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MLPs: How Perceived Market Foe May be Fundamental Investment
Summary:
- Master Limited Partnerships (MLPs) continue to trade at significant discounts relative to the historical averages if you use cashflow metrics
- With simplification transactions having resulted in some distribution cuts and casting investor doubt, things may look different going forward. Some MLPs may have these same simplification transactions sans the distribution cuts, while others may change the way they manage their distribution, focusing more on keeping cashflow to develop organic growth projects and, in turn, increasing their distribution coverage ratios and improving the stability of that distribution
- Future returns are believed to be significantly better than many other parts of investors’ options today
Joined by Ed Russell, Managing Director — Tortoise and James Cunnane, Managing Director and Chief Investment Officer of the Advisory Research MLP & Energy Infrastructure team, we discuss one of the more curious performances of the market this year.
The following Q&A recaps the conversation that originally took place as part of CEFA’s podcast series on April 20, 2018, which can be heard here. |
James Cunnane |
Ed Russell |
Libby Hastert |
| LH: |
For those
who frequent our monthly podcast, I'm Libby Hastert of the Closed-End Fund
Association. This week, I'm returning to discuss the energy sector and master
limited partnerships. Despite MLPs having a challenging start to the new year,
we're going to consider the potential for improvement over the remainder of
2018. Here to provide insight are a couple of the industry's experts, addressing
some concerns around product valuation and also identifying the outlook for
income-seeking investors. Kicking things off today is Tortoise's senior
managing director, Ed Russell. Ed, I've had the pleasure of working with you
before at some of our CEFA Advisor Summits all over the country, but there's
also a new voice on the mic today. That said, I'd like to extend a big welcome
to you, Jim. Jim, who some of you may know as James Cunnane, is Managing
Director and Chief Investment Officer of the Advisory Research MLP & Energy
Infrastructure team. Jim and Ed, thanks for joining us today.
Ed, turning things over to you, as
the Managing Director of Tortoise, can you kick us off touching on the fundamentals of MLPs? Specifically,
how are they positioned with regard to cashflows and the potential to bolster distributions?
Ed?
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| ER: |
Thanks,
Libby. With the exception of the last few days, it's been a rough start for
MLPs in 2018, but if you look at the last, these numbers are, as of quarter
end, the valuations are very attractive. MLPs
continue to trade at significant discounts relative to the historical averages
if you use cashflow metrics. MLPs will normally historically trade at about
11.5 times enterprise value to EBIDTA and about 10 times price to discounted
cashflows. Today they're trading at about nine times 2019's estimated EV to
EBIDTA and about five and a half times price to discounted cashflow. Very
attractive multiples.
If
you look at the average yield right now for the sector, at the quarter end it
was almost 9%. We still expect throughout the sector to see distribution growth
at about 5% to 7% for the next 12 months. That's a very attractive total return
potential. I would, however, state that I think that you need to look at the
individual companies, as well. Do not subscribe 5% to 7% across the entire
sector. Our suggestion would be to look
at companies with lower yields and higher growth expectations because, to be
frank, there are companies out there, MLPs in particular, that are trading at
yield levels that are there because there's going to be very little implied
distribution growth in 2019. Again, if you look at the entire sector,
distribution growth expectations are in a range that are the historical
average. I really don't think the valuations today reflect that distribution
growth. Then if you compare them to
REITs and utilities, MLPs are about 11% cheaper than utilities and about 43%
cheaper than REITs, respectively. Again, I think relative valuation if you
look at yield-oriented stocks, MLPs are very attractive today.
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| LH: |
Then
if we could zero in on the energy segment of that, we have an environment that's had pretty stable energy prices and
continued strength in the US production. Can you address what seems to be the
disconnect between this backdrop and the recent performance that you spoke
to?
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| ER: |
That's
obviously been the question on investors' minds, and rightfully so they're very
frustrated because it seems as if we were only correlated to commodity prices
on the way down. As they started to improve, we did not see the improvement in
the midstream sector. Clearly investors have been frustrated by that. I would
have to say that there's really no fundamental reasons that you can point to on
why we have not seen more improvement in the midstream sector with the
exception of the last few trading days. We believe the outlook though is very
positive for the MLP sector. We have,
unfortunately, gone through some transactions, simplification transactions,
that did result in distribution cuts, which I think really put a lot of doubt
in retail investors' minds on the stability of the distribution of these
underlying securities. That kept them on the sidelines when you would
normally see them as buyers when you get attractive yield rates like the 9%
average.
If you look going forward, we think the
continuation of these simplification transactions that will take place without
those backdoor distribution cuts will make this sector more attractive to the
retail market. You also have seen MLPs
change the way they manage their distribution where they're focusing more on
keeping cashflow to develop organic growth projects, increasing their
distribution coverage ratios, which again, I think improves the stability of
that distribution. We believe that will also help bolster the
attractiveness to the sector. I'll let Jim touch a little bit more on the FERC
issue. I think what's going to need to take place over the next couple of
quarters is good quarterly announcements, which we expect very few surprises,
so no surprise distribution cuts that were not expected, and then more clarity
on the FERC issue that recently happened because we think that has very little
material effect on the sector, but we think the market really overreacted to that.
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| LH: |
Yeah,
thanks, Ed. Obviously there's been some specific things that we can point to
like FERC. Jim, with that in mind, we
had the federal tax reform bill and then a ruling in mid-March by the Federal
Energy Regulatory Commission, FERC, regarding certain tax allowances for the
MLPs. Can you touch on how these have impacted MLPs and how the market properly
reflected these impacts?
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| JC: |
Sure,
Libby. I think it's been a mixed bag from a standpoint of taxes and FERC, and
as Ed already referenced, it's created some uncertainty and a lack of
confidence among investors that's going to need to be sorted out over a period
of time. But there are some real positives here. If you look at the tax bill,
for example, the tax bill was a benefit for both corporations and for MLPs. On
the margin, you can argue that corporations benefited more, but MLPs benefited
significantly as well. A lot of energy
infrastructure, including energy infrastructure that we own in our portfolios,
are both MLPs and corps. Overall, we feel that was an advantage for MLP
investors and energy infrastructure investors in general.
On
March 15, as you referenced, we had a ruling out of FERC that while the
announcement itself was not a surprise, the content of the announcement, I
think, caught the market, including ourselves, off guard. The issue at hand was
an income tax allowance issue that's been debated between pipeline operators
and their customers, between the courts and the FERC for 20 years. It's gone
back and forth. The ruling that came out
of the FERC on March 15 was certainly not an advantageous one for MLPs.
Without getting into great detail on it, I think the bottom line was that the
market's immediate reaction was to assume a worst case scenarios. When we break
down the impacts, we believe that the
longer-time impact is going to be fairly minimal for most of the MLP group.
There will be a handful of securities that maybe are more impacted. As Ed
already referenced, maybe the bigger issue behind both of these items is that
it's infused some uncertainty that's going to take time to sort itself out.
That has come at a time where MLPs are at the tail end of a fairly long period
of underperformance. That's created, I think, some selling pressure among
fatigued investors.
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| LH: |
Jim,
obviously you spoke to this, and I don't want to dwell too much on the
difficult start they've had in 2018, but really what's your view on the current valuations in the sector? Are you
finding any interesting opportunities with specific types of MLPs, or have
valuations gotten to the point where these opportunities are across the board?
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| JC: |
Ed already
laid out the valuation case, and I completely agree. Valuations are very
attractive at this time in a variety of metrics. We look at absolute metrics,
cashflow metrics, for example, we look at relative metrics to other asset
classes in the market. Without repeating those, they all look attractive at this
time. I don't think valuations today are
certainly as attractive as at the bottom of the energy crisis or back in the
financial crisis in '08. Other than that, this is as attractive as we've been
since probably the 1999, 2000 window where you actually had some similarities
to today's market. Technology stocks were hot. Dividends weren't of much
interest. Energy companies were somewhat out of favor. But there certainly were
some differences. Oil prices were much lower at that time.
Today,
I think the fundamental outlook is much better. We've talked about before here
when you look at the EBITDA of these companies, it's sound. I think that that
is what makes us confident that eventually this undervaluation will be
corrected. We also can look to the debt markets. The debt markets have been
strong for these companies. Again, I
feel like the issue we're running into here is not a lack of confidence around
current earnings but confidence around MLP equities and some of the uncertainty
that's been infused.
When
we look at opportunities, we're thinking about looking for quality as this
period of uncertainty works its way out. When we talk about quality, I'm
talking about things like friendly management teams; great assets; and companies with distribution
coverage and with reasonable leverage entities that are able to sustain their
distributions and hopefully grow. We
share Ed's view that there will be growth in distributions as we move forward
from here.
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| LH: |
It's
certainly great to hear that. Jim and Ed, just to wrap things up, if you could give me your quick take on the biggest
thing that investors could take away from this discussion in relation to recent
volatility in the markets and these MLP fundamentals and value. Jim, do you
want to start that off?
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| JC: |
Sure,
Libby. MLPs have been a poor performing
asset class for the last five years, but when you look at the underlying
fundamentals, the fundamentals are improving. The story around MLPs should
continue to improve. You should see sentiment pick up as we move through this
year. We believe future returns will be
significantly better than many other parts of investors' options today.
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| LH: |
Ed,
is there anything that you'd like to add?
|
| ER: |
Sure. I'll
just echo what Jim said in that the issue that's causing a lot of frustration
with advisors is when you see a period, which is now quite a long period, of
poor performance, advisors want to know why. What is fundamentally wrong that
is causing these stocks to trade down? Their frustration more recently seems to
get sometimes magnified when we say, "Look, we can't point to a
fundamental reason why these stocks are trading down." What I try to
express is that there are some opportunities here for investors is that if you
ask me what needs to happen to be a catalyst for the midstream space to perform
better from the stock price, I don't need a change in commodity prices. I don't
need the economics of drilling activity in the United States to change. I don't
need the demand for these commodities or refined products to increase or
change.
Fundamentally we're in a very good space in
the US in the energy. We can drill at attractive returns for both crude oil
and natural gas in a number of basins. The demand for those products continues
to improve. We don't talk about natural
gas a lot in this country, but we're starting to export that at very high
levels. I would expect that to continue to grow. Natural gas is continuing
to grow in terms of the percentage of electrical generation that is done by
natural gas. There's a lot of tailwind helping push the energy sector. We think
that eventually midstream will continue to catch up with that and start to
improve along with that. We definitely think it's a very unique opportunity
where I don't need to point to specific things to drive the fundamental
increase in these stock prices. We just need market sentiment to improve, I
think, relatively through no negative headlines and just a couple of quarters
of essentially demonstrating the earnings growth that Jim and I have both
mentioned throughout this call.
|
| LH: |
Ed,
Jim, I think you gave investors a lot to think about today. I really am excited
to see where we go with MLPs because, as you both touched on, we've got a
really interesting backdrop right now, lots of opportunities and many considerations.
Thank you both for calling in today. We'll touch base soon. Thanks.
|
| Speaker: |
Thank
you for joining us. We hope you will stop by again for news on this ever
changing space. Until next time, connect with us on Twitter at @CEFAssociation
or by searching for the Closed End Fund Association on LinkedIn and YouTube.
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Disclosure
Closed-end funds trade on exchanges at prices that may be more or less than their NAVs. There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price, or that a CEF's discount will narrow or be eliminated. CEFs often use leverage, which increases a fund's risk or volatility. The actual amount of distributions may vary with fund performance and market conditions. Past performance is no guarantee for future results.
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