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Monday, January 21, 2013

MLP Selection Criteria

The main goal of DivGro is to generate a reliable and growing dividend income stream. In striving for reliability, I look for high quality, fairly valued businesses with long histories of strong, rising dividends. Taking on unnecessary risk for short-term gains or unsustainable yields will not deliver a reliable income stream in the long run.

I've designed my selection criteria to help me identify appropriate candidates for DivGro. As stated, the selection criteria target dividend paying companies that report their financial results regularly, and for which metrics like price to earnings ratio, dividend payout rate, and earnings growth rate are readily available.

There is another class of businesses that produce dividend-like income worth considering: Master Limited Partnerships (MLPs). For MLPs, I use a different set of selection criteria, because they operate with special rules and offer certain tax advantages.

About Master Limited Partnerships

MLPs are limited partnerships that trade publicly on a securities exchange. They must generate at least 90% of their revenue from real estate, natural resources and commodities. Given this constraint, MLPs don't pay corporate taxes, but they have to pay a minimum quarterly distribution to partners who have individual responsibility to pay taxes on their income.

When you invest in an MLP, you buy units and become a limited partner (LP). As an LP, you can experience certain tax benefits. Specifically, a cash distribution identified as return of capital is unlikely to incur a tax liability until you sell units. But a return of capital reduces your cost basis, and if you remain a partner for a very long time, your cost basis could go down to zero. If that happens, future distributions are no longer sheltered as return on capital, but instead becomes fully taxable.

Owning MLPs require special treatment at tax time. You'll receive a special tax form called a Schedule K-1 and you'll need to report your income, deductions, credits and other important information. You'll also be adjusting the cost basis of your units each year, depending on the level of cash distributions, taxable income, and deductions such as depreciation.

Personally, I don't like dealing with Schedule K-1's because some MLPs send their forms rather late, or sometimes repeatedly with corrections. MLPs also report their results differently, so there isn't a simple recipe to follow when completing your tax forms for MLPs. And I'm not in a particularly good mood when I'm filing taxes, so dealing with obscure details and slight variations is not my idea of fun. But MLPs do have tax advantages and many deliver excellent yields.

It is a good idea to consult a tax professional before investing in MLPs.

Selection Criteria for MLPs 

To evaluate MLPs, I consider the MLP's ability to create wealth and to pay distributions over an extended term. Some of these criteria are quantifiable, while others are not.

1. Distribution yield exceeds 6.75%

In my view, the extra work involved with MLP ownership at tax time is only worth my effort if I can earn a great yield. I think a premium of 4% is reasonable. (For non-MLPs, I require a yield of at least 2.75%).

2. Promising prospects for future growth

MLPs are known for a unique mix of stability, income and growth. Most operate as providers of infrastructure, which don't require ongoing capital expenditure. Income is generated through stable, rate-regulated fees. To grow sufficiently, MLPs have to expand capacity. They can do so by borrowing money at favorable interest rates and investing in new infrastructure. I like to see evidence of future growth opportunities, either through acquisitions or planned expansion projects.

3. A strong history of increasing annual distributions

A "streak of annual distribution increases" would be preferred, but in some cases MLPs keep distributions constant, preferring to deploy earnings to instead ensure growth, often through acquisitions. I allow for such cases, particularly because most MLPs are set-up with strong incentives to the general (managing) partners to grow cash distributions to limited partners.

4. Price discount is at least 10% of fair value

Purchasing an MLP at a 10% discount ensures upside potential in case I ever need to sell. Also, I'm not a financial analyst and so I'm relying on others' estimates of fair value. A 10% discount provides some security.

5. Distribution coverage ratio is at least 100%

To ensure sustainable distributions, MLPs must earn enough from operations to cover not only distributions, but also maintenance and other operational expenses. As most MLPs distribute all available cash, the coverage ratio will be tight. If it is deficient, future distributions could be compromised.

6. Debt to capital ratio is below 67%

In today's low interest environment, MLPs use debt to invest in future growth. This strategy is fine as long as the financial leverage is reasonable. If the debt to capital ratio exceeds 67%, an unhealthy portion of the MLP's operations may be relying on debt. If that happens, risk will increase over time and future distributions may be compromised.

7. Distribution growth rate averages at least 5% over last 5 years

I like to use a weighted average distribution growth rate calculation to favor recent distribution increases. Without real justification, I assign a weight of 5 to the most recent distribution increase and decrease this weight in whole numbers for distribution increases going back in time. Thus, the distribution increase 5 years ago gets a weight of only 1. For MLPs, I'd like to see the average top 5%.

8. Price to earnings ratio is less than 16

I consider a P/E ratio not exceeding 16 to be favorable for MLPs. A ratio higher than 16 would not disqualify a candidate, but I would be more cautious in my analysis. Note that a preferred way to assess the relative valuations of different MLPs is to consider the ratio EV/EBITDA, or enterprise value over earnings before interest, taxes depreciation and amortization. I nevertheless use the P/E ratio because it is readily available online.

9. Return on equity exceeds 12%

Return on equity (ROE) measures the profitability of a business. I don't want to invest in a business that cannot generate at least 12% return on equity. The ROE of S&P 500 companies average between 10 to 15%.

10. Consistent revenues and limited exposure to commodity price fluctuations

The MLP should generate positive net cash flow from operations every quarter and should not have significant exposure to commodity price risk in its revenue stream.

I've added the MLP selection criteria to my summary of DivGro's constitution and investment strategy.

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