These MLPs Look Cheap, but Are They Worth It?

Master limited partnerships are not like other stocks, and the metrics we use to compare an MLP to its peers differ from the metrics we use to compare most companies. For example, instead of the traditional P/E ratio, we emphasize MLP-specific metrics like distribution coverage ratio and, today's focus, price to distributable cash flow (P/DCF). I'll use Boardwalk Pipeline Partners (NYSE: BWP  ) , Eagle Rock Energy Partners (NASDAQ: EROC  ) , and Southcross Energy Partners (NYSE: SXE  ) as our three examples.

Why this metric?
Price to distributable cash flow is the MLP metric that comes closest to the P/E ratio most investors know and love. Like any good ratio, it allows you to compare MLPs on a relative basis, regardless of size.

Distributable cash flow per unit replaces earnings per unit in these relative valuations because MLPs pass through almost all of their cash to unitholders. Distributable cash flow drives distribution growth, which in turn drives unit prices. That's really what investors care about the most with MLPs, and that's why analysts and management never discuss earnings per share for their MLPs; it's all about distributable cash flow.

How the metric works
To calculate P/DCF, you take the market cap of the MLP and divide it by a full year of distributable cash flow.

Let's use Boardwalk Pipeline Partners as our first example. We'll use distributable cash flow numbers from the four most recent quarters. The numbers shake out like this:

Q1 2014

Q4 2013

Q3 2013

Q2 2013

Total

 $161.8

 $138.9

 $116.6

 $148.7

 $566.0

Source: MLPData.com. Dollar figures are in millions.

Now we'll divide the partnership's market cap by $566 million to derive our P/DCF multiple:

Market Cap

DCF

P/DCF

$3.81

$0.566

6.7x

Source: MLPData.com, Yahoo! Finance. Dollar figures are in billions.

The whole point of this exercise is relative valuation, so let's see how Boardwalk's multiple compares to some of its peers. The DCF numbers for Eagle Rock Energy Partners and Southcross Energy Partners come from the same four quarters that we used for Boardwalk Pipeline Partners.

MLP

Market Cap

DCF

P/DCF

BWP

$3.81

$0.57

6.73x

EROC

$0.65

$0.09

7.63x

SXE

$0.58

$0.03

22.48x

Source: MLPData.com, Yahoo! Finance. Dollar figures are in billions.

Boardwalk and Eagle Rock have both fallen off a cliff this year, so it's no surprise that they both trade at extremely low multiples. But what is the benchmark for this cash flow multiple anyway? Most investors have heard that a P/E ratio greater than 15 is high, and the further it floats above that magic number, the more overvalued the stock is. According to analysts at Morgan Stanley and Wells Fargo, the average multiple for large-cap MLPs like Boardwalk Pipeline Partners is between 15 and 16 times price to distributable cash flow while smaller gatherer and processor MLPs are averaging closer to 18 times.

By that standard, Southcross Energy Partners is the only MLP here that is "expensive." Our other two MLPs really bring home the point, however, that just because something is trading at a cheap multiple does not mean you should buy it.

Boardwalk Pipeline Partners and Eagle Rock Energy Partners are two of the worst-performing MLPs over the past six months, and most investors know this. Now we also know that they're trading at a rock-bottom multiple for the industry, so where do we go next?

First and foremost, there is virtually no reason to buy Eagle Rock until it resumes paying a distribution. Distributions are the whole point of buying MLPs to begin with, so this is one for the watchlist only.

As far as Boardwalk is concerned, there are some bulls out there. Now that the company's massive Bluegrass Pipeline project is on hold, however, many investors are taking the wait-and-see approach with this MLP as well. If you do think Boardwalk is worth waiting for, start tracking management's turnaround progress. It all starts with meeting the goals outlined in the company's first-quarter earnings transcript, which include repurposing assets to maximize system loads and reducing debt to EBITDA. Those are fairly transparent targets, and investors should know if and when things begin to improve.

Bottom line
The P/DCF ratio is useful for relative valuations, but by no means would you want to base your entire investing thesis on this one metric alone. In that regard, it is exactly like the P/E ratio: a great place to start your search.

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