Energy-related master limited partnerships, or MLPs, offer investors a great way to cash in on the growth of U.S. energy production. MLPs come in different flavors. Some offer high yields that may not grow over time. Others offer a relatively low initial yield, but with a strong history of growing distributions. One way to determine the value of an MLP is to calculate its price to distributable cash flow, or P/DCF. This is done by dividing the market capitalization of the MLP by its annual distributable cash flow. A generally reasonable ratio is around 16.
Not too long ago, both Valero and Phillips 66 launched their own respective MLPs. Both of these started by paying a yield of roughly 2% -- not the sort of yield that causes investors to stampede a stock. Yet, both MLPs have done nothing but go up. Valero Energy Partners, LP (NYSE: VLP) units are up 77% over the past year, and Phillips 66 Partners LP (PSXP +0.00%) is up over 160% over the past year, with most of that gain in the past five months or so. One driver of Phillips' capital gains has been its distribution growth. Specifically, Phillips has increased its distribution from $0.155 to $0.274 in three quarters. Valero has made only one payment so far. With the run-up in their respective unit prices, are these MLPs overpriced, or not?
By the numbers
Since both MLPs are relatively new, we'll annualize the distributable cash flow from each company's latest earnings report. Phillips Partners reported $23.3 million in distributable cash flow, Valero Partners, $16.6 million. This works out to $93.2 million for Phillips, $54.4 million for Valero. Divide each company's market capitalization by its annualized distributable cash flow, and Phillips has a P/DCF of 61.8 and Valero, 52.6. Not cheap by any means.
Put another way, in order for Phillips to achieve a P/DCF of 16, it would have to increase its distributable cash flow 15-fold. Valero would have to increase its distributable cash flow 13-fold.
What is driving these valuations?
Both of these MLPs have short track records, Valero particularly. What do they offer investors to justify such a high premium? First, it's not yield. Currently, Phillips yields 1.44% and Valero 1.73%. Distribution growth, as mentioned before, is impressive for Phillips, but so far short-lived.
Most likely, investors are looking at their business model. Both MLPs have contracts with their parent companies to ship crude oil, refined products and natural gas liquids from company-owned terminals to refineries. That is, they have captive markets. These are fee-based contracts, so there is no direct exposure to volatile energy prices. The parent companies are well-established companies that aren't disappearing anytime soon. Both parent companies look to expand the scope of their MLP operations. Which is all to say, revenues and distributable cash flow should keep growing for both Phillips and Valero Partners.
Are they worth it?
I'm inclined to say no. While their business model seems to virtually guarantee success, for a starting yield of under 2%, no meaningful track record of distribution growth, and a sky-high P/DCF, I can't see these MLPs being a good investment at this time. A great deal of expectation is built into the price of both MLPs, and I can see a significant drop in unit price if distribution growth disappoints.
An alternative investment
Instead of paying a premium for Phillips or Valero MLPs, I would look at Williams Partners LP (NYSE: WPZ). This MLP was spun off of Williams Companies in 2005, currently pays a 6.7% yield, and sells for a P/DCF of about 10. In 2010, the distribution started at $0.635 per unit and rose every quarter since. Today, the payout is $0.905 per unit.
Williams operates a large network of natural gas and natural gas liquids pipelines and other midstream services. These assets connect some of the best sources of natural gas to some of the biggest markets in the U.S. These assets recently expanded with the recent announcement that Williams Companies acquired more assets from Access Midstream Partners. The parent company proposes transferring Access assets to the MLP, thus significantly expanding the scope of Williams' operations. There is some debate regarding the wisdom of this transaction, but given the response of the stock to the news, investors seem to like the deal for Williams.
Final Foolish thoughts
Investing in MLPs allows investors to benefit from the growing U.S. energy business. Like the price to earnings ratio for corporations, the P/DCF helps investors assess the value of an MLP. For both Phillips and Valero MLPs the ratios are much higher than average, with little yield or track record to justify their prices. No doubt both MLPs have solid business plans and will grow their distributions. Given their low yields and short track records of distribution growth, I would go elsewhere until distributable cash flow catches up to the price.
