Enterprise Product Partners (EPD 0.16%) has long been a favorite of income-oriented investors for its steady and consistently growing distribution. The company has been one of the best-run midstream companies for a long time and at the forefront of shareholder friendly moves, such as being one of the first MLPs to eliminate its IDRs (incentive distribution rights). This allowed the company to continue to increase its distributions even during the energy-price plunge of the mid 2010s.
That said, investing in an individual master limited partnerships (MLPs) like Enterprise Product Partners may not be best for everyone. Instead investing in an MLP exchange-traded fund, or ETF, such as Alps ETF Trust-Alerian MLP ETF (AMLP 0.32%) may be the better option. And it come with one other big benefit: no extra paperwork.
Investing in MLPs
The Alerian MLP ETF tracks the Alerian MLP Index, which holds a variety of midstream energy stocks that are structured as MLPs. The MLP structure was designed to provide tax benefits to companies involved in the production or transportation of natural resources, as well as their unitholders. MLPs don't have to pay taxes at the corporate level, while usually, a large percentage of MLP distributions are designated as a return on capital. This portion of the distribution is tax deferred until the stock is sold and instead reduces an investor's original cost basis.
That's a nice benefit for investors. However, it does come with one drawback: the issuance of a tax form called a K-1. Many investors dislike dealing with the complexities of K-1s, and they often arrive after most other tax forms. In some instances, MLP investments can also cause issues when held in retirement accounts, creating a taxable situation. As a result, some investors look to avoid MLPs altogether.
However, there are a number of top MLP stocks with attractive yields that investors can own while avoiding K-1s by investing in the Alerian MLP ETF.
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Why MLPs currently look attractive
The Alerian MLP ETF is invested in energy midstream companies involved in activities such as gathering, processing, storing, and transporting natural gas, oil, natural gas liquids (NGLs), and refined products. These companies generally don't have much direct commodity exposure and are often viewed more as toll roads. They tend to generate a lot of cash flow and pay out handsome distributions. The ETF has a yield of 7.3% and an expense ratio of 0.85%.
There have been a lot of positive changes in the midstream space with MLPs over the past decade. In the past, the MLP structure was very unfriendly to investors, as companies' general partners (GP) would take advantage of LP holders, which was the level where retail investors would most often own the stocks. GPs would own incentive distribution rights (IDRs) where LPs would have to pay a percentage of the distribution to the GP when distributions reached a certain level.
Once IDRs got to a 50/50 high split, the LP was paying double for any incremental distribution increase. For example, if the LP raised its distribution by two cents per unit, or $2 million in aggregate, and additional $2 million would go to the GP, not accounting for any units the GP held. Most pipeline MLPs had IDRs, although the percentages for each were slightly different and a few energy producers that were structured as MLPs that never has then.
This led many MLPs to add leverage and frequently raise equity in order to chase low-return projects and continue to push up distributions. About 15 years ago, it wasn't uncommon to see MLPs diluting holders with two to three equity raises a year. Investors liked the large distribution increases, but it ultimately benefited the GP more than the average MLP unitholder. At the same time, it left many MLPs overleveraged with slim distribution coverage ratios, which measure how much a company's cash flow is covering the distribution.
Enterprise Partners was one of the first pipeline MLPs to address the issue of IDRs, reducing its high split in 2002 to a 75%/25% split and eliminating them altogether toward the end 2010. However, most midstream companies followed suit several years later, as the industry began to change for the better out of necessity as a difficult energy environment and tax change ruling rattled the sector. Companies bought back and eliminated IDRs, GPs and LPs merged, balance sheets were repaired, growth was slowed, and conflicts of interest in much of the industry were eliminated. Today most MLPs do not have IDRs, with only a few stragglers still holding on to them.
Despite all these positive changes, midstream stocks actually trade below where they did before the pandemic. Prior to COVID-19, MLPs traded at an average enterprise value (EV) to adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio of nearly 12 times the prior 10 years. Today, the top five holdings of the Alerian MLP Index all have EV/EBITDA valuations of less than 10 times.
PAA EV to EBITDA (Forward) data by YCharts
A great time to buy the Alerian MLP Index
The Alerian MLP Index has performed well the past several years. The ETF is up over 13% this year, and it had a nearly 100% cumulative return over the past three years.
Despite the recent solid performance, MLPs still trade at historically low valuations. At the same time, companies are in much better shape financially and are better run today than 10 years ago. Leverage throughout the industry has come down, coverage ratios are higher, and companies now typically look to pay for growth projects from free cash flow after distribution payments. This allows them to grow while also paying down debt and lowering leverage.
The Alerian MLP Index gives investors to access to some of the best-run MLPs, including Enterprise Products Partners (EPD 0.16%) and MPLX (MPLX 0.02%), two companies that have consistently grown their distributions year in and year out. The ETF also holds two companies that have turned their businesses around in the past few years in Energy Transfer (ET 0.12%) and Plains All American Pipeline (PAA 0.90%).
For investors looking for yield, there aren't many places better than MLPs, and the Alerian MLP index is a great way to invest in the space.
