Black Swan Events: Avoiding Disaster When Investing in MLPs

Warren Buffett's first rule of investing is "don't lose money." His second rule is "remember rule one." This famous quote shows the importance of capital preservation in long-term investing success. All investing requires some risk (as Yogi Berra said "prediction is hard, especially about the future"), but protecting our portfolios from catastrophic losses is paramount. 

This article attempts to highlight this important principle by comparing two case studies of midstream MLPs. The first, Atlas Pipeline Partners (NYSE: APL  ) is one of the fastest growing MLPs in America and is yielding a very generous 7.6%. The second, Kinder Morgan Energy Partners (NYSE: KMP  )  yields 7.5%, but many fear that its best growth days are behind it. In a head-to-head match up there is one clear winner, but it's not the one most investors might expect. 

At a glance, it appears as if Atlas is the clear winner. After all, its pipelines service some of the most prolific shale areas of the country, including east and west Texas, Oklahoma, and Kansas. In the last five years its distribution has grown at a 32.8% CAGR, and its unit price is up 478%. Compare this to Kinder Morgan's paltry distribution growth of 5.8% CAGR and 70% price appreciation.

In the fourth quarter of 2013 Atlas announced record results, including:

  • Revenues up 65% 
  • Adjusted EBITDA up 35%
  • Distributable Cash Flow up 28%

All this sounds very impressive, so readers might be asking how I can possibly argue that Kinder Morgan is a better investment. The answer lies in the lesson of this article, capital preservation. 

2008-2009: When the tide went out Atlas was found swimming naked
The reason that Atlas Pipelines has such impressive growth statistics is because of the catastrophic losses the partnership (and investors) faced during the financial crisis of 2008-2009. 

During the crisis Atlas Pipelines nearly went bankrupt, slashing its distribution 84.4% over two quarters. The unit price declined by 95.5%. It's from this tiny base (in distributions and price) that Atlas appears to outperform so many of its peers. 

Kinder Morgan, on the other hand, sailed through the financial panic and even managed to raise its distribution by 2.9%. A small gain to be sure, but much better than the severe cut Atlas investors faced. This also explains the relative underperformance of Kinder compared to Atlas. Kinder never faced the same terrible price drop (its maximum price decline was 21.84%). What caused Atlas' near bankruptcy? And why did Kinder do so well? The answer is fixed-revenue contracts and scale. 

Atlas Pipeline Partners, unlike Kinder Morgan, derives the majority of its revenues from "percentage of proceeds" contracts. This is in contrast to the "fixed-revenue" contracts Kinder prefers (because it creates cash flow security and predictability). When times were good, Atlas and its profit sharing contract arrangements allowed for fantastic income, but when times got very bad cash flow disappeared and the partnership nearly went under. 

Has Atlas learned its lesson from its brush with death? The answer is "no". In the third quarter of 2010 17% of the partnership's contracts were fixed-revenue while 51% where "percentage of proceeds." The company is expecting 2014's contract mix to be 38% fixed-revenue, 61% "percentage of proceeds." 

What this means is that Atlas Pipeline will face immense pressure and may once more cut its distribution when the economy turns downward. 

How likely is that situation? To answer that we must also consider the issue of scale. Kinder Morgan Energy Partners is part of a much larger empire with Kinder Morgan Inc as the general partner. Its network of pipelines, processing facilities, and storage tanks is the largest and most diversified in North America. Its access to cheap cash (the lifeblood of the capital-intensive MLP industry) is far greater than Atlas Energy LP (the parent company of Atlas Pipelines). 

This means that should credit dry up again (as it did during the financial panic) Kinder Morgan will once again have the support of its vast-parent empire, while Atlas will face a tougher time obtaining credit. 

Atlas may already be showing signs of financial stress. Its distribution has ceased growing despite record DCF growth and its distribution coverage ratio stands at just 1.01. Meanwhile Kinder Morgan has recently reiterated its guidance of 5% distribution growth, and management has stated it has $14.8 billion in potential joint ventures and expansion projects it is considering. 

Foolish takeaway
Atlas Pipeline Partners is not a bad MLP. It is fast growing, high-yielding, and may have a place in the portfolio of more aggressive investors. However, due to the nature of its contracts, it is a more speculative investment. For the same yield, Kinder Morgan Energy Partners offers a more secure income source. Investors can consider investing in both partnerships but should be aware of the differences in risk. 

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