3 Reasons to Avoid MLPs

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Three things investors need to understand about master limited partnerships before they buy in.

Three things investors need to understand about master limited partnerships before they buy in.

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  • 1. 3 Reasons to Avoid MLPs
  • 2. MLPs are on fire The Alerian Index tracks MLPs and it is easily outperforming the S&P 500 YTD.
  • 3. No contest
  • 4. …BUT Despite that performance, master limited partnerships are not for everyone. Here are three reasons to avoid MLPs…
  • 5. #1 Risk • S&P credit ratings max out at BBB+ • Moody’s ratings max out at Baa1 MLPs are risky assets
  • 6. Inherent risk Credit agencies note that the mere structure of an MLP is risky. There are exactly ZERO MLPs rated higher than BBB+, and many of them are rated “junk”, or below investment grade.
  • 7. From Moody’s “…MLPs come with some clear benefits, including that they manage for cash flow to ensure consistent distributions and only raise capital when needed, but they also typically include high distribution payouts, financing risk, acquisition risk and the need for ever-greater cash flow to support distribution growth, and these risks generally lead to lower ratings.”
  • 8. Examples BBB+ BBB- BB- TC PipelinesEnterprise Products Partners Genesis Energy Magellan Midstream Partners Buckeye Partners Suburban Propane
  • 9. #2 Value erosion • Constantly issuing equity • IDRs hamper distribution growth MLP business model REQUIRES dilution
  • 10. Dilute away MLPs are pass-through entities, which means they pay out almost all the cash they bring in. That in turn means these businesses are constantly issuing debt and equity to pay for growth.
  • 11. What that looks like Every time an MLP issues equity, it must pay distributions on the new units. This dilutes the distributable cash flow per unit, which in turn slows distribution growth. Example: Kinder Morgan Energy Partners Q2 DCF/Unit 2013: $1.22 2014: $1.23 Q2 Weighted Avg. Units Outstanding 2013: 413 million 2014: 457 million
  • 12. #3 Investor issues • Shareholders are a second thought • Beyond the K-1 form, selling MLPs can have serious tax consequences No voting rights, just tax headaches
  • 13. No say whatsoever The “limited” in master limited partnership is indicative of your role in ownership. Essentially, the only way shareholders can enact change is via a lawsuit.
  • 14. No say whatsoever Ownership varies widely, but sometimes management and/or the general partner controls so much of the float, even if shareholders DID have a vote it wouldn’t matter anyway! Example: % of Float Controlled by the Public Phillips 66 Partners – 28.3% TC Pipelines – 72.6% Enbridge Energy Partners – 51.6%
  • 15. Taxes Many investors avoid MLPs merely because it complicates things come April 15. Other investors aren’t troubled by it, but the tax hang ups related to owning MLPs don’t end there.
  • 16. Taxes From the National Association of Publicly Traded Partnerships: “Partnership Tax Basics: Gain and Recapture • When you sell your MLP units, your taxable gain is the difference between the sales price and your adjusted basis. • Not all of the gain when units are sold is taxed at capital gains rates. – The gain resulting from basis reductions due to depreciation is taxed at ordinary income rates—this is called “recapture.” – Gain attributable to your share of some types of assets held by the MLP—substantially appreciated inventory and unrealized receivables—is also taxed as ordinary income. ”
  • 17. Taxes Maybe some MLPs are worth the extra tax work, just be sure you have a buy and sell strategy before you take the plunge.
  • 18. Key takeaways • MLPs are risky by definition • Dilution is more or less guaranteed • MLP investors have no real rights, but plenty of tax questions You may ultimately decide to buy MLPs, but copious amounts of due diligence should precede any buying decision. You may find a traditional dividend stock is better for your portfolio, and that’s okay.
  • 19. Top Dividend Stocks for the Next Decade