With the markets bouncing around all-time highs, many investors are now finding it hard to find stocks that offer a decent dividend yield.
Master Limited Partnerships, or MLPs, offer some of the best yields on the market. Some offer mid double-digit payouts, while the rest of the market offers an average yield of around 2%.
But how are MLP’s able to achieve these high payouts?
Well, it all comes down to the structure of the partnership. MLP’s are structured in a way that encourages them to return cash to shareholders.
Master Limited Partnerships are not normal companies
MLPs have two separate partners, the general partner and a limited partner. The general partner can be a person or entity responsible for the running of the partnership. The general partner is paid a management fee and an additional incentive for increasing the distribution to limited partners.
On the other hand, the limited partners provide the capital for the company (through the purchase of shares) and receive a distribution of the profits (the dividend). The general partner is geared towards the distribution of profit, and legally must pass along the vast majority of its earnings to partners.
As MPL’s partners (shareholders) are effectively the owners of the partnership, the main body of the partnership avoids federal and state taxation on its profits. Instead, shareholders (partners) are taxed directly. This is unlike normal corporations, which have their profits taxed before dividend payments, then see their investors taxed on the dividends they receive. This lack of double-taxation really lends itself to the creation of an entity that generates a lot of cash and focuses on shareholder returns.
For example, StoneMor Partners L.P. (NYSE:STON), an owner and operator of cemeteries and funeral homes in the U.S., is able to return more of its income to unitholders than it would be able to if it were not structured as an MLP.
Indeed, during Q1 2013, the company’s GAAP operating profits fell by 74% to $1.4 million, compared to the prior-year period, while GAAP operating cash flow fell 16% to $6.9 million.
However, the company’s non-GAAP distributable income grew 28% to $16.9 million, of which the company returned 70% to shareholders or $12 million — almost double the GAAP operating cash flow that it would have been able to return to shareholders if it had been a normal company.
Are these payouts sustainable?
Yes and no. You see, since a MLP pays unitholders out of its free cash flow, dividends can be highly unstable from year to year. For example, Terra Nitrogen Company, L.P. (NYSE:TNH) distributions have been erratic for the past five years, as volatile natural gas prices have resulted in varying profits.
|Distribution per unit||$15||$9||$5||$14||$16|
In addition, while Terra Nitrogen Company, L.P. (NYSE:TNH) is in-line to achieve record profits this year, CAPEX spending is going to consume a large amount of cash flow, and unit holders will receive less in dividends than if the partnership were structured as a normal company. In particular, as a normal company, Terra Nitrogen Company, L.P. (NYSE:TNH) would be able to use retained profits from previous years to fund CAPEX, while maintaining a consistent dividend.
Meanwhile, investors should be wary
Many investors could get starry-eyed at the prospect of the double-digit yields that some MLP’s offer in such a low interest rate environment. However, investors need to be careful, since these high unit distributions can often distract investors from the actual state of the business.
For example, Navios Maritime Partners L.P. (NYSE:NMM), is currently yielding near 12%, but the company has a wave of charter expirations on its fleet of dry-bulk tankers in 2014, which will seriously constrict distributable cash flow, making it hard for the partnership to maintain payouts to unit holders.
In addition, Kinder Morgan Energy Partners LP (NYSE:KMP) is suffering due to its commitments to maintain a high yield for shareholders. The partnership returned $1.1 billion to partners through distributions during 2011 and $2.6 billion during 2012. However, this was almost all of the partnership’s operating income. To fund maintenance and CAPEX activities, the partnership has to borrow and issue stock to the value of $2 billion during 2011 and $3 billion during 2012, diluting shareholder value.
It appears that investors who are interested in high yields may want to consider an MLP. However, investors need to do their research and not be drawn in by the lucrative-looking yields in today’s low yield environment.
The article A Quick Rundown of Master Limited Partnerships originally appeared on Fool.com.
Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends Enterprise Products Partners L.P. and StoneMor Partners. The Motley Fool owns shares of StoneMor Partners. Rupert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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