A Buyer's Guide to Master Limited Partnerships: What to Look For Before Investing

Looking for a juicy dividend to pad your retirement income? Or perhaps you're someone who wants to build wealth the old-fashioned way, sitting on some dividend stocks for several years and letting reinvestment do the rest? Master limited partnerships, or MLPs, are a pretty compelling answer to both of those scenarios. The Alerian MLP Index, an aggregate of all MLPs, currently yields 5.57%, more than double the yield of the S&P 500. 

But here's the catch: MLPs aren't like regular stocks, and investors looking to add an MLP to their portfolio should evaluate these investments differently from how they would a traditional company. While there's no surefire way to determine the best MLP for you, there are some things you should look for when evaluating them that are unique to MLPs. Let's look at four critical questions you should ask when looking at an MLP, as well as what answer you should look for and how a few companies in the space are responding today.

1. How does it generate revenue?
Master limited partnerships can be involved in a multitude of businesses, but the one thing they all have in common is that they seek to develop assets and operations that will generate stable, predictable cash flows that can then be passed on to unitholders in the form of distributions. For an individual investor, it's critical to know how the MLP plans on maintaining these steady cash flows through its revenue stream. Here are a few examples of questions worth looking into when diving into the business of an MLP:

• If the company is focused on oil and gas production, how much of its production is backed by a futures contract to lock in prices for the long term?
• If it specializes in oil and gas gathering or transportation, is capacity in its pipelines secured by contracts?
• Is the company more or less vulnerable to commodity price swings? 

This is extremely challenging for MLPs, because they try to shield themselves from boom-and-bust business cycles in an industry that constantly goes through booms and busts. A company that's able to generate revenue from its assets under long-term contracts that have fixed fees unrelated to the price of a commodity is going to be the most stable, and it will be easier for that company to plan new growth projects. 

2. How good is it at raising capital?
A Master limited partnership's appetite for capital is a lot like this.

Image: giphy.com. 

Since they are set up as pass-through organizations in which individuals play taxes on distributions, many don't retain much -- if any -- excess cash to fund future growth. Instead, they do so with debt and equity issuances. With the need for so much capital, it's critical that an MLP can access that capital as cheaply as possible, and there are several components that go into how an MLP can do so. For example, how large are the distributions on newly minted units? What kind of credit rating does the MLP have, and what coupon rate does it have on its debt? There are a bunch of metrics you can look at when evaluating an MLP's ability to source capital, but the simplest way is to examine the weighted average cost of capital, or WACC.

The WACC takes into account the cost of raising new capital through either new debt or through new equity. Sometimes, calculating WACC on your own can get a little confusing because of things such as incentive distribution rights to general partners, preferred shares, and what not. Luckily, you can normally find an analyst group that has done the calculations already, if you do enough digging. Here is a list of WACCs for eight MLPs in the space, all of which were calculated by Bloomberg:

In some cases, a higher cost of capital can also be an indication that shares in that MLP are performing very well and that the MLP may be funding some of its growth from excess cash left over after distributions to unitholders -- which brings us to our next question.

3. Is it over-promising with its distribution?
The appeal of owning an MLP is that we get those fat distribution payments, so we want to make sure that the distribution we're getting is on a solid foundation and not just a house of cards. Any company can pay out huge distributions, but the ability to sustain and grow that distribution over several years is more important. 

To best way to evaluate the staying power of a company's distribution is to look at its distribution coverage ratio. This metric is very simple to understand and calculate. It's the total amount of distributable cash flow a company brings in divided by how much it pays out in distributions to its unitholders. If you're lucky, a company will publish its distribution coverage ratio directly in its quarterly earnings release. If not, it will all at the very least publish its distributable cash generated and the total amount it distributed to shareholders on either a total or per-share basis.

There can be quite a bit of quarterly variance in distributions because of price swings in commodities or from large new projects that haven't come online yet, so from an individual investor's standpoint, it's better to look at distribution coverage on an annualized basis. Here is a basic guide of what various distribution coverages mean.

If you're looking at a company with a low weighted average cost of capital but a high distribution coverage ratio, that means the company doesn't need to access the debt or equity market as frequently, and therefore the value of the equity in that company is higher. So don't write off a company with a high WACC without looking at distribution coverage as well. Here's the distribution coverage ratios for the companies I've mentioned:

Source: Company 10-Q filings and press releases

4. Am I getting a good deal on these shares?
Up until about now, everything here has related to the overall health of the company, but what about the stock itself? The really tricky part about master limited partnerships is that the most universal valuation metric that investors use to evaluate companies, the P/E ratio, is pretty much useless, because in this case we care more about cash generation than about earnings power. Instead of looking at price to earnings, we can use two other metrics instead: enterprise value-to-EBITDA, and price-to-distributable cash flow. EV-to-EBITDA is valuable because it evaluates how all the capital in the company can generate EBITDA, or earnings before interest, taxes, depreciation, and amortization. According to Wells Fargo, the EV-to-EBITDA for the entire MLP sector is 15.7.

Price-to-distributable cash flow is basically how much you're willing to pay for a dollar's worth of distributions from that particular MLP. As you'd expect, companies that are in a better position to grow distributions for the long term will carry with them a higher valuation. Here's how all of the previously mentioned companies stack up based on these metrics.

Sources: S&P Capital IQ and company 10-Q and 10-k filings.

What a Fool believes
It may take some time digging into master limited partnerships to find the one right for your portfolio, but with distribution yields approaching 10% for some companies, it can be well worth the time. There are other things to consider when looking at MLPs, but answering these questions will help you get a much clearer picture of a partnership's current health, its future prospects, and its value as a stock. It may just help you get one step closer to finding that perfect income investment.