This MLP Still Looks Attractive After The FERC's Policy Revision

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).”

Source: Federal Energy Regulatory Commission Website

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.”

Source: Bloomberg

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.

ETP Energy Transfer Partners Distribution Yield History

Source: YCharts

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.

Final Thoughts

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.

The Die Has Been Cast

The financial markets seem locked in a tug of war amongst a goldilocks global economy, accelerating growth with muted inflationary pressures, and geopolitical risks, which has led to rising volatility and a lack of direction in the markets.

No one can argue against Trump’s success. He has passed his pro-growth, pro-business America First agenda but the political infighting in his administration has muddied the waters. It did not help that the Republicans lost an election last week in Pennsylvania but the media has framed the loss incorrectly as the Democratic winner, Conor Lamb, ran away from his “liberal” party platform and supported the Republican agenda for the most part. If he becomes the norm for future Democratic Party candidates then we have little to fear that the next administration will reverse current economic policies.

The market seems to hang its hat on each reported monetary statistic. Remember how the market freaked out when the Atlanta Fed earlier forecasted first quarter GNP growth of 5.4% with wage pressures accelerating? Well, now, the Atlanta Fed is forecasting first quarter growth beneath 2% with moderating inflationary pressures. We said then, and continue to recommend, that you don’t hang your hat and make any investment decision based on any one or two economic data points. A successful investor must pause and reflect on any shifts that have occurred and then, look to where we are going; not where we have been.

The die has been cast. Our economy will benefit dramatically from tax and regulatory reform as well as Trump’s America First Policies. Can you really argue against free, fair trade with reciprocal tariffs, if any at all, in today’s global economy? Can you argue against protecting our intellectual property? It is generally acknowledged that the Chinese have pirated away hundreds of billions of dollars of our IP demanding significant ownership in any foreign corporation wanting to operate in China.

Peter Navarro made a lot of sense to me when interviewed last week on CNBC. He advocates free and fair trade. And who could argue against Larry Kudlow replacing Gary Cohn as head economic advisor to Trump? He is a pro-growth supply side economist who will monitor the stock market as does Trump for measuring the success of their programs!

We often say that the pendulum swings too far to either side as a new course is charted like on foreign trade. Yes, there are risks, but taking them may be better than maintaining the status quo where we, as well as our closest foreign partners, are greatly taken advantage of by the Chinese. They are not our friends. Remember The Godfather, when Don Corleone said “Keep your friends close but your enemies closer?” That may be Trump’s strategy dealing with the Chinese. The U.S and its allies are in an economic war with China and thank heaven Trump is taking a firm stand against unfair trade rather than kicking the can down the road as past Presidents did. Our future and that of our children are at stake.

Do you believe that the U.S. economy is getting better or not when last month we added over 300,000 more jobs, consumer confidence hit a 14-year high and industrial production rose a surprisingly strong 1.1%?

Do you believe that tax and regulatory reform will lead to accelerating corporate profits, employment and capital spending? Do you believe that Trump’s trade policy, including steel and tax tariffs, will lead to foreign producer building plants here hiring American workers? All of this will boost wages and consumer spending. And higher capital spending will lead to accelerating productivity gains holding down unit labor costs and future inflation. Not a bad scenario but none of this happens overnight so be patient and invest accordingly as there will be clear winners and losers, too.

Concerns over China’s growth evaporated last week after it was reported that industrial output accelerated 7.2% over January/February with fixed capital investments expanding 7.9% led by the technology sector. The government is focusing on growth in consumer demand and technology rather than industrial production. We have as well with investments in Alibaba (NYSE:BABA) and Baidu (NASDAQ:BIDU), to name two that we have made in China.

Growth has remained strong in the ECB and Japan with inflation moderating somewhat from prior periods. We were pleased that Kuroda was reappointed head of the Bank of Japan for another five years. He pledged to maintain an overly accommodative policy at least through the end of 2019. As long as inflation remains benign and the euro strong, we expect the ECB to keep its overly accommodative policy too. Don’t worry about the higher union wage hikes in Germany as rising productivity and competitive forces will hold down reported inflation.

The bottom line is that the global economic environment has never been better than now. Yes, we are concerned and watching closely discussions about trade policies here and abroad. But we believe that it is about time that our government, along with our closest partners, faces this problem that has only been kicked down the road by past administrations. Change is in the air and there will be clear winners/losers by regions, industries and companies.

The die has been cast.

Invest looking through the proverbial windshield by finding and investing in the beneficiaries of the longer-term trends mentioned above and short the losers. For instance, it is clear that our domestic steel and aluminum industries will benefit. Maybe not overnight but certainly over the next few years.

Other long term beneficiaries of these trends include financials who benefit from growth and deregulation; industries/companies that will benefit from a surge in domestic capital/infrastructure spending over the next few years including capital goods and low cost industrial commodity companies; technology companies where growth far outstrip GNP and special situations where internal changes will boost earnings, margins and future valuation. Stay long the market, as it remains undervalued and short bonds. But not all markets or stocks are equal. Herein lies our strength. Paix et Prospérité continues to outperform all indices.

Our success over our 40+year career managing the leading hedge funds like the Quantum Fund has been in part correctly identifying investable long-term trends just like our former partner, George Soros. And we know when to close ranks and go to cash or be net short. Now is not that time! It is next to impossible trading this market. How many very wealthy traders do you know?

Stay the course!

Review all the facts; pause, reflect and consider mindset shifts; analyze your asset mix and risk controls; do independent research and… Invest Accordingly!