Its Cash Runneth Over

10/05/2009 12:30 pm EST


Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst David Rodziewicz say master limited partnerships can be great investments for some people, and they recommend a gas pipeline operator.

For those who can and do own master limited partnerships (MLPs), break out the champagne!

As of this writing, the Alerian MLP Index had returned just shy of 50% thus far in 2009. The combined 2008–09 return for this sector is still down 5.4%, but the back-to-back result is still the best for any broad group of income-oriented equities.

How can MLPs go on generating superior returns year after year? Part of the credit goes to the steady cash flows and resilient returns on capital these predominantly fee-based businesses generate. Compared to other high-yielding areas of the market, distribution cuts have been quite rare.

We have a class of equity investments with constrained demand—their tax characteristics are impractical for mutual funds and other institutional investors, and they shouldn’t be owned in tax-deferred accounts (a huge portion of the capital Americans hold in the stock market).

At the same time, MLPs don’t pay income taxes. This allows MLPs to generate after-tax returns just as high [as] or higher than other types of businesses can. For taxable money, and where the additional income and total return offered by these partnerships can provide adequate compensation for the additional tax-filing burdens, I think they provide great value.

In our view, [MLP] Energy Transfer Partners (NYSE: ETP) operates one of the best natural gas transportation systems in the industry, with strong growth prospects, generous cash distributions, and good cash-flow growth visibility.

At the heart of Energy Transfer’s operations is the company’s Texas intrastate pipeline system. The scale of the system allows Energy Transfer to offer competitive shipping rates, save on fuel and operating costs, and arbitrage gas pricing across its system. Moreover, significant investment over the past several years in large-diameter pipe to provide takeaway capacity for the Barnett Shale and East Texas gas plays has resulted in staggering cash-flow growth.

We’d like to see Energy Transfer bring its debt/capital down closer to 50%, from 2008’s 61%. But given the company’s liquidity position, leverage, and coverage ratios, we continue to think Energy Transfer is among the healthiest MLPs. Management targets cash-flow coverage for partner distributions at 1.1x, a level we find appropriate.

We project double-digit revenue and earnings growth during the next five years, building off a solid asset base that is the product of acquisitions and internal projects. New equity issues and general-partner incentive payments will dilute the growth rate attributable to Energy Transfer’s high-yielding limited units, but we still see per-unit payouts rising an average of 6.5% annually over the next five years.

Energy Transfer’s combination of high current yield and solid growth indicates annual total return potential in the mid-teens over the next several years. (It closed below $42 Friday—Editor.)

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