The wrong metric: Why some investors may miss out on a great investment

The main reason some investors prefer MLPs as alternative investments is their stable and generous cash distributions. However, MLP unitholders need to put in extra work with their accountant to ensure that the additional income from MLPs remains tax-friendly each quarter. Due to the fact that income from MLPs is filed with Schedule K-1 tax forms as well as standard income tax returns, investors can be turned off by the additional paperwork at tax time. Although, the focus of these investors should not be on the complexities of tax returns, which an accountant can easily handle for unitholders, it should be targeting the right MLPs to invest in. This proves more tricky as many investors use traditional metrics to evaluate MLPs, which are simply inapplicable to this type of alternative investment.

Investors are using the wrong metric
Investors are leery about MLPs because they evaluate the investment opportunity using the debt-to-equity ratio. This metric is used primarily for traditional asset classes because it measures a company’s financial leverage by dividing total liabilities by shareholder equity. However, this metric does not adequately apply to MLPs because of how they operate and fund their companies.

MLPs raise fresh capital from debt markets for funding new projects, so by the very nature of their business model, they incur debt. This can be misleading for newcomers to the MLP space because they may think the companies operate deeply in debt.

For example, Emerge Energy Services’ debt-to-equity ratio has risen in the last 12 months from 0.89 to 1.82 times, but the company has no plans to slow down capital spending on new projects to repay debt obligations. The reason for the company’s comfort with its debt level is that MLPs evaluate themselves with the debt-to-EBITDA ratio. This is the primary ratio for MLPs because while book equity is flat or down nearly every quarter, distributions exceed their earnings. Therefore, unless MLPs issue new equity, their book equity account will remain flat or down, meaning that the debt-to-equity ratio is not applicable because debts will appear high while equity is stagnant.

MLPs pay out all earnings as distributions. So for investors to look to the debt-to-equity ratio in evaluating an MLP’s value proposition, it may appear worse than it actually performs.

Why investors should focus on the debt-to-EBITDA ratio
MLP investors should focus on the debt-to-EBITDA ratio because the companies themselves use it to evaluate the profitability of their projects. For instance, if a project has a one-year or two-year payback, it makes for a valuable investment. The same applies for investors because it presents an opportunity to buy low on a company that will bring massive oil and natural gas supply to a market in demand for it. Particularly in the midstream sector where pipelines and storage operations function on fee-based contracts, meaning they will continue to accrue distributions even in down markets.

Although the debt-to-EBITDA metric is paramount for MLPs because it measures their debt against underlying cash flow, it serves as a better measurement of how growth projects can be viewed. For instance, an MLP is content with letting its debt ratio go a little higher in order to fund a project with a quick payback, which will inevitably bring the ratio back down to its target range. In turn, organic projects with strong and quick paybacks will lower debt-to-EBITDA ratios for MLPs over the long-term.

Ultimately, investors will need to take the debt-to-EBITDA into context for finding the right MLP to buy, because it is a more accurate indicator of value than the debt-to-equity ratio. But finding the right MLP is the most important focus because while some MLPs with less long-term cash flow security prefer lower ratios, others that operate with long-term fee-based toll contracts are comfortable with higher ratios. Therefore, an investor needs to evaluate the security of a company’s cash flow before determining if its leverage is too high.

Bottom line for MLP investors
Many investors pass up MLPs because the value is not clear. However, with the right metrics, MLPs represent a premium long-term investment opportunity, particularly with the current low rate environment, fallen oil and gas share prices and double-digit yields.

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