Tuesday, July 16, 2013

How to Increase Current Yields with Master Limited Partnerships

As a buy and hold investor, I usually refrain from selling, unless there is something drastic like a dividend cut. Over the past year however, I have tried to sell some legacy positions, which either didn’t perform well or were overvalued with similar companies available at cheaper prices. The transaction I did last week was an example of this, as I replaced a position with other similar equities, without sacrificing quality.

Last week, I sold two-thirds of my position in Enterprise Product Partners (EPD). The units had reached a current yield of 4.30%, which was a little low for an MLP, even in the current low interest environment. Over the past five years, this partnership has managed to boost distributions by 5.70%/year. I believe EPD is a high quality partnership, which will likely produce very good distribution hikes over the next decade. However, I believe that there are better values out there in the MLP space. In general, despite low interest rates today, I do not find pass-through entities yielding 4% to be a good value, although they could be decent holds if no other opportunities along the quality curve are available.

The good thing about this transaction was that I was able to find values in the same sector, without sacrificing quality. I split the proceeds in three equal portions, and purchased the following securities:

The first lot was allocated to shares of Kinder Morgan Inc (KMI), which owns the general partnership interests in Kinder Morgan Partners (KMP) and El Paso Pipeline Partners (EPB). The company also owns limited partnership interests in KMP and EPB. As a general partner, Kinder Morgan Inc receives 50% of the distributions growth above a certain threshold. Therefore, because the underlying partnership has been growing over the past several years, Kinder Morgan Inc is expecting to be able to boost dividends in the low double digits for several years to come. Currently, the stock yields 3.90%.

One third was invested in Kinder Morgan Management LLC (KMR). Kinder Morgan Energy Partners has managed to boost distributions by 7.40%/year, over the past five years. In addition, the partnership is expecting very decent distributions growth over the next several years. However, instead of purchasing the partnership units (KMP), I invested in the LLC, which is treated like a corporation (KMR). Kinder Morgan Management LLC (KMR) owns units of Kinder Morgan Energy Partners (KMP). The LLC pays distributions in stock, which eliminates the taxable event in the eyes of the Internal Revenue Service. As a result, for investors in the accumulation stage, investing in Kinder Morgan Management LLC (KMR) is a better alternative to investing in Kinder Morgan Energy Partners (KMP). KMR has always traded at a discount to KMP, which should magnify total returns going forward. For every share of KMR, there is a partnership unit of KMP. The yield on Kinder Morgan Energy Partners is 5.90%.

The last portion was allocated to ONEOK Partners (OKS), which operates Natural Gas Gathering and Processing, Natural Gas Pipelines, and Natural Gas Liquids. The partnership has managed to boost distributions by 5.40% over the past five years. ONEOK Partners is undergoing a massive capital investment phase, which should result in much higher distribution growth over the next several years. Currently, the partnership yields 5.60%. Check my analysis of ONEOK Partners.

In essence, I view this swap as maintaining quality of ownership stakes by staying in the same sector, while achieving better yields and similar if not slightly better growth prospects.

My position in Enterprise Product Partners was initiated in the low 40s in 2011, and therefore by selling in the low to mid 60s, I am probably going to face decent sized capital gains hit. MLP distributions are usually tax-deferred, and they reduce your current basis. As a result, while you do not pay taxes on the majority of distributions during your holding period, you get to pay them when you sell. For example, if you bought EPD at $40/unit in 2011, and received $6.27 in distributions over the next 2 years, your cost basis would have been reduced to approximately $33.73/unit. Therefore, if you sold at $63.73/unit, you would owe taxes on $30/unit, not $23.73/unit.

The goal of successful investment is to identify great companies, which can provide promising returns through distributions and capital gains. Tax considerations should come secondary for investors. If you do not like something about a position, and the only reason you are not selling is because of the potential tax hit you would take, then you are asking for trouble. If you are correct about the negative investment outcome and do not do anything about it, you would be able to deduct your losses later on, before you move on.

Overall, I replaced an equity stake that grows at 5.7% and yields 4.30%, with three ownership stakes that deliver a better current yield in total. In addition, the new stakes will be able to generate a higher growth in distributions over the next few years.

Full Disclosure: Long EPD, KMI, KMR, OKS

Relevant Articles:

Check Out the complete Archive of Articles
Enterprise Products Partners (EPD): A Pipeline Cash Machine
ONEOK Partners (OKS) Dividend Stock Analysis
Kinder Morgan Partners (KMP) for High Yield and Solid Distributions Growth
Kinder Morgan Partners – One Company three ways to invest in it

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