Betting on the Jockey: Why Management Matters When Investing in MLPs

The Motley Fool recommends investing in companies, not stocks. This means finding quality companies with proven track records of growth, great management teams, and strong catalysts for future expansion. The same applies to high-yield income investing in the MLP space. In this article, I'll explain why betting on the jockey (investing in quality management) is vital to long-term investing success. 

MLPs (master limited partnerships) pay high yields because they retain very little earnings. This is just the nature of the asset class and results in two characteristics that investors might not like. First, MLPs take on a lot of debt to grow (average debt/EBITDA of 6.24). Second, partnerships finance growth through issuing additional equity, which is called a secondary offering. This dilutes existing unit holders unless the money is used to fund accretive investment or acquisitions. Accretive simply means that the return on investment is high enough to improve the distributable cash flow/unit.

For example, if a 5% yielding MLP sells equity it's equivalent to a 5% perpetual bond. If the proceeds are used to buy an investment returning 10%, then existing investors are actually better off despite the apparent dilution. This only works if management can execute on this growth strategy. If investments or acquisitions fail, then investors are materially harmed and the distribution that supports the unit price can be threatened. 

NuStar Energy (NYSE: NS  ) is a good example of poor management. It started off as a midstream MLP (transportation and storage of oil and gas). In 2008 management decided to enter the Asphalt business. Its rational was that most refiners were exiting this industry and that a long-term catalyst (necessary repairs of America's aging highways) would cause demand to soar. Management thought they were buying into a long-term growth story at the bottom of the business cycle. In March of 2008 it purchased the asphalt assets of Citgo Petroleum Corporation (subsidiary of Venezuela's national oil company) for $810 million. The deal included two asphalt refineries, three terminals, and leases in fifteen other terminals (as well as $360 million in inventory). Instantly NuStar became the third largest asphalt producer in the U.S.

The partnership invested heavily into its new venture. In 2009 it upgraded the blending technology at its refineries and in 2009 and 2010 it added six terminals which greatly expanded its storage capacity. However, during these years management was ignoring weak demand for asphalt. In other words, despite mounting evidence that it had made a mistake, management decided to double down, throwing good money after bad.

Suddenly in July of 2012 management reversed course and sold 50% of the asphalt business to Lindsay Goldberg LLC. The terms of the deal were terrible for NuStar investors. $175 million in cash and $263.8 million for inventory. However, NuStar agreed to fund operating costs through 2019 up to $250 million. Thus the net terms for the partnership was $183.8 million in cash and a 50% stake in a struggling business. 

The beginning of NuStar's failed adventures in asphalt marked a decrease in the distribution growth from an average of 7% (2003-2008) to just 1.75% since 2009. 

Contrast NuStar's poor management and non-accretive acquisitions with Plains All American Pipeline (NYSE: PAA  ) which has excellent management that has built the company's 18,000 miles of pipelines to take advantage of America's strongest oil and gas producing areas. This includes the Eagle Ford and Bakken shales, the Permian basin, and the Alberta Tar Sands. Since 2001 the partnership has made $10 billion in accretive acquisitions yet has maintained a low leverage ratio (debt/EBITDA of 3.1). The benefit to shareholders of this managerial excellence has been distribution growth of 8.4% CAGR over the previous decade. Better yet, management is guiding for 10% distribution growth in 2014. 

Or consider Kinder Morgan Inc  (NYSE: KMI  )  the general partner to Kinder Morgan Energy Partners and El Paso Pipeline Partners. Its founder and CEO, Richard Kinder, has a spent the last 22 years building the largest and most diversified gas transportation, storage, and processing company in America. 

Company ROA ROE Operating Margin Net Margin
NS -5.1 -12.2 -0.6 -7.9
PAA 4.9 13.5 4.1 2.3
KMI 1.7 8.9 28.4 8.5
IND Avg 2.4 8.8 8.2 3.4

Data from Morningstar

As seen above, Kinder Morgan has some of the highest margins in its industry which is a sign of superior management. With the recent media attention of Kinder's short-term decline in distribution growth (management recently reaffirmed its guidance of 5% distribution growth for Kinder Morgan Energy Partners and 8% for Kinder Morgan Inc) investors now have an opportunity to purchase one of the best midstream MLPs in the country at a discount.

With $14.8 billion in potential joint venture and expansion projects identified by Kinder Morgan's management, and Richard Kinder owning 22.6% of the company (total insider ownership 35%), investors can be assured that management is investing right alongside them. 

Bottom line
Investors should never forget that investing means owning a piece of a company (or partnership). The generous yield we enjoy does not appear out of thin air but from real assets that produce value but only if stewarded well by management that has proven itself capable and trustworthy with investors' money. 

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