MLPs: The last high-dividend sector with reasonable valuations

North-American mid-stream energy companies known as Master Limited Partnership (MLPs) generate at least 90% of their revenues from pipelines and other infrastructure assets for processing and transportation of crude oil, natural gas and natural gas liquids. Since MLPs generate most their revenues via fee-based contracts which are usually capacity- and not price-driven, they have less direct exposure to commodity prices than more traditional energy companies. They also combine the tax benefits of a limited partnership with the liquidity of publicly traded securities. Indeed, MLPs differ from C-Corp companies (the typical legal structure of a US Corporation) as they do not pay taxes at a corporate level but instead make regular distributions to their unitholders.

We recently received in our office one of the few PM managing a MLPs strategy through a UCITS vehicle. He firstly pointed out the size of the sector which is now close to 125MLPs with a total market cap of $375 billion and was pleased to notice that it has reached the critical mass needed to achieve sufficient diversification. In his view, the investment case for MLPs remains attractive despite the recent strong performance (+39.6% over the last 12 months for the Alerian MLP Index)

Outlook

While the strategy is focused on midstream assets and not on exploration and production sector, some MLPs still face credit issues. The PM doesn’t see near-term refinancing risk but some firms could be challenged if oil prices stay below $50/bbl

Fundamental

From a top-down perspective the PM sees two favourable catalysts. He expects oil price to be more stable, underpinned by strong global demand and he also thinks the Trump administration to be net positive for the energy sector.

From a bottom-up perspective, balance sheet quality has improved over the last 18 months due to deleveraging and dividend cuts measures. Importantly the manager sees some $50 billion – $60 billion of growth opportunities for MLPs during FY 2017-2020, which should allow them to increase distributions over time. His expectations are a distribution growth by 3%-5% over the coming years while by current prices, the market expects distribution cuts in 2017 and no growth in distributions over the next four years.

Valuation

The MLP sector is trading at a discount to long-term averages, yielding 7% versus an average close to 6%. MLPs are also trading 150 basis points more than high yield bonds which is historically at the highest level.

Finally, the strategy should be relatively spared if inflation start to picking up. MLPs own infrastructure assets, which in many cases have inflation-linked revenues.

Conclusion

As we saw in 2015 MLPs are not immune from oil price fluctuation even though they are capacity- and not price-driven. Moreover MLPs are anyway strongly correlated to other energy companies as part of Energy indices and therefore of ETFs. As a result, the volatility of the MLP industry is higher than 20%, substantially higher than the equity market.

Knowing that, we believe that the investment case for MLPs remains attractive and offers interesting long-term potential, backed by a favourable blend of fundamental and technical factors. As many high-dividend yielding industries (REITS, Utilities, Consumer Staples) are trading near their historical highs, we think that a reasonable allocation into MLPs should be considered both in income oriented or in capital appreciation oriented portfolios.

We have decided to introduce this fund in our Watch list and a full due diligence is planned before considering it for inclusion in the WSP master list.

Key fund characteristics

Source: Fund management company