Most investors love master limited partnerships for their generous cash distributions. That being said, investors need to do a little extra work to earn the additional income these entities throw off each quarter. Part of that work comes at tax time as MLP unitholders file a Schedule K-1 along with their normal tax documents, which requires more forms to be filled out. However, before an investor even starts to worry about a Schedule K-1 they need to find the right MLP to buy. That can prove tricky as traditional evaluation metrics simply don't work with these entities, meaning some investor arithmetic is required.
One number investors like to look at when evaluating an investment opportunity is the debt-to-equity ratio, which measures a company's financial leverage by dividing its total liabilities by shareholder equity. However, because of how MLPs operate and fund their business, this measurement can sometimes mislead investors into thinking an MLP is deeply in debt.
That's the case Emerge Energy Services LP (NYSE: EMES) CFO Robert Lane made on the company's latest quarterly conference call. An analyst on the call noted the company's debt-to-equity ratio has risen substantially over the past year, from 0.89 to 1.82 times, and wondered if it might be time for Emerge to slow spending to repay some its debt.
In response, Lane said the company keeps a close eye on its debt, but that its quite comfortable with the current level. That's because the metric that matters to Emerge isn't the debt-to-equity ratio.
We tend not to look at debt-to-equity as a primary ratio, given that as an MLP, we expect our book equity to be flat to down really every single quarter. As many of you know, we have -- most MLPs have their distributions exceed their earnings. That's par for the course for an MLP. As such, unless we issue new equity, our book equity account is going to be flat to down then every single quarter. So if we look at our debt-to-equity ratio, that's probably not a great metric for us to be following internally and it really isn't an area of focus.
Essentially, the fact that Emerge Energy Services pays out all of its earnings, and then some, as distributions causes investors looking at the debt-to-equity ratio to to think its leverage is worse than it really is. That's why Emerge and other MLPs pay closer attention to another key debt metric.
The metric that matters
Lane focused on a different ratio in his comments:
Our debt-to-EBITDA certainly is a much bigger area of focus and really -- I think we take a look at our projects and internally I think that the answer is if it's a one-year payback, it's a go. If it's a two-year payback, it's probably a go. If it's a four-year payback, it's something that we really have to see something pretty tremendous for our board to be able to agree to move forward with that. ... So I think if you want to talk about where we are with how we manage our debt, it's by doing these organic projects and have very strong and quick paybacks to ultimately lower our debt-to-EBITDA over the long term.
The debt-to-EBITDA ratio measures a company's debt against its underlying cash flow. Emerge believes this is a better measurement that it can use as a guide when evaluating growth projects. The company's goal is to keep that ratio at no more than 2.0 times, and it stands at just 1.80 times now. However, Lane noted the company is willing to let the ratio go a bit higher in order to fund a quick payback project that will bring the ratio back to its target range within a year or so.
Each MLP has a different view on what constitutes a safe debt-to-EBITDA ratio. Those with less long-term cash flow security tend to prefer that the ratio stays below 3.0 times, while others with rock-solid long-term fee-base contracts are OK with ratios of 4.0 times or more. That means an investor not only needs to look at the ratio, but also at the security of the company's cash flow before judging whether its leverage is too high.
Investors looking at buying MLPs need to make sure they're looking at the right metrics before passing on an investment opportunity. As Lane pointed out, one of the company's debt metrics is misleading because of MLP accounting. Looking at the wrong ratio could cause investors to pass on the company and miss out on its current double-digit yield.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.