Interest in the Master Limited Partnership (MLP) space has been expanding rapidly in the last few years as the group's stability and high yields have attracted new people to these companies. To capitalize on the popularity of MLPs, index funds have emerged, promising to simplify holding these units from a tax perspective, while still allowing investors to take advantage of the high yields.
The Alerian MLP Index (AMZ) is "a composite of the 50 most prominent energy Master Limited Partnerships," according to its website. However, the top 10 holdings of the index represent 58.1% of the index, ranging from Enterprise Products Partners (EPD) being 15.1% as the largest holding to Energy Transfer Equity (ETE) at 3.2%, ranked as the 10th largest. That means these top 10 holdings will really drive the index's performance, as the remaining 41.9% of the index is spread over the 40 smallest positions. Therefore investors willing to do a little bit of research should be able to pick two or three of these top 10 holdings instead of buying the index, and benefit from the performance of the asset class. Since I have already written my opinion of Enterprise here, let us look at Kinder Morgan Energy Partners (KMP).
Kinder Morgan Energy Partners is a leading owner and operator of pipelines and terminals in the U.S. and Canada. The company operates in five business segments: Products pipelines, which move oil and refined oil products; natural gas pipelines, which move natural gas; a CO2 business that sells CO2 and produces oil; a terminals business tied to ethanol and coal; and its Canadian pipelines. This diversity of the businesses allows Kinder Morgan to benefit from all aspects of increased demand for energy resources in North America, with an emphasis on the U.S. Based on projections of $3.8 billion in earnings before DD&A for 2011, the CO2 segment will make up 29% of earnings, natural gas pipelines will be 28%, products pipelines will be 19%, Canada will be 5%, and terminals will be 19%. The vast majority of earnings come from stable, fee based businesses, however the CO2 segment does have some oil price risk as it produces oil and is not completely hedged. Distributions for 2010 of $4.40 were up 4.8% over 2009 and in line with prior guidance. Distributions are expected to increase to $4.60 in 2011, an increase of 4.5% YoY. Based on the 2011 distribution guidance KMP currently yields a very attractive 6.3%.
Distribution growth is, in my opinion, the most important metric to consider when examining an MLP. MLPs with consistent growth in distributions are more desirable, as the yield on units will hold up as unit price increases. MLPs are formed to pay out earnings in distributions, so a management that is able to grow the distribution each year, either through new projects or accretive acquisitions, is highly sought after. KMP has a strong history of rewarding its unit holders through increasing distributions, proving the value in a great management team. KMP has raised its YOY distribution rate every one of the last 11 years, exceeding guidance in five of those years, and failing to meet the guidance only in 2006. Distributions have gone from $1.71 in 2000 to the $4.40 paid last year, showing how long-term holders have benefited from management's dedication to its unit holders.
Another key metric to consider when looking at MLPs is the coverage ratio on distributions. This figure is a good measure to predict where the dividend is going, and how much room management has to possibly raise the distribution beyond projects. While KMP earned enough cash to cover the $4.40 in distributions paid, the company's 2010 annual report says it fell about $23 million short "of meeting its budgeted excess cash coverage above that distribution target." (Details here) For 2011, the company projects having excess cash coverage of roughly $37 million, a small number when considering the approximate 300 million units outstanding. Based on these numbers, it does not seem KMP has much excess room to increase distributions beyond guidance.
The partnership aims to spend $1.4 billion on growth expenditures in 2011, with nearly two-thirds of that spending in the natural gas pipelines and CO2 businesses. That number is on pace with the $22.4 billion in acquisitions and expansion projects KMP has undertaken over the last 13 years, and will enhance the partnership's ability to grow in the coming years. However, given the shortfall in projected excess cash coverage, investors might want to see a larger budget here to help fuel excess cash growth.
KMP has several other things potential investors should consider. First, unlike Enterprise or Inergy (NRGY), KMP has not bought out its General Partner. Therefore KMP still must make incentive distribution payments to its G.P., owned by the newly public Kinder Morgan Inc (KMI). These payments are made before the distribution is paid to Limited Partners, so - while common - can be seen as a negative when compared to MLPs without a GP. Second, the oil prices KMP is hedged at are all significantly below the market right now. For example, 79% of 2011 production is hedged at $69/barrel. While this shows short sightedness when the hedges were locked in, there is a silver lining here. KMP's earning projections are based on an average price of $89/barrel on unhedged production, so the company is benefiting from the higher prices, though admittedly not in as a significant way as it would be without the hedges. Third, the structure of the company includes Kinder Morgan Management LLC (KMR). The company describes KMR shares as effectively the same as KMP, the difference being that the distribution from KMP is paid in cash, while KMR holders receive new KMR shares. The distributions paid are the same value, however KMR trades at a discount to KMP, with the average discount being 7% since KMR was formed. KMR is supposedly more simple for tax purposes, and insiders buy more KMR then KMP.
Kinder Morgan Partners is a well run MLP with a fantastic long term record for growth. Its assets stretch further across North America than any other MLP, and touch everything from ethanol to coal terminals to oil fields. Its 6.3% yield is strong, and should support the units, even in a down market. However, a thin coverage of the distribution means management has left itself little margin for error, and missing distribution guidance would have a significant negative impact on the unit price. The low oil hedges are mistakes of the past, and as they roll off each year the company will benefit, should oil prices remain above $80 in the next five years. The strong operating history of the company makes me confident in its prospects going forward, but investors should keep a close eye on distribution coverage.
Next up will be Energy Transfer Partners (ETP).
Disclosure: I am long EPD, NRGY.
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