By the Sure Dividend staff
Master limited partnerships are an interesting asset class for high-yield investors. There are a number of reasons why.
First of all, they have distribution yields that are well above the average dividend yield in the S&P 500. This makes MLPs an attractive asset class for retirees and other income-oriented investors.
In addition to their high yields, MLPs are notably tax efficient. Since a portion of MLP distributions are composed of a return of capital, MLP investors can defer a portion of their distribution taxes until they actually sell the security.
MLPs also offer reasonable diversification opportunities. Many investors are surprised at how many publicly-traded MLPs trade on the major stock exchanges. In fact, there are currently 128 MLPs in our investment universe. You can see our full list of MLPs here.
Unfortunately, one of the downsides to investing in MLPs is their (sometimes) elevated levels of stock price volatility.
This was seen on March 15th, when the entire MLP sector took it on the chin in response to a notable policy revision from the Federal Energy Regulatory Commission. More specifically, the FERC published a press release stating that they will no longer allow MLPs that operate interstate pipelines to recover an income tax allowance in the calculation of their cost of service rate agreements.
Fortunately, not all MLPs are created equal. While the FERC’s new decision will certainly impact some partnership’s, others will be barely impacted.
In fact, several MLPs countered the FERC’s announcement by publishing their own press releases and stating that they expect to experience no material impact from the policy revision.
This article will discuss one such master limited partnership – Energy Transfer Partners (ETP). More specifically, this article will provide a detailed analysis of the FERC’s decision and Energy Transfer Partners’ response before concluding with an update on the partnership’s expected total returns.
Inside The FERC’s Press Release
The FERC’s press release is surprisingly short (especially when you consider the impact that the press release had on the unit prices of various MLPs). Because of its brevity, we believe that the best way for investors to understand the press release’s implications is to read the publication in its entirety.
“The Federal Energy Regulatory Commission (FERC) today responded to a federal court remand by stating it no longer will allow master limited partnership (NYSE:MLP) interstate natural gas and oil pipelines to recover an income tax allowance in cost of service rates.
The U.S. Court of Appeals for the District of Columbia Circuit in United Airlines, Inc. v. FERC, (827 F.3d 122 (D.C. Cir. 2016) held that FERC failed to demonstrate there was no double recovery of income tax costs when permitting SFPP, L.P., an MLP, to recover both an income tax allowance and a return on equity determined by the discounted cash flow methodology.
The Commission today acted in response both to the court remand and comments filed in response to an inquiry issued after the court ruling. FERC will now revise its 2005 Policy Statement for Recovery of Income Tax Costs so that it no longer will allow MLPs to recover an income tax allowance in the cost of service.
The revised policy statement explains that, while all partnerships seeking to recover an income tax allowance will need to address the double-recovery concern, the application of the United Airlines court case to non-MLP partnerships will be addressed as those issues arise in subsequent proceedings.
In Docket Nos. IS08-390-008 and IS08-390-009, the Commission denies SFPP an income tax allowance and determines a real return on equity of 10.24 percent (Agenda Item G-3). In Docket Nos. IS09-437-008, et al., FERC accepts SFFP’s compliance filing, subject to the company submitting a further compliance that, among other things, removes the income tax allowance in SFPP’s East Line cost of service and calculates refunds (Agenda Item G-4).”
This press release is chock full of legal jargon, so we’d like to simplify the terminology a bit for you.
There are two types of fee structures that pipeline MLPs can use to determine the fees they charge to their customers:
- Cost of service agreements, under which service fees are calculated based on the expenses incurred by the pipeline
- Other agreements, which are calculated based on other criteria
Cost of service agreements have historically included income tax as an expense. Under this new ruling, this will no longer be permitted, which means that only companies that use cost of service agreements will be impacted by this new FERC ruling.
An article from Bloomberg on this topic had a very concise summary. The passage is so insightful that we’ve decided to include it in this analysis:
“[I]t’s unclear how much the ruling will impact different assets, Selman Akyol, an analyst at Stifel Nicolaus & Co. wrote in a note Thursday. That’s because these pipelines can charge rates based on different agreements — there are “cost of service” rates, which will be affected, as well as market-based rates or negotiated ones, which won’t be impacted. What’s more, “cost of service” rates are partly built on aspects that have nothing to do with taxes — including maintenance and depreciation costs for the pipeline.”
Energy Transfer Partners is one example of a master limited partnership that does not use cost of service rate agreements. Accordingly, the partnership’s irrational price decline after the FERC’s press release has only amplified its expected returns and created a compelling buying opportunity for today’s investors.
Before discussing Energy Transfer Partners’ expected total returns, however, we’d like to provide you with some information on the partnership’s response to the FERC’s press release.
Energy Transfer Partners’ Response
Like the FERC’s press release, Energy Transfer Partners’ response is short – in fact, even shorter than the original publication. The partnership’s single-paragraph response to the FERC’s press release is quoted below:
“Energy Transfer Partners, L.P. (NYSE: ETP) is aware of revisions the Federal Energy Regulatory Commission (“FERC”) is proposing to its 2005 Policy Statement for Recovery of Income Tax Costs, which if adopted after a public comment period, would no longer allow interstate pipelines owned by master limited partnerships to recover an income tax allowance in the cost of service. These revisions are not expected to have a material impact to ETP’s earnings and cash flow. Many of ETP’s rates are set pursuant to negotiated rate arrangements or rate settlements that it believes would not be subject to adjustment, or would be limited in terms of adjustment. In addition, many of its current transportation services are provided at discounted rates that are below maximum tariff rates, many of which it believes would not be impacted by a change in the maximum tariff rate.”
Source: Energy Transfer Partners, emphasis our own
As you can see, Energy Transfer Partners’ rate agreements are largely structured outside of cost of service rate agreements. This means that the partnership will experience no meaningful impact under the FERC’s new policy revision.
With this in mind, we believe that Energy Transfer Partners continues to look attractive here. To conclude this article, we’ll provide an update on the partnership’s expected total return profile.
Valuation & Expected Total Returns
Like most MLP’s, Energy Transfer Partners distributes the vast majority of its cash flow as distributions to its unitholders. Accordingly, the partnership’s distribution yield is the most notable component of its expected return profile.
Energy Transfer Partners currently pays a quarterly distribution of $0.565, equivalent to an annualized distribution payout of $2.26. Using the company’s March 16th closing price of $16.97, Energy Transfer Partners is currently priced at a distribution yield of 13.3%.
The following diagram compares the MLP’s current distribution yield to its long-term historical average.
As you can see from the chart above, Energy Transfer Partners’ current distribution yield is noticeably above its long-term average.
Here’s what the numbers look like: Energy Transfer Partners has traded at an average distribution yield of 9.0% over the last 5 years and an average distribution yield of 14.5% over the last 10 years.
While the partnership’s current yield is lower than its 10-year average, this includes a prolonged period of noticeably undervaluation that drove its dividend yield above 50%.
Accordingly, we believe that the MLP is undervalued today. It is likely that some rationality will return to this MLP’s unit price. Valuation expansion should be a positive contributor to future total returns.
With that in mind, some modest valuation expansion combined with the partnership’s underlying business growth and its 13.3% distribution yield mean that the MLP has a very, very good chance of delivering total returns that are superior to those of the broader stock market.
With that said, these returns are highly dependent on the partnership’s ability to continue its current distribution payment. Distribution safety is paramount for Energy Transfer Partners and all other MLPs.
Fortunately, Energy Transfer Partners’ current distribution appears very safe. In the most recent quarter, the partnership reported a distribution coverage ratio of 1.30x. This equivalent to a payout ratio (using distributable cash flow as the denominator) of 77%.
Taking a longer-term view, the partnership’s distribution payments through the entirety of fiscal 2017 was also covered by its cash flows. Energy Transfer Partners reported a distribution coverage ratio of 1.20x, equivalent to a cash flow payout ratio of 83%.
In any case, Energy Transfer Partners’ distribution payments are covered by its cash flows. This means that the most important component of its total return profile – its distribution yield – is safe for the time being.
The FERC’s announcement that it had revised its income tax allowance policy for interstate pipelines that operate under cost of service rate agreements had a profound impact on master limited partnerships through the energy sector.
With that said, we believe that the price movements were largely an overreaction. Many MLPs operate the majority of their pipelines outside of these cost of service rate agreements, which means they will not be materially impacted by the FERC’s policy revision.
Energy Transfer Partners is one example of such an MLP. Despite the FERC’s policy revision, our opinion on the partnerships remains unchanged – the MLP is a buy at current prices, particularly for investors who are looking to generate current portfolio income.
Disclosure: I am/we are long ETP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.