The Case for MLPs and the Top Sector Bet

03/28/2019 5:00 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

In August 2014, the Alerian Master Limited Partnerships (MLP) Index hit an all-time high of 540 and change. Fueled by the US shale oil and gas boom, that left this cap-weighted index of energy infrastructure companies up 409 percent from their November 2008 low point, recalls Roger Conrad, editor of Deep Dive Investing

The index is still 54 percent below those summer 2014 highs. Given the magnitude of those losses and the corresponding dividend cuts, it’s hardly surprising that MLPs are as unpopular now as they were in demand at their peak.

And with some general partners attempting to "roll-up" their affiliates, the conventional wisdom is the sector is dead money. That’s a mistake for several reasons: 

MLPs have posted strong share gains so far this year. The Alerian has returned better than 15 percent year-to-date, its hottest start in this now 10-year-old bull market. Gains have followed recovering oil prices, which have caused energy stocks to rally up and down the value chain.

MLPs have undergone a major business transformation since mid-2014. The biggest change is many are self-funding the equity portion of capital spending. That’s a huge contrast with the group’s historical reliance on selling stock to finance pipelines and other projects. And having enough cash on hand to fund distributions as well as capital spending insulates growth plans from volatile capital markets. 

The business environment for MLPs has vastly improved.  Contracts with shale producers are still the midstream sector’s bread and butter. But the economics of the leading companies are now solid, as the strongest have cut costs effectively and weaker players have been weeded out.

At the same time, surging US energy exports have greatly increased demand for transportation and processing capacity. That’s created a massive investment opportunity to spur MLPs’ growth. 

MLPs’ unpopularity means even the best are trading close to their lowest valuations this cycle. The Alerian MLP Index yields nearly 8 percent and has an Enterprise Value-to-EBITDA ratio of 9.3 times. Those same numbers at the end of 2014 were 5.9 percent and 14.7 times, the latter a discount of around 40 percent. 

Even the strongest MLPs trade at far lower prices than they did at their peaks. Enterprise Products Partners (EPD), for example, yields north of 6 percent and has an enterprise value of less than 12 times EBITDA. That compares to 3.5 percent and 20 times at the shares’ late 2014 peak. 

The great irony is as Enterprise’s shares have lagged, the MLP has successfully executed on the most ambitious US energy midstream expansion in history. Management has focused the past several years on building a vast network of assets to facilitate America’s burgeoning exports of oil, gas and natural gas liquids.

Current projects in progress total $6.7 billion. That includes a converted gas-to-oil pipeline that will come into service in April, carrying oil from the Permian Basin of West Texas to the Gulf Coast until 10-year contracts. 

Two years ago, Enterprise reduced its annual distribution growth rate from roughly 5 percent to about 2.5 percent. Coupled with fee-based cash flows from asset expansion, the savings produced a 155 percent increase in 2018 retained cash flow, enabling management to avoid issuing new shares. In fact, the MLP has announced a $2 billion share buyback, a move that will further increase retained cash flow. 

2018 distributable cash flow increased 33 percent to a record $6 billion. Distribution coverage for the fourth quarter was 1.7 times distributions, up from a solid 1.4 times a year ago.

Enterprise has also guided to a 50 percent increase in 2019 free cash flow, as five new projects come on stream and share buybacks kick in. Debt-to-EBITDA is now down to just 3.5 times, earning the MLP a sector-high BBB+ rating from S&P. 

I do think that a self-funding equity model is absurdly conservative for an industry that measures the lives of assets and contracts in decades. But following one, means Enterprise will be able to execute its growth plan, no matter how hostile capital markets become this year. 

That also means limited risk to its 6 percent plus yield and low single digit payout growth rate, which is likely to be ramped up by 2020. And it doesn’t hurt that Enterprise’s assets and operations are almost wholly focused in US states that are friendly to the oil and gas sector, especially Texas and Louisiana. 

If I had to recommend just one MLP suitable for the most conservative income investor it would be Enterprise, particularly at a price more than 30 percent below its 2014 high.

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