During 2009, the Alerian MLP Index (NYSE: AMZ) delivered a 76% total return.
However, it is important to remember that the AMZ fell 37% in 2008. Because compounding off a lower base makes a significant difference in returns, the index needed to recover 59% in 2009 just to break even. Many actively managed MLP funds fell more than 60% in 2008, and so they would have had to return 150% in 2009 just to break even.
Given the confluence of events in 2008 – the collapse of two large MLP-focused hedge funds (GPS and Lehman Brothers), the exit of many banks from the MLP swaps business, and forced deleveraging by funds during the credit squeeze – MLP performance was artificially depressed.
As a result, although 2009 returns appear extraordinary at face value, in the context of a two-year period, the AMZ rose a tempered 11%. Although this significantly outpaced broader equities as the S&P 500 fell 20%, MLPs still present a strong buying opportunity at current levels. Instead of focusing on 2009 headline performance, investors should consider the fundamentals and valuation.
Toll-Road Model Proves Stable
Many MLPs have toll-road business models. They (1) receive a specified tariff for hauling a product over a certain distance; (2) do not take title to the commodities they transport; (3) are agnostic to the absolute level of commodity prices because these prices do not enter the revenue equation; and (4) do not have significant credit risk as commodity prices rise or fall.
As a result, these toll-road business models produced consistent margins and performance over the tumultuous economic period of the last two years. The margins earned by pipeline and storage assets in particular were largely unaffected by the commodity collapse of 2008 and the subsequent rebound of 2009.
We prefer to value MLPs by discounting cash flows at conservative, asset-specific required rates of return. Our analysis indicates that the group, on average, is close to being fairly valued. But that does not mean that investors should not add to positions. Current net asset values discount low-teens equity returns for the sector, which we believe is highly attractive in this or any market, especially on a risk-adjusted basis.
Drilling down further, some large-cap MLPs have catapulted ahead of themselves, which is normal for an economic recovery and the resulting flight to quality. But we continue to see strong value, particularly in the mid-cap space, and solid opportunities to put money into undervalued businesses with upside potential due to asset positioning, management acumen, or both. Generally speaking, we see the greatest number of opportunities in the refined products pipeline and storage group.
As compared to other asset classes, MLPs also remain attractive on a yield basis. Further, our expectation for 4% average distribution growth in 2010 compares favorably to that of other yield-oriented investments.
Outlook for 2010
With the improvement in valuations, we expect the IPO market to return after a hiatus dating back to May 2008. We expect to see at least two to four IPOs in 2009 as private equity players and rapidly growing companies will be eager to gain access to the public markets.
We expect secondary equity issuance to approximate 2009 levels of $7 billion to $8 billion. Though less deleveraging will be needed in 2010 (aside from a few MLPs who remain precariously over-levered), we expect third-party acquisition activity to increase as oil and gas companies continue to pursue asset optimization strategies and private equity players (and lenders in distressed situations) seek liquidity on these investments.
We believe MLPs will grow their distributions on average by 4% in 2010, with almost all of that growth driven by the pipeline and storage names. Commodity-sensitive MLPs, including those engaged in the gathering and processing businesses, will likely use 2010 to improve leverage ratios and cushion coverage ratios.
Given the average yield of 7.4% and our expectation for muted valuation improvement going forward, we expect the group to provide low-teens returns for 2010. There is upside to these expectations if valuation continues to improve as investors seek yield. Given the relatively low risk profile of many MLP business models, we believe these base case return expectations are more than compelling enough to warrant additional investment at this time.
MLPs have generated 15.5% annualized returns over the past 14 years, not because of any one-time event or change in relative valuation, but by consistently growing their cash distributions over that period by 8% per year.
Although we expect a more modest 4%-6% growth over the next decade, the model remains the same: (1) top-line growth driven by energy demand growth and/or PPI-indexed transportation tariffs; (2) low-single-digit cash flow growth as these fixed-cost business models allow much of the predictable revenue growth to reach the bottom line; (3) attractive organic investment opportunities resulting from regional franchise footprints; and (4) asset acquisition opportunities, which create additional distribution growth.
MLPs offer more secure and predictable earnings than the broader market, with earnings volatility one-third that of the S&P 500. Given attractive current yields coupled with distribution growth of 4%-6%, we expect MLPs to generate superior risk-adjusted returns over the long term.