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By emiller8988
September 17, 2004

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There is no better place on equity earth to study the relation between cash flow distributable to owners (shareholders) versus earnings than in the field of Master Limited Partnerships. The consistently distribute more cash than they "earn". Of course, this is because of the effect of depreciation.

MLP's are no more complex than any other corporation. They are similar to REIT's in that they pass profit through to the individual unitholders (shareholders) thusly avoiding the double taxation of profits.

There are four sectors of natural resource-related MLPs:
1- pipelines
2- propane distributors
3- coal
4- oil and gas exploration and production (E&P).

The pipeline MLPs are considered more conservative and are characterized by stable cash flow and slow growth. Propane distributors are more aggressive investments than pipelines. The propane industry is a non-regulated, seasonal, slow-growth industry with moderate exposure to commodity prices. Coal MLPs also have moderate exposure to commodity price volatility. However, their principal end-user customers are public utilities, thus, overall risk is considered relatively low. The riskiest are the E&P MLP's

Generally, the MLP distribution (similar to a dividend) is not guaranteed. Most MLPs (like corporations) have restrictive debt covenants, which can impair distribution payments if a default occurs.

MLPs can be affected by interest rate trends independent of underlying fundamentals. Investor flight to quality during August to October 1998 is a good example of the MLP group declining in price, despite strong fundamentals in the pipeline and the propane business.

MLPs do not pay taxes, thus allowing for a higher cash flow payout to shareholders. This is different from regular corporations, which are subject to double taxation of dividends. The corporation's earnings are taxed and then the stockholder's dividends are also taxable. The amount of a MLPs distribution that is shielded from ordinary income taxes is generally expressed as a certain percentage of the distribution. As an example, an 75% tax-deferred distribution would indicate that on a $2.00 per unit annual distribution 75%, or $1.50, would be tax deferred and $0.50 would be taxed as ordinary income in the year received. The tax deferral percentage amount could slowly decline over the years. However, the amount deferred can vary depending on the amount of cash distributions, the number of shares outstanding and the amount of additional taxable income related to acquisitions or growth. This is important... acquisitions sort of re-set (or increase) the amount of the tax deferred portion of the distributions

MLPs mail individualized K-1 tax forms to unitholders in late February or early March of each year. The K-1's are not a big deal at all and most MLP's have very helpful websites for dealing with these things. Cash distributions are not taxable but are treated as a reduction in a unitholders original cost basis in the investment. Since MLPs generally pay out more cash distributions than the amount of taxable income, the cost basis for each individual unitholder is decreased by the difference between total cash received and taxable income reported. The MLP form allows for the pass-through of depreciation (a non-cash expense) to unitholders. The cumulative tax-deferred portion of the distribution becomes taxable as ordinary income in the year the units are sold, allowing investors the flexibility to recognize taxable income in any given year.

Because of the possibility of generating unrelated business taxable income (UBTI), you should tend to avoid the use of master limited partnerships in IRA's. If you have over $1000 of UBTI in an IRA, you could technically get into a pickle.

Atlas Pipeline Partners (APL) is an MLP that currently owns and operates a system of natural gas gathering pipelines in eastern Ohio, western New York and western Pennsylvania, an area known as the Appalachian Basin. They recently acquired Spectrum Field Service, Inc., a natural gas gathering pipeline in south-central Oklahoma and northern Texas. This quadruples APL's asset base and diversifies the partnership from its eastern market. Growth should come from both acquisitions and internal expansion (which is great for an MLP owner, just what you want to see).

Right now APL has a 28% debt to total capitalization versus the pipeline MLP average of 50%. Even after the last acquisition, APL is still a small MLP, with an asset base of approximately $206 million. The partnership's moderate size could enable management to display an absolute rate of growth that is one of the fastest within the entire MLP universe. Management has been successfully growing the partnership via acquisitions. Now that they have an expanded credit line and a more flexible source of equity capital available, you should expect acquisition activity to continue. Considering management's 23% equity interest in the partnership, their financial interests are directly aligned with the publicly traded common unitholders. That should be music to the ears of any marginal investor.

The current yield of 7.5% is expected to be 70% tax deferred over at least the next three years. As the MLP distribution tax deferral depends on depreciation of assets... further acquisitions should push the tax deferral along. Although not declared, management has indicated the annual distribution could increase around 8% from $2.52 to $2.72 with the mid-November distribution payment, an 8.1% indicated yield on the current price. These units not only have an attractive yield, but also hold the possibility for distribution increases from acquisitions and rising natural gas prices. If natural gas drilling and production levels continue to grow or should APL continue to make acquisitions, you should expect further growth in the rate of increase of the distribution. APL has all the elements necessary to be a successful investment: experienced management, a solid asset base, and a flexible financial position.

APL units trade with an approximate yield of 7.5%... a 3.25% premium to the 10-year Treasury note and trade at 9.8 times 2005 distributable cash flow per unit. The pipeline MLP group's historical average premium to the 10-year Treasury note has ranged between 1.50-4.50%. So, you could expect APL to trade as high as $45 and as low as $31 in 2005... right now at $35 it looks pretty good.

There are two factors entering the market that should have a positive influence on MLP valuations over the next six to 18 months. The first is the advent of closed-end funds that invest in MLPs. The second is the current pending legislation in Congress that would allow mutual funds to more readily own MLPs. The total tradable float of MLP's, that is all limited partner units excluding those held by management, general partners, employee stock option plans, unitholders with a low adjusted cost basis (won't be selling), estimated pure long-term income investors and other long-term private investment firms, is said to be approximately $15 billion to $20 billion. On a combined basis, the two publicly traded closed-end funds currently have an investment base of $556 million. These two funds are relatively new and still in the process of investing their cash in MLPs. There's likely to be more MLP closed-end funds coming to market, I've read this could provide another $1 billion hunting for MLP investments. These new investors would provide demand for MLPs, which could help offset the negative influences associated with holding income oriented investments during a rising interest rate environment. Closed-end funds are professionally, actively managed portfolios similar to open-end mutual funds. The following describes the major factors associated with MLP closed-end funds...

Good News
1- You would get a diversified professionally managed portfolio of MLPs.
2- You get a single Form 1099 with a significant portion of the income considered as a tax-deferred return of capital.
3- I'm given to understand there won't be a big problem holding one of these funds in an IRA

Not so Good News
1- The advisers are paid a fee, and incur expenses associated with overseeing the fund investments.
2- These funds are structured as taxable corporations and as such, may incur income tax liabilities.
3- I promise the funds will use leverage, which would cause increased risk affected by rising interest rates.
4- Fees, taxes and interest expense will come from income available for dividends.

There is a so-called MLP Mutual Fund Amendment, which is part of the American Jobs Creation Act, a bill currently floating around in the Congress. It provides the following:

1- MLP distributions would be qualified income for registered investment companies (mutual funds).
2- MLPs cannot represent more than 25% of a fund's assets.
3- Funds cannot hold more than 10% of assets in any single issuer.

The American Jobs Creation Act and the Senate's version is now in conference committee awaiting a negotiated bill to be presented for approval by both Houses of Congress. The slate of conferences has not yet been completed. The overall tax bill contains some controversial items. The MLP amendment is a small and non-controversial part of the pie. The Washington politico's give the bill a 50/50 chance of making it to the finish line this year. If enacted, the MLP provision could provide significant favorable effects on the sector...if mutual funds could more freely buy MLP's, it would add additional sources of capital. Large-cap MLP valuations would likely move up first, due to income funds seeking diversification and alternatives to utility stocks, which carry 4% yields and only marginal growth.

So, long and short, you've got a good opportunity to buy a good MLP [with] a nice tax deferred yield at a reasonable price. Interest rate increases will depress the share prices. I do not believe the interest rates will rise nearly as much as some predict. The new Jobs bill has some aspects that will boost MLP prices if passed.

I bought APL on a recent price swoon. It won't help me win any prizes for fastest growing portfolio this year. But as the preacher said in Ecclesiastes 9:11...
I saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise...

And we are here for the long haul, right?


ps: much of this taken from reports on AG Edwards site which has the best MLP research I've found. There is also a great Yahoo group called "Master Limited Partnership and Royalty Trusts" that covers articles on these subjects

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