Enterprise Product Partner (NYSE:EPD) has long been a favorite of income-oriented investors due to its ever-growing distribution. The company has long been one of the best-run midstream companies and has been at the forefront of shareholder-friendly moves, such as being one of the first MLPs to eliminate its IDRs (incentive distribution rights). This allowed the company to continue increasing its distributions even during the energy price collapse of the mid-2010s.
However, investing in individual master limited partnerships (MLPs) like Enterprise Product Partners may not be best for everyone. Instead, invest in an MLP exchange-traded fund or ETF, such as Alps ETF Trust-Alerian MLP ETF (NYSEMKT:AMLP) might be the better option. And it comes with another big advantage: no additional paperwork.
Invest in MLPs
The Alerian MLP ETF tracks the Alerian MLP Index, which includes a variety of midstream energy stocks structured as MLPs. The MLP structure is designed to provide tax benefits to companies involved in the production or transportation of natural resources, as well as their shareholders. MLPs do not have to pay taxes at the corporate level, while typically a large percentage of MLP distributions are earmarked as return of capital. This portion of the distribution is deferred for taxes until the stock is sold and instead reduces an investor’s original cost basis.
This is a nice advantage for investors. However, there is one downside: the issuance of a tax form called a K-1. Many investors don’t like dealing with the complexities of K-1s, and they often arrive after most other tax forms. In some cases, MLP investments can also cause problems if held in retirement accounts, creating a taxable situation. For this reason, some investors try to avoid MLPs altogether.
However, there are a number of top MLP stocks with attractive returns that investors can own while avoiding K-1s by investing in the Alerian MLP ETF.
Why MLPs currently look attractive
The Alerian MLP ETF invests in midstream energy companies involved in activities such as the extraction, processing, storage and transportation of natural gas, oil, natural gas liquids (NGLs) and refined products. These companies generally do not have much direct commodity exposure and are often viewed more as toll roads. They tend to generate high cash flow and pay out handsome dividends. The ETF has a yield of 7.3% and an expense ratio of 0.85%.
In the midstream space, there have been many positive changes in MLPs over the last decade. In the past, the MLP structure was very unfriendly to investors because the companies’ general partners (GP) took advantage of the LP holders, which was the level at which retail investors most often owned the shares. GPs would have incentive distribution rights (IDRs) where LPs would have to pay a percentage of the distribution to the GP when distributions reached a certain level.
Once the IDRs reached a high 50/50 split, the LP paid double for each incremental increase in distribution. For example, if the LP increased its distribution by two cents per unit, or a total of $2 million, an additional $2 million would go to the GP, not counting any units held by the GP. Most pipeline MLPs had IDRs, although the percentages were slightly different for each and some energy producers structured as MLPs never did at the time.
This led many MLPs to increase their leverage and often build equity to pursue low-yielding projects and further increase distributions. About 15 years ago, it was not uncommon for MLPs to dilute their shareholders with two to three equity raises per year. Investors liked the large distribution increases, but it ultimately benefited the GP more than the average MLP shareholder. At the same time, many MLPs were overleveraged and had low distribution coverage ratios, which measure how much of a company’s cash flow covers the distribution.
Enterprise Partners was one of the first pipeline MLPs to address the issue of IDRs, reducing the high split to a 75%/25% split in 2002 and eliminating it altogether towards the end of 2010. However, most midstream companies followed suit a few years later. as the industry inevitably began to change for the better as a challenging energy environment and tax changes rocked the sector. Companies bought back and eliminated IDRs, GPs and LPs merged, balance sheets were repaired, growth slowed, and conflicts of interest in much of the industry were eliminated. Today, most MLPs don’t have IDRs, and few laggards still keep them.
Despite all these positive changes, midstream stocks are actually trading lower than they were before the pandemic. Prior to COVID-19, MLPs traded at an average enterprise value (EV) to adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio that was nearly 12 times the prior-year value. Today, the five largest holdings in the Alerian MLP Index all have EV/EBITDA valuations of less than 10x.
A good time to buy the Alerian MLP Index
The Alerian MLP Index has performed well in recent years. The ETF is up over 13% this year and has delivered a cumulative return of nearly 100% over the past three years.
Despite recent solid performance, MLPs are still trading at historically low valuations. At the same time, companies are in a much better financial position and are better managed today than they were 10 years ago. Leverage across the industry has fallen, funding ratios are higher and companies now typically look to fund growth projects using free cash flow after dividend payments. This allows them to grow while simultaneously reducing debt and reducing leverage.
The Alerian MLP Index provides investors with access to some of the best-run MLPs, including Enterprise Products Partner (NYSE:EPD) And MPLX (NYSE:MPLX), two companies that have consistently increased their payouts year after year. The ETF also holds two companies that have transformed their businesses in recent years Energy transfer (NYSE:ET) And Plains All American pipeline (NASDAQ:PAA).
For investors looking for yield, there aren’t many better places than MLPs, and the Alerian MLP Index is a great way to invest in this space.
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Geoffrey Seiler has positions in Alps ETF Trust-Alerian Mlp ETF, Energy Transfer, Enterprise Products Partners and Western Midstream Partners. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.
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