Where do MLPs go now that Kinder Morgan (KMI) has slashed its dividend? So far, the broader MLP market is looking to Kinder Morgan for guidance even though it abandoned the MLP structure a year ago. The short answer is, quality matters.
On Thursday, Jerren Holder of Goldman Sachs wrote that Kinder Morgan's decision to cut its dividend by 75% would have "negative near-term read-through for the midstream sector, as it could provide a rationale for others with high leverage and/or low coverage to reduce dividends."
Even worse, Holder found that "distribution cuts of 62% on average have led to 60% cumulative stock price underperformance."
For investors, the question is which MLPs will reduce their distributions next. It's no easy feat as companies in the midstream sector seem to trade very closely even though the balance sheets of individual companies may vary widely.
For example, investors in the MLP ETFs such as Alerian MLP (AMLP) and Kayne Anderson MLP Investment (KYN) may find that they are disproportionately hurt by the weakness of one MLP, or MLP-like company, such as Kinder Morgan, despite there being better participants in the indices. Shares of KYN and AMLP are down 61% and 37%, respectively, for the year while Kinder Morgan is down 60%. Investors may avoid the hassle of receiving K-1s for their individual MLP holdings but their losses could be outsized due to trouble in some pockets of the industry.
In their heyday, MLPs were expected to provide tax-advantaged, bond-like returns with little correlation to the volatile energy assets that flowed through their pipelines. Whether energy prices were good or bad, oil and natural gas would still have to flow and the MLPs would continue collecting the tolls. (If this concept seems abstract, imagine the pipelines quite literally as a toll road: Even in a depressed economy, people will still have to drive to work during the week even if there are decreases in traffic at the margins.)
Unfortunately, the promise of low correlation to energy prices has proved not to be true as the financing energy companies can get depends heavily on the price of oil and gas. When times are tough, balance sheets are stretched thin and companies have a difficult time making distribution payments without further tapping debt and equity markets.
The prospect of tapping equity markets is less attractive in what Tom Abrams of Morgan Stanley calls the "vicious bear cycle."
"If we expected a company to fund growth with a $40 stock, but it had to be done with a $20 stock, then twice as many shares would have to be issued at twice the distribution yield (assuming the distribution hasn't changed) to raise the same amount of money," Abrams wrote on Tuesday.
So what does this mean for MLPs? Holder admitted that using past distribution growth as an indicator of future growth or cuts to distributions is no longer relevant. Instead, Holder and his team are relying on forward distribution growth, low debt to EBITDA ratios and high coverage ratios as positive indicators for distributions.
In this market, Gabe Moreen of Bank of America Merrill Lynch advised investors to seek quality businesses as measured by the ratio of their enterprise value to EBITDA instead of just looking at distribution rates.
"We believe quality will work over higher distribution rates amidst the current market condition," Moreen wrote in a report on Wednesday. "While we acknowledge the argument that higher-quality MLPs are relatively 'expensive' on an EV/EBITDA basis, versus high-distribution-rate MLPs that are trading at depressed valuations, we believe that higher quality may outperform."