For income investors, the sustainability of a company's payout is an extremely important consideration, almost as much as the yield itself. For oil and gas Master Limited Partnerships, this is especially true. These operators of energy pipelines and storage terminals traditionally pay extremely high dividend yields, since their favorable tax structures require them to pass along the vast majority of cash flows through to investors.
That's why, if an oil and gas MLP isn't earning enough to cover its distribution, investors are often right to be concerned. In light of recent troubles covering their distributions with sufficient cash flows, should investors worry about Kinder Morgan Energy Partners (NYSE:KMP) and Buckeye Partners LP (NYSE:BPL)?
Cash flow concerns
The primary measure for evaluating whether an MLP is earning enough to cover their hefty yields is its distributable cash flow. This is essentially a non-GAAP equivalent to a traditional metric such as earnings per share. And just as investors would analyze a company's payout ratio to determine whether a company can afford to pay its dividend, MLP investors should focus on the distribution coverage ratio.
Consider that in the most recent quarter, Kinder Morgan Energy Partners' distribution coverage ratio fell to under 1.0, meaning it didn't generate as much distributable cash flow as it paid in distributions. At the same time, the MLP increased its cash distribution to investors by 7% over the third quarter 2012 distribution.
At the same time, Buckeye Partners generated just $96 million in distributable cash flow during the most recent quarter, yet paid $115 million in distributions. That's a coverage ratio of just 0.84 times, compared to a coverage ratio of 1.19 times in the same quarter last year. And yet, Buckeye Partners increased its distribution as well, by 3.6% year over year.
Investors are likely concerned not just that Kinder Morgan and Buckeye Partners are having trouble covering distributions, but also because other MLPs are simply firing on all cylinders right now. Consider that Enterprise Products Partners (NYSE:EPD) produced record volumes in its liquids pipelines, and reached a near record in terms of gross operating margin in its third quarter. All told, Enterprise Products Partners generated distributable cash flow of $908 million for the third quarter, up 22% year over year. And, its distribution coverage ratio clocked in at a very healthy 1.5 times in the quarter.
Enterprise Products increased its distribution by 6% year over year, but with underlying results that continue to impress, there's no reason to be concerned over the sustainability of its payout.
With this in mind, it's reasonable to question your MLP holdings if they aren't generating enough cash flow to cover the most recent quarterly distribution, especially if industry peers are having no trouble on that front. Moreover, investors may begin to even doubt the skills of management if they're increasing distributions while cash flow disappoints. However, in the case of Kinder Morgan Energy Partners and Buckeye Partners, here's why that would be short-sighted.
Focus on the broader perspective
While it's understandable to become concerned when quarterly distributable cash flow doesn't cover distributions, it's worth taking the long view. One quarter's performance doesn't make or break a company. Kinder Morgan's and Buckeye Partners' results look much better, provided you keep a longer-term perspective.
In Kinder Morgan's case, management knew for some time that this quarter's distribution coverage ratio would suffer, and gave fair warning to analysts and investors alike. Kinder Morgan reiterated its intention to cover distributable cash flow for the full year. The company expects full-year distributable cash flow to increase nearly 7%, which is why a 7% distribution increase is not a cause for concern in management's view.
For Buckeye Partners, a portion of this quarter's miss was due to the conversion of 8.5 million Class B units. And, when you take a broader view, you'll see that over the first nine months of the year, the company's coverage ratio stands above 1.0, which gave management the confidence to raise its distribution.
As a result, the takeaway from recent MLP earnings is to not overly focus on one quarter. Kinder Morgan and Buckeye Partners are well-run with management teams that fully understand the importance of properly cushioning distributions with cash flow. These two, in addition to Enterprise Products, are very strong MLPs.
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Bob Ciura owns shares of Kinder Morgan Energy Partners LP. The Motley Fool recommends Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.