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To Be an MLP or Not to Be, That Is the Question

Enterprise Products Partners LP is a bellwether for the master limited partnerships sector. Which is why this chart represents a fundamental problem for the MLPs:

MLPs aren’t strictly a “sector,” like healthcare or utilities; just a particular, tax-advantaged form of financing that wraps around an underlying business operating energy infrastructure, such as pipelines. The sole purpose of the MLP is to raise financing as cheaply as possible. As I’ve written here and here, MLPs have come under severe pressure as the energy crash has exposed earlier excesses in terms of leverage and bad investments. The model of issuing new units to pay for growth while raising distributions — often compounded by expensive incentives paid to the general partner — ultimately proved horribly dilutive for investors, who also lacked much power over management due to a heavy retail element and partnership structures. The Alerian MLP has slumped by more than half from its peak in August 2014, its membership dropping from 50 to 39. Hence, that whole cheap-financing rationale doesn’t really hold anymore:

 

Early in the crash, the thinking was that MLPs were simply getting caught in the general revulsion toward anything energy-related. It’s true the sector’s correlation with oil prices did jump initially. But it has actually dropped in recent months — just as oil has begun to climb again:

That Enterprise Products Partners seemingly hasn’t escaped this trend is especially troubling because it studiously avoided most of the mistakes that undid the MLPs. It didn’t raise distributions too quickly off the back of volatile trading revenue like Plains All American Pipeline LP or build byzantine empires like the Energy Transfer “complex” or Genesis Energy LP. Enterprise got rid of incentive distribution rights a while ago, and its leverage and direct exposure to commodity prices are both relatively low. Meanwhile, profits are growing, and it is still raising distributions.

Only a month ago, Enterprise signaled it understood the world had changed, with a plan to raise distributions minimally for at least a year and become self-funding. If investors were not rewarding dividend growth, Enterprise reasoned, then why keep flogging that particular dead horse? Since then, though, Enterprise has lagged the S&P 500 by another 10 percentage points.

It’s possible the moniker of MLP has itself become a burden.

The investor base appears to be undergoing fundamental changes, with the recent sales of specialized MLP asset managers and indexers such as Harvest Fund Advisors and Alerian pointing the way. As institutions become a bigger force relative to retail investors, so the old model of grabbing attention with big distribution hikes, only to undercut them by issuing ever more units, becomes less effective. The key thing pension funds want is exposure to a steady stream of earnings based off regulated energy infrastructure.

All too often, investors thought they were getting that exposure with MLPs when they actually weren’t. This is the danger of seeing MLPs as a “sector” rather than looking at the underlying businesses. The real sector here is regulated or long-term contracted energy infrastructure, providing reliable income without continuous dilution from issuing new units or shares. And that, as I wrote here last year, can encompass some MLPs as well as regular C-corp. companies and utilities operating regulated power networks (the latter sector currently trades close to an all-time high). On that front, it is interesting to note that Oppenheimer

Funds Inc. just launched a new mutual fund centered on energy infrastructure, but with MLPs capped at 25 percent of holdings.For the likes of Enterprise, it might be worth ditching the MLP structure altogether. Converting to a regular company has some complications, especially as investors associated with the founders control 32 percent of the partnership and would potentially face a big tax hit. However, it is possible this could be mitigated with some creative structuring, and the resulting company would benefit from a tax-shield of its own for several years as it depreciated the assets acquired at stepped-up market prices in the transaction. This is what happened with Kinder Morgan Inc. and, more recently, Oneok Inc. when they converted.

Conversion isn’t a magic bullet on its own. Kinder Morgan, for example, has suffered as it was forced to cut excessive dividends and deal with its leverage. Oneok, on the other hand, has healthier payout and leverage metrics, and its conversion to a regular company by buying out its MLP earlier this year coincides with significant outperformance:

Oneok has had the benefit of better conditions in the natural gas liquids market, but the new structure also opens up a wider pool of potential buyers, reducing the company’s cost of capital.

For other pipeline operators such as Enterprise (Williams Cos. Inc. is another potential candidate) looking at that chart, it must at least be worth considering a full-on MLP makeover.
Source: Bloomberg

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