’m reinvesting dividends then the decision on which investment to choose is primarily based on total returns, div yield + growth. In my model, my income for the year comes from other sources, the cash/trading account, bond investments etc… the power of compounded dividends is so strong that I try to maximize that as much as I can. Also, that dividend growth can really power future wealth, tax implications are less, etc…
On the other hand, if I HAD TO live off the dividend stream then the consideration is completely different. I would need a minimum yield to make ends meet so current yield is a critical parameter that I would have to consider. Its not so much an age thing then but more so how your investments are structured and your outlook.
My 2 cents anyway. By the way, did you go with KMP over KMR because you’re not reinvesting dividends?
Paul
J Carroll · January 14, 2012 at 12:36 pm
Thanks for the response. I do not reinvest dividends directly back into the stocks from which they came; however, I have not yet started “harvesting” from my portfolio and, therefore, currently buy shares of something–usually a dividend producing stock, which may be an MLP–when the cash position gets higher than I want. I plan to start “harvesting” within the next few years. I have shied away from KMR because, in order to “harvest” KMR, one has to sell. My intention with MLPs is to never sell due to the tax complications, and just let the shares be a part of my legacy which my heirs can then sell with no tax considerations at all. Interesting, and in spite of my intention to never sell an MLP, I lightened up my position in NRGY this past year (first sell of any MLP); if the tax calculation from this sell is not too bad, I may reconsider my position regarding KMR.
libertatemamo · January 15, 2012 at 9:10 am
Makes sense for your approach. Another options for the div yield vs div growth choice is to build a base portfolio of div yielders to satisfy your income needs and once that base is met start investing in higher div growth stocks to build future wealth.
Paul
Tony · January 16, 2012 at 9:38 am
Paul,
What do you think about the falling natural gas price may have on some of the MLPs? The productions would eventually have to be cut back; and as a result, the growth for upsteam and even some midstream may be negatively impected (may be for EPD?). What would the falling gas price impect the building and transfering (selling) of the midstream pipelines?
libertatemamo · January 16, 2012 at 9:08 pm
Tony, falling nat gas prices have had little effect on most MLPs. The only ones that have been affected are those that have natural gas storage businesses, predominantly NKA which is down 56% in the past year. Others can handle this drop just fine. ETP has been affected by lower nat gas prices for over 2 years and has never cut their distribution. MLPs that have nat gas pipelines are paid mainly on volumes not commodity prices and most contracts are long term and many are take or pay type contracts. They would only be marginally affected. I would look at EPB’s earnings for more info on this. Upstream MLPs like LINE are more exposed but they have big hedge portfolios that mitigate. I recommend looking at LINE or VNR’s presentation if you’re curious about how these MLPs would be affected by lower nat gas prices. These guys are just fine even with nat gas down to $2 or less.
In general, midstream MLPs have a variety of businesses, not just nat gas transportation and many of those businesses generate more money as nat gas prices go down, for example nat gas processing, ethane production, etc.. For example. lower nat gas prices have been a huge benefit for EPD. They are printing money in this environment. Also, the NGL businesses for many midstream MLPs are going gangbusters. Watch when they report earnings.
In short, MLPs are not very affected by lower nat gas prices and many are benefiting from it.
Paul
Tony · January 17, 2012 at 1:30 pm
Paul,
Thanks for the thoughtful reply.
Actually I am more concern about the expected grwoth for some MLPs relating to the falling gas prices. As the prices falls sharply, the drilling for shale gas would eventually have to be cut back until the price rises again. As a result, fewer pipelines would be constructed and the growth expectations for some MLPs eventually have to be lowered.
Besides, the gas price hedge for MLPs will eventually expire, but their impect on earnings depends on how long the gas price stays very low.
libertatemamo · January 17, 2012 at 5:18 pm
Tony, for a few MLPs, like LINE yes. But MLPs also have huge and growing oil, and NGL businesses (NGL prices are tied to oil, not nat gas) and all other kinds of businesses that are not tied to nat gas prices. Your concern would only be an issue for the portions of businesses that are pure nat gas production and nat gas storage and marketing businesses. Like I said before, nat gas transport businesses are under fee based contracts tied to volume, not price.
To paraphrase something they say in the commodity business, the solution to low nat gas prices is low nat gas prices. What that means is that on one side, while the E&P companies are shutting production due to low prices, the low prices are stimulating demand as nat gas becomes a more preferred fuel vs coal, oil, etc…
That brings supply and demand back in line.
We’re about to start MLP earnings season tomorrow when KMP announces earnings. Listen to the calls, I’m sure the issue of low nat gas prices will be raised.
Paul
Don · January 17, 2012 at 7:18 pm
Paul, First, thank you for sharing your investment expertise.
Investors Business Daily had an article last Friday about MLPs. It mentioned the advisability of knowing how they pay their dividends/distributions since it could have a real impact on whether that income is treated at a lower income tax rate or an ordinary income tax rate.
The article specifically mentioned the difference between individual MLP’s issuring K-1’s and ETN’s distributions being taxed at ordinary income tax rates and ETF’s being taxed at the 15% rate.
Do you have any comments about this?
Don
libertatemamo · January 17, 2012 at 8:39 pm
Hey Don, thank for the comment. This is a great and very important question for MLP investors. I covered this topic in detail a while back. See this post.
Basically, owning the individual MLPs is far superior to owning the MLP ETFs. Let me know if you have other questions after reading the post.
Paul
Bart · February 3, 2012 at 10:22 am
Paul,
Have you done much work on ATLS/APL and the soon to be spun-off E&P MLP from ATLS? ATLS IDR’s are about to be fully in-the-money on APL. ATLS is transforming itself to a pure play GP MLP once the E&P spin-off occurs. ATLS just announced a $0.24 quarterly distribution with 1.6X DCF coverage. ATLS has stated it will go closer to 1.0X coverage once pure play GP.
The E&P MLP is interesting, even in a low NG price environment. Imbedded in the E&P business model is a long-standing syndication operation where much of the risk is shifted to investors and the MLP earns fees on fund raising, fees on drilling and fees on production.
Interestingly, if you look at the organic projects coming on line at APL and syndication plans, once can see a path to a $3.00 or more annual distribution at ATLS over next 3 years from just under $1.00 today………
libertatemamo · February 4, 2012 at 8:24 am
Hey Bart, good timing. ATLS/APL had fallen off my radar for a while but their Dec presentation at an MLP conference peeked my interest again. For the short term I would call this a special situation (like the recent WPX spinoff from WMB), due to the spinoff, which often presents a great opportunity to make money in the short term. In these case I like to look at the value creation of the spinoff and the long term potential of the business separately. Just with a cursory look an investment in ATLS could be interesting much more so than owning the LPs. I’m going to dig into this in more detail. They need to do this spinoff. Investors don’t really want to own a combination of an E&P and a more traditional midstream GP. You can buy each type separately in the market.
I like some of the E&P MLPs. I won VNR. They’re undervalued right now and have great yields. In the liquids space similar to what ATLS seems to be going after, I really like TRGP and NGLS.
Paul
David Fleischer · May 8, 2012 at 6:01 pm
Hi Paul,
It’s been a while… hope all is well.
David
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