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MLP stocks are trading sideways but equity costs remain reasonable

Ingrid Pan, CFA

Why the financing environment remains positive for MLPs (Part 2 of 2)

(Continued from Part 1)

Master limited partnerships rely heavily on external financing to fund growth

Master limited partnerships or MLPs are specially structured entities that must pay out most of the cash they generate to unitholders. So MLPs rely especially on external funding sources (as opposed to internally generated cash) to execute growth projects and acquisitions. Because of this, the state of the capital markets (generally referring to the equity and bond or loan markets) is an important factor in determining whether an MLP can find the money to participate in growth-oriented activities.

MLP equities traded mostly sideways recently, cost of equity remains attractive

Most MLP stocks have traded roughly sideways over the past few months. To give a few examples, since late August, Kinder Morgan Energy Partners (KMP) has traded in the $78-to-$82-per-unit range. Enterprise Products Partners (EPD) has traded in the $58-to-$64-per-unit range. Targa Resources (NGLS) has traded in the $48 to $53 unit range. Genesis Energy (GEL) has traded in the $48-to-$51-per-unit range. Also, the Alerian MLP ETF (AMLP) has traded in the $17-to-$18-per-share range.

The sideways trading action for most MLP stocks over the past few months means that the cost of equity capital hasn’t changed much (barring major changes in distributions). When stocks rally, it means the cost of equity has decreased, because the distribution yield (distributions divided by unit price) has decreased, meaning investors require less return on their equity investment. Conversely, when stocks sink, it implies a higher cost of equity capital. When the cost of equity increases, it’s negative in the sense that it’s more expensive for MLPs to fund growth and makes fewer growth projects and acquisitions attractive. The upside of this is that more expensive equity capital inherently comes from higher MLP yields as a result of stock price depreciation, providing a potentially attractive entry point.

MLP yields are down significantly since the financial crisis

From a longer-term perspective, MLP yields have compressed dramatically since the financial crisis. So raising funds by issuing equity had become a more and more attractive option over the past few years, as the cost of equity has continued to cheapen. During the financial crisis of 2008, yields on the aforementioned MLP stocks spiked up to levels from ~10% (KMP) to over 30% (NGLS) compared to levels of ~4% to 7% now on the same names.

Cheaper equity capital means more growth projects may be attractive

Again, the long-term yield compression on MLP stocks has been a positive for growth because generally, the lower the cost of funds, the more projects a company may find attractive. For example, if a company has identified a project that has returns of 15% and the company’s cost of funds is 10%, it may pursue the project. If the cost of funds increases, for example to 20%, the same project may no longer be viable to the company. Usually, the more attractive projects a company is able to pursue and fund, the greater the likelihood for an increase in a company’s assets and cash flow.

Currently, equity capital remains relatively cheap for MLPs. This helps fund MLPs’ growth, which is positive for the companies. The equity financing environment is an important factor for the majority of MLP names such as KMP, EPD, NGLS, and GEL. For more on MLP cost of capital, please see MLP cost of debt roughly flat through 3Q with Fed taper unlikely.

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