Fundamentally, the return on the stock market is derived from the cash flows generated by the underlying companies. This could be further simplified by analyzing dividends rather than cash flows, as dividends are an essential component of return. Since 1871, on a one-year time horizon, nearly 80% of the market’s return has been generated by fluctuations in valuation. However, as the time horizon is extended, fundamentals play an increasing role in return generation, such that, at a five-year horizon, dividend yield and dividend growth account for almost 80% of the return. On average, over the very long term, dividends have accounted for some 90% of the total return to the stock market.
We highlight this historic factoid to put the cash flows generated by MLPs in perspective. A substantial portion of MLP total return is yield. This income is far from fixed. Since June 1, 2006 until March 31, 2012, the average yield on the Alerian MLP Index has been roughly 7.2%. And over the past five years, MLPs have increased distributions at a five-year compound annual growth rate of 7.9%.
MLP cash distributions and annual increases in cash distributions have been among the highest for any asset class since the inception of modern-day MLPs in the mid-1980s. In today’s yield-starved environment, they continue to stand out with high distributions and stable business models. Generally speaking, we think businesses that pay investors more this year than they did last year, are a good place to be in a low-interest rate environment.
MLP cash distributions depend on each partnership’s ability to generate adequate cash flow. Unlike Real Estate Investment Trusts (REITs) that must distribute a certain percentage of their cash flow, each MLP’s partnership agreement determines how cash distributions will be made to general partners and limited partners. Generally speaking, partnership agreements mandate that the MLP distribute 100% of its distributable cash flow (DCF) to unitholders.
As previously discussed, MLPs do not pay corporate-level tax like regular corporations. Instead, they pass through the majority of their income (and deductions) to the holders of their limited partnership, resulting in higher distributable cash flow to investors. Since the MLP itself does not pay corporate-level tax, the income, deductions, and tax attributes from the MLP are passed through to their limited partnership unitholders. One of the appeals of an investment in MLPs is the tax-deferred treatment of quarterly cash distributions. A portion of these distributions are a “return of capital” and a reduction to the cost basis and thus, not taxed when received. Furthermore, MLPs can create a tax shield through required allocations of depreciation, depletion and special tax basis adjustments for investors.
Instead of receiving a Form 1099 detailing cash distributions paid, an MLP investor will receive a Schedule K-1. We think this distinction is important in understanding the lack of institutional ownership in the past, but recent developments (more on this below) have created a compelling opportunity for MLPs to gain sponsorship in the future. It is notable that a number of pensions and endowments, with long-time horizons, have started to develop an interest in the asset class, particularly in 2011. Examples include the Missouri Teachers Association and the UT Investment Company (University of Texas at Austin).
Long Term Upside In Valuation
After two years of substantial outperformance, MLPs have taken a breather in 2012, providing investors with an attractive entry point. Recent underperformance has been a function of mean reversion (valuations appeared relatively full going into a year where high risk assets have performed best), mixed fundamentals in certain sub-sectors (i.e. natural gas), and a heavy issue calendar (MLPs have raised $14.3 billion of equity this year). We believe this near term consolidation has laid the foundation for MLPs’ next leg of outperformance. Looking forward, we expect a gradual rerating of the sector based upon increased institutional sponsorship, overall industry maturation, improved liquidity, and the ongoing search for alternative sources of income in a slow-growth and low-yield world.
The most common metrics and methods by which MLPs are valued include Price-to-Distributable Cash Flow (P/DCF), Enterprise Value-to-EBITDA (EV/EBITDA), Yield Spread to the 10-year Treasury, and the Dividend Discount Model. Similar to how REITs define their cash flow from operations as Funds From Operations (FFO), MLPs use Distributable Cash Flow (DCF) as a measure of cash available to distribute to unitholders or to fund growth.
Although P/DCF and EV/EBITDA multiples screen roughly in line with historical averages, we believe attractive yields will be the overriding investment consideration in this environment and expect robust yields to continue to attract investment in a low interest rate environment. MLPs currently have a median yield of 7% which we think compares quite favorably to yields below 2% on both the S&P 500 Index and Ten Year Treasury Bond.
While there has been considerable healing in the credit markets since the financial crisis, spreads continue to remain above historical averages. The historical spread to the Ten Year Treasury is roughly 340 basis points compared to a much juicier 550 basis point spread today. Essentially, treasury rates have collapsed in Japanese fashion, but many “interest-rate-sensitive” securities have not followed suit. So spreads are attractive, but investors continue to fret that those spreads are sitting on top of artificially depressed treasury yields. In our view, this is precisely where the opportunity lies. With clarity on interest rates now through mid-2015 (at the earliest), we believe the yield trade should continue to propel MLPs higher as long as we are stuck at the zero bound (don’t hold your breath). Given scarcity of yield alternatives in the current low interest rate environment and continued global economic uncertainty, we expect MLPs to see a renewed bid as investors gravitate to the sector’s relative stability and secular cash flow growth story – one largely uncorrelated to macroeconomic conditions. Moreover, low interest rates are highly accommodative of large capital funding needs required for MLPs to satisfy midstream infrastructure investment required over the coming decades.
Corporate bonds offer another point of comparison. While MLP yields have typically traded at discounts (i.e. higher yields) to investment grade bonds, given that MLPs can and have historically grown their “coupon” (distribution), it follows that a fair valuation for MLP distribution yields may have them lower than their bond counterparts in the future. The current spread to investment grade bonds is approaching 250 basis points, and also remains well above the five and ten year historical averages.
On a day-to-day basis, there is generally no correlation between interest rates and MLP yields. But over the past three decades, MLPs have certainly benefited from the general trend of declining interest rates. We think the sector’s robust yields will continue to attract investment in a low interest rate environment. And based on the outlook for the global economy and the Federal Reserve’s continued accommodative stance, we expect interest rates to remain low for the foreseeable future. In addition, given investors’ income requirements, we continue to believe MLPs will be an increasingly attractive investment option for investors searching for yield. MLPs continue to offer among the most attractive yields in the market, especially on a risk-adjusted basis, in our view.
We will conclude our overview of the sector tomorrow, with some thoughts on various investment options available to market participants and some perspective on portfolio construction. We’ll also include the full Broyhill Letter in tomorrow’s post.