However, like with most high-yield stock classes, MLPs have their own unique challenges when it comes to successfully investing for the long-term.
Investors can learn more about the complete list of 46 publicly traded MLP stocks here.
Differences Between MLPs and Common Dividend Stocks
The majority of MLPs operate in the oil & gas sector, particularly in the midstream space. Midstream MLPs are those that specialize in the gathering, storage, processing, and transportation of oil, gas, and refined petrochemicals.
Midstream MLPs generally derive most of their cash flow from long-term, fixed-fee contracts, which makes their cash flow far less volatile than that of regular oil & gas companies who are at the mercy of cyclical commodity prices.
However, MLPs are a special type of company known as “pass-through” entities, which means that the partnership doesn’t pay corporate taxes because it passes through its cash flow and tax obligations to unit holders. There are several other differences between MLPs and C-corps, too.
Perhaps the biggest difference is that MLPs, because they pass on the majority of their cash flow as distributions, retain very little earnings with which they can fund growth investments, such as construction of a new pipeline.
In fact, their entire business model is predicated on using the majority of cash flow to fund a generous payout (to attract investors) and then fund growth through external debt and equity issuances.
The biggest and most important differences for income investors are how MLPs are taxed and the presence of a general partner and its incentive distribution rights.
Distributions vs. Dividends – What’s The Difference?
As a result of their substantial non-cash depreciation and amortization charges, MLPs’ GAAP earnings are artificially suppressed, and the distributions paid are usually higher than earnings. Therefore, the IRS considers the majority of an MLP’s distribution a return of capital, or ROC.
Unlike qualified dividends which are taxed at 0%, 15%, or 20% rates, ROC isn’t taxed, at least not right away. That’s because the IRS considers any ROC portion of a distribution to be the equivalent of an MLP simply returning capital to investors and thus not truly income or capital gains.
The ROC portion of a distribution is outlined in the annual K-1 form that all MLPs send you at tax time. As you can see in the example below, this form can significantly increase your complexity at tax time.
However, services such as Turbotax are an easy and cost effective means of streamlining the process and generally require no more than 10 minutes per K-1.
At that point the distributions are taxed as long-term capital gains, just like qualified dividends. When you sell an MLP, then the government will recoup those deferred taxes, because your capital gain will be larger by the amount of your cumulative ROC.
For example, if you paid $10 per share for your units and received $3 per share in distributions that are classified as a return of capital, your new cost basis would be $7 per share rather than $10.
If you then sold your shares for $12 per share, your gain would be $5 per share ($12 sale price minus $7 adjusted cost basis), which captures the ROC distributions you previously received but weren’t taxed on.
Essentially, MLPs can provide potential tax advantages, including deferring distribution taxes by your total cost basis.
In fact, if you never sell your units, then when you pass on and your heirs inherit them, the cost basis will be adjusted up to the stock’s price on the day of your death.
That means that you and your family could potentially permanently defer those taxes, up to $5.6 million per individual, or $11.2 million couple. This is the most you can pass onto your heirs before the estate tax kicks in.
In other words, if you spend decades buying and holding quality MLPs, such as Enterprise Products Partners or Magellan Midstream Partners, then you could potentially avoid a mountain of taxes and leave your heirs with large and income producing inheritances.
What Are Incentive Distribution Rights and Why Do They Matter?
These are the sponsors and managers of the MLP’s assets. Usually a GP will own a 2% GP stake, a large amount of regular units, and something called incentive distribution rights, or IDRs.
The idea behind MLPs is that they allow a company that owns a lot of MLP qualifying assets to monetize them in a highly tax efficient manner. Here’s how it works.
Phillips 66 (PSX), which is one of America’s largest oil refiners and petrochemical manufacturers, owns a lot of midstream assets. In 2013 the company set up Phillip 66 Partners (PSXP) as an MLP in order to help it to grow and diversify its business away from volatile refining to better stabilize its long-term cash flows.
Phillips 66 Partners would raise debt and equity capital from investors and then buy Phillips 66’s midstream assets in what is known in the industry as “drop downs.” These purchases would be paid for the form of either cash, debt assumption, or new units.
In this way, Phillips 66 could recoup the construction costs of these assets, and then reinvest that money into growing its business. Meanwhile, Phillips 66 Partners would get a valuable, cash flow-producing asset with long-term contracts with Phillips 66, who serves as GP, sponsor, and manager.
And because Phillips 66 owns the majority of its MLP’s units and the incentive distribution rights, this means that the vast majority of PSXP’s fast-growing distribution is flowing back to it.
But what exactly are IDRs? They are incentives designed to get the GP to grow the MLP and raise the distribution over time.
That’s because they entitle the GP to up to 50% of all distributions above certain hurdle rates. The table below provides an example.
As the quarterly distribution amount to LPs rises (far right column), the GP’s share of cash distributions increases from 0% to 50%. In other words, the cash distribution growth enjoyed by LPs will be much less than the MLP’s total distribution growth because an increasing share of it goes to the GP.
Since IDRs raise the cost of capital, each new potential investment has a higher bar to clear in order to be accretive (i.e. increase DCF per share).
Finally, be aware that due to the major growth headwinds that IDRs can represent, some MLPs have bought out their GP’s, or at least the IDRs. This means that 100% of distributable cash flow is available to secure and grow common unit distributions. It also means a lower cost of capital and thus larger growth potential. Here are the notable midstream MLPs without IDRs:
- Enterprise Products Partners (EPD)
- Magellan Midstream Partners (MMP)
- Buckeye Partners (BPL)
- Genesis Energy (GEL)
Most Important Financial Metrics for MLPs
Here are the most important things to focus on in order to successfully invest in this high-yield sector.
Meanwhile, maintenance capex is how much the MLP must pay to keep its infrastructure, such as pipelines and storage tanks, from deteriorating and becoming useless.
A DCR of less than 1 over an entire year or longer, is a major red flag that the distribution isn’t sustainable or safe and could be cut in the future.
Our website makes it easy to see an MLP's current, projected, and historical distribution coverage. We plot the DCF payout ratio, which is calculated by dividing an MLP's distributions by its DCF over a 12-month period of time. A payout ratio below 100% indicates that the distribution is more than covered by an MLP's DCF.
Here is a look at Magellan Midstream Partners' DCF payout ratio. You can immediately see that management has been conservative with the firm's payout policy, keeping a ratio near 80% over the years (equivalent to a 1.25x distribution coverage ratio).
This includes cash plus existing revolving credit facilities, as well as short-term (i.e. less than one year) credit lines.
This is essentially what happened to Kinder Morgan (KMI), which was an MLP until 2014, when debt and equity markets quickly soured on the MLP sector. With the company’s stock price tumbling in 2015, KMI’s high dividend yield made it too expensive to sell new units to raise capital.
Management ultimately had to slash the distribution by 75% to protect the balance sheet and continue funding its growth projects. Speaking of the balance sheet, debt is another really important factor MLP investors need to consider.
This means that their Debt / EBITDA ratio, which is the most important debt metric in this industry, gets so high as to threaten their debt covenants, credit rating, or both.
This can result in a liquidity crisis in which the risk of losing an investment-grade credit rating (and having to obtain new or refinanced debt in the much higher cost junk bond market) can force management to cut the distribution so that more DCF can be used to pay back creditors.
How to Value MLPs
The price-to-distributable cash flow (Price / DCF) ratio is a great way to know what you’re paying for an MLP’s units, using the metric that actually funds the distribution.
Many MLP investors also focus on dividend yield, which is the underlying reason for owning MLPs in the first place, as a way to quickly determine whether an MLP is undervalued or not relative to its historical trading range.
Our website allows you to see not just the current yield, but also an MLP’s historical yield and five-year average yield. That allows you to see whether or not today could be a reasonable time to buy an MLP for income. Here is a look at Magellan Midstream Partners' dividend yield over the last five years.
Closing Thoughts on Investing In MLPs
However, if you have the time and interest in following this industry, some MLPs can offer a long-term method of generating substantial income and unique tax advantages as part of a well-diversified dividend portfolio.