MLPs, or master limited partnerships, pass along nearly all of the income earned to investors through distributions. These distributions can be quite large, as the current yields of top MLPs look really appealing. For example, Enterprise Products Partners L.P. (NYSE:EPD) currently yields 3.5%, while fellow MLP Energy Transfer Partners LP (NYSE:ETP) yields an even more enticing 6.67%. However, investors seeking high-yielding MLPs need to know that the yield is only as strong as the numbers that support it. One critical number supporting that hefty distribution is the distribution coverage ratio, which is why investors in MLPs really need to understand this metric.
Distribution coverage ratio
MLPs typically pass along most of the cash flow earned from operations to investors each quarter. However, some MLPs pass along more than is earned each quarter either in anticipation of future growth, or because income has dropped, but the MLP doesn't want to cut its distribution. This is why investors need to know how much of a company's cash flow is being distributed by knowing the company's distribution coverage ratio.
The distribution coverage ratio is simple to calculate: It's the company's total available distributable cash flow divided by what it actually distributed to investors in a given quarter. Investors want to see that number above 1.0, with a ratio above 1.1x being favorable, as that means the company has a margin for safety. This extra cash flow can even be reinvested in projects that will grow distributable cash flow or used in other investor-friendly moves like repaying debt or buying back units.
One of the MLPs I mentioned in the beginning, Enterprise Products Partners, has an exemplary distribution coverage ratio. As the bottom-right chart in the following slide notes, the company's distribution coverage ratio hasn't been less than 1.2x in the past four years.
What's remarkable about this is the fact that Enterprise Products Partners has actually increased its distribution for 40 consecutive quarters. So, as we can see, Enterprise Products Partners is growing cash flow even faster than it is growing its distribution. That speaks to just how safe its distribution really is today.
Distribution growth is vitally important for MLPs because it really boosts returns for investors. This is clearly seen as Enterprise Products Partners' units have risen along with its distribution:
So, while Enterprise Products Partners' current yield might not be as appealing as the yields of other MLPs, long-term investors in Enterprise Products Partners have done quite well. Not only that, but its current yield is about as safe as it gets as the company still has plenty of room to grow its distribution to investors in the years to come, even if cash flow growth slows a bit.
When the distribution coverage ratio is weak
While Enterprise Products Partners has increased its distribution to investors for 40 straight quarters, investors in Energy Transfer Partners recently went a very long time without a distribution increase, as the following chart points out.
The reason for this is quite simple: Energy Transfer Partners' distribution coverage ratio was well below the critical 1.0 level for many quarters, as the following chart shows.
Because Energy Transfer Partners' distributable cash flow wasn't growing fast enough, the company simply couldn't increase its distribution. This put a lid on the price of units, as investors were not willing to pay up for a company that was having trouble growing its cash flow. Today, Energy Transfer Partners' distribution coverage ratio is much safer, so the company has been able to grow its distribution to investors. But, as its history clearly shows, once that coverage ratio slips below 1x, it's a warning sign for investors that the distribution likely won't grow for a while or, even worse, could be cut.
Investor takeaway on MLPs
The takeaway here is pretty clear: Dig a little deeper past the high yield of MLPs and look to see if the company is actually covering the payout. Investors should go back a couple of quarters just to make sure the current quarter isn't an outlier. As we saw from comparing Enterprise Products Partners to Energy Transfer Partners, a growing distribution that's supported by a strong distribution coverage ratio can yield very compelling long-term returns for investors in MLPs.
Matt DiLallo owns shares of Enterprise Products Partners. The Motley Fool recommends Enterprise Products Partners. 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.