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I Just Made This Energy Stock Part of My Portfolio. Should It Be in Yours?

By Tyler Crowe - Apr 15, 2018 at 9:33AM

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Here's why I just bought into midstream oil and gas company MPLX.

Probably the best stock investing ideas I can convey to anyone are the ones in which I have invested myself. Stocks on a watchlist or ones that look compelling at a given moment in time are like dating, but stocks you own are the ones you have put a ring on. 

So in this spirit, I thought I would share with you a stock you may want to consider for your own portfolio because it is one I have recently purchased myself: oil and gas logistics player MPLX LP ( MPLX -0.55% ). Here's why I think it is a company worthy of investment and the recent change to the business that compelled me to buy this stock. 

person pointing to a stock chart on a screen with a pen.

Image source: Getty Images

When evaluating midstream oil and gas companies, especially those structured as master limited partnerships, there are two things that I look for more than anything else: A business model that generates a vast majority of its revenue from fixed-fee services and a management team that acts as good stewards of shareholder capital. That last point sounds a bit vague, but you can recognize this trait when looking at financials and strategic plans. When looking at MPLX, it has these traits.

One critical metric for master limited partnerships is its distribution coverage ratio. This measures how much money it has available to pay out to investors during any given quarter versus how much management actually doles out to its investors. A company that pays out all available cash would have a distribution coverage ratio of 1.0, with anything more than 1 meaning it generates more cash than it takes in and vice versa. To me, retaining some generating cash flow is critical to the long-term health of the business. So, I like to see master limited partnerships that maintain a distribution coverage ratio of 1.2 or greater. Over the past two years, MPLX has maintained a distribution coverage ratio of 1.25 or greater. 

By retaining a decent portion of its cash flow every quarter, MPLX is less beholden to the capital markets to fund its growth projects. That certainly doesn't sound like a revelatory idea in business, but all too many MLPs seem to think it is OK to pay out all of its cash flow every quarter and rely on external financing for growth. It's a decision that has led to numerous distribution cuts over the past several years that have absolutely wiped out investor returns. 

Thanks to MPLX's conservative approach to its payout, the company has been able to maintain modest debt levels on the lower end of its peer range, which has also enabled it to receive an investment-grade credit rating. (It also helps that the company has a well-capitalized parent company in Marathon Petroleum

MPLX Financial Debt to EBITDA (TTM) Chart

MPLX Financial Debt to EBITDA (TTM) data by YCharts.

The last thing that is encouraging about owning MPLX as a long-term dividend stock is that management isn't trying to shoot for the moon with unrealistic growth targets despite the opportunity to do so. Thanks to the acquisition of MarkWest Energy Partners back in 2015, MPLX is one of the nation's largest processors of natural gas, with a sizable presence in the Marcellus and Utica shale formations. It could be incredibly easy for management to step on the gas and build out its processing business in this basin at breakneck pace, but management is electing instead for a plan that will grow its payout by 10% in 2018. 

By keeping its investment pace at a reasonable rate and using retained cash to fund a large chunk of its spending, MPLX looks to have the kind of business plan in place I want from a midstream investment. 

Why Now?

Despite all of these good qualities that would make MPLX a good investment, there was one thing that kept me on the sidelines with this stock: its structure. Historically, MPLX was a limited partner subsidiary of Marathon, which had a general partner stake and carried with it something called incentive distribution rights (IDRs). These rights are basically a management fee paid to the holder of the general partner stake that entitles it to a certain percentage of the subsidiary's cash flow. The percentage to which it is entitled increases as the per unit distribution for ordinary investors grows.

Gas pipelines at a processing plant.

Image source: Getty Images.

From an individual investors perspective, there are two issues with this structure. One is that your interests aren't 100% aligned with management because of the ownership structure. The other is that incentive distribution rights drastically increase the cost of capital for a company over time.

Think of it this way. Say an MLP wants to fund a new project. For that project to make sense financially, it would need to generate enough cash flow to cover its funding source (either a distribution to new units or interest on debt) plus distribution growth for all units plus the incremental cash flow for those distribution rights. This can make the rate of return on new projects prohibitively expensive and constrain growth over time.

Thankfully for investors, several master limited partnerships have been restructuring lately to get rid of these incentive distribution rights. MPLX is just another one in a long line of companies that have realized the cost of giving its general partner jus primae noctis over its cash flow is detrimental to the long-term health of the business

IDRs have always been a sticking point for me when it comes to investing in master limited partnerships, which is why two of my largest holdings are master limited partnerships that don't have incentive distribution rights. With MPLX's simpler corporate structure that aligns all parties, I feel much more comfortable adding it to my portfolio.

What a Fool believes

MPLX shares a lot of qualities with the kind of energy companies I own in my personal portfolio, and its stock looks like a compelling investment with a distribution yield of 7%. That is why I elected to add it to my own portfolio as I intend on holding it for several years and reaping the benefits of reinvesting that distribution

I am going to keep an eye on the company's distribution coverage and management's plans over the long term. The company IPOed only 5 years ago, so it's hard to say that management has the long track record of generating returns and growing its payout that many like to see. Personally, I would much prefer a company that targets 8%-10% distribution growth that maintains that 1.2 coverage ratio or higher than trying to stretch growth into the double digits at the risk of a lower coverage ratio. As long as MPLX's management maintains its current trajectory, I'm willing to forgive its shorter lifespan as a public company.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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