Most master limited partnerships hail from the energy industry. It’s a proven model for flow through entities and it’s where we’ll be concentrating the majority of our efforts in MLP Profits.

 

That, however, is where the similarities between individual MLPs end. Some MLPs’ cash flows are almost wholly dependent on energy prices. Others, in contrast, are almost entirely independent of them, while still others lie somewhere in between.

 

Some derive revenue wholly from fees for the use of their assets, or by selling capacity on them. Others garner income from the spread between various refined and unrefined products. And still others utilized some combination of the two.

 

There are potential risks and rewards with every strategy. But here are a few general points. First, the less an MLP’s cash flow is affected by energy prices, the more secure its distribution, and the more likely its payout is to be increased steadily over time. The more cash flow is affected by energy prices, the greater the upside potential for both dividends and capital gains, though potential risk is greater as well.

 

Second, the MLPs’ earnings per share are basically irrelevant. Rather, what matters is funds from operations (FFO), or the cash generated that it can pass through to investors after taking out debt interest and capital expenditures. FFO can be wildly at odds with earnings per share, or it can closely mirror them. But it should, at a minimum, cover whatever payout the MLP has, both on a rolling 12-month basis and quarter-by-quarter.

 

The more secure the cash flows from the business, the higher a payout ratio can go without threatening distributions. Owners of pipelines that garner fees based on capacity rentals, for example, can routinely pay out nearly all of their FFO, since it is ultra reliable. In contrast, energy producers should have coverage ratios of at least 1.4-to-1.

 

Finally, there’s debt. Since MLPs must add to assets to grow cash flow, most access debt and equity markets on a regular basis. As a result, few show up favorably on conventional debt-to-equity ratios. Again, the key is the cash flow and the ability to spread out debt maturities. Most MLPs will try to maximize use of equity financing in good times, rather than rely on debt.

 

When we research a particular MLP, we take all of these factors into account. We also look at myriad other items like distribution track record, management’s strategy and effectiveness, age of assets, percentage of capital spending devoted to growth as opposed to maintenance and the location of the assets themselves. The result is a comprehensive assessment of potential risk and reward, which then shapes the buy/hold/sell advice presented in the portfolio “How They Rate.”

Hyper-aggressive MLPs can be extremely attractive at the right price, but only for investors who understand and are willing to take on the risk. Conversely, an ultra-safe MLP can be too high priced and/or wholly unsuitable for someone with a more aggressive risk profile.

 

That’s why we’ve divided the MLP Profits Portfolio into three segments, which are Conservative, Growth and Aggressive. Below, we discuss the Conservative segment. Growth and Aggressive are highlighted in other articles on the MLP site that can be accessed from the Home Page.Conservative is Cool

The Conservative Holdings are at the pinnacle of the quality spectrum. As the market volatility of the past several months showed, even the safest MLPs can take a hit from panic-stricken investors, particularly with institutions controlling so much of the market. But even in the toughest times in 60 years, there hasn’t been a whole lot to worry about our selections’ ability to keep paying and even increasing their distributions. The underlying businesses have been just that safe.

 

If garnering safe, high income is your game, you’re going to want to focus on this group. We’re starting out with three: Enterprise Products Partners (NYSE: EPD), Kinder Morgan Energy Partners (NYSE: KMP) and Sunoco Logistics Partners (NYSE: SXL).

All three start out as strong buys. We’ll be adding to their ranks in the coming weeks. Note that all three are discussed thoroughly in the Premium “Master Limited Partnerships: High Yields and Low Taxes.” It can be accessed from the “How To” menu on the Home Page.

Enterprise Products Partners is one of the largest and oldest MLPs in the US, focusing on fee-generating assets related to natural gas. And it’s on the verge of becoming larger still with a proposed takeover of sister MLP TEPPCO Partners (NYSE: TPP). TEPPCO has partnered with Enterprise on several occasions and is also heavily owned by billionaire empire builder Dan Duncan. TEPPCO has rejected an initial offer as too low, but with Duncan in the mix a deal looks likely.

Enterprise’s current asset mix includes both onshore and offshore gas pipelines, a series of floating production platforms in the Gulf of Mexico, natural gas processing and fractionating facilities for removing NGLs from the gas stream and NGL pipelines. First quarter earnings were extremely strong, showing almost no impact from the recession and with the MLP continuing its steady asset expansion program.

Enterprise’s payout ratio for the quarter came in about 83 percent, allowing yet another distribution increase, it’s 19th in a row. All assets performed well, in large part because the company doesn’t have much exposure to natural gas prices other than gas processing margins. But processing revenues tends to rise when oil is expensive relative to gas, increasingly the case recently. That should give profits a lift going forward into 2009.

As mentioned in the Premium report, the company’s two largest projects to be completed recently are the Meeker gas processing facility and the Sherman extension pipeline in the fast growing Barnett Shale region. The former is a gas processing facility located in Colorado; gas processing capacity in the Rocky Mountains isn’t sufficient to meet demand because the region has seen strong gas production growth in recent years.

We expect Enterprise to continue growing its distributions by at least the 5.9 percent rate it has over the last 12 months. Despite these defensive characteristics, it still yields nearly nine percent paid quarterly. Charter recommendation Enterprise is a buy up to 27.

Kinder Morgan Energy Partners is perhaps even less vulnerable to economic and energy price pressures than Enterprise. All operations are fee-based and there’s no direct exposure at all to energy prices, other that what the effect on throughput could be from a prolonged industry slowdown. And even there, Kinder’s assets are contracted to only the most secure customers.

As mentioned in the Premium, Kinder owns and operates refined petroleum products pipelines, natural gas lines, crude oil terminals and gas processing facilities. And most facilities are also backed by long-term capacity agreements in which shippers pay Kinder a demand charge whether or not they actually use their capacity.

Kinder Morgan Energy’s carbon dioxide (CO₂) business is basically a series of pipelines to transport carbon dioxide to mature oilfields where it’s used in enhanced oil recovery. Enhanced oil recovery is simply the process of injecting CO₂ into an old oilfield to help pressurize the field and produce more oil.

At present, this business is based around enhancing output from two mature oilfields owned by the MLP. At nine percent of overall revenue, that gives the company some exposure to commodity prices, though it essentially hedges all output. Long-term, however, Kinder’s experience with handling CO2 could prove to be an enormous asset, as power companies and others adopt carbon capture technology and need to dispose of their stored CO2. That’s a lot more likely now than last year, as the Democrats advance legislation to regulate CO2 in Congress.

Kinder’s first quarter dividend was above its distributable cash flow. The factors behind the shortfall, however, are ephemeral and should be reversed later this year. In fact, management is certain to boost distributions again at the first opportunity. Meanwhile, investors can enjoy the yield of nearly nine percent paid quarterly.

As noted in the Premium report Kinder has three major new gas pipelines in the works: the Rockies Express (REX), MidContinent Express (MEP) and Fayetteville Express pipelines. REX is designed to move natural gas from the Rockies east to the Pennsylvania/Ohio border. REX is in high demand because there’s a chronic glut of gas in the Rockies, leading to depressed local prices. As for MEP and the Fayetteville pipe, they’re also progressing and should be in service by the end of 2009, as will REX.

That will also provide cash for dividend growth. Buy Kinder up to 52. Note IRA investors should buy sister MLP Kinder Morgan Management (NYSE: KMR) instead. That’s because KMR pays distributions in stock and is therefore not liable for unrelated business taxable income. Buy up to 45.

 

The third charter member of the Conservative Holdings is Sunoco Logistics. The MLP owns a portfolio of extremely stable refined products pipelines and crude oil terminals. Refined products pipelines carry petroleum products like gasoline and jet fuel for which volumes vary very little even, including during the recent recession.

Moreover, Sunoco is able to offset any decline in volumes there may be with higher tariffs. Sunoco is also seeing even stronger growth in its terminals segment, as it’s been able to raise fees dramatically on older contracts coming up for renewal. And terminals are generally seeing high demand for ancillary services such as mixing ethanol and other additives to gasoline.

As for growth projects, tank facilities and a pipeline between the Nederland terminal in Texas and the Massive Motiva Port Arthur refinery are on track. So is the acquisition of a refined products pipeline in Texas from integrated oil giant ExxonMobil. These should enable management to meet its goal of a 10 percent distribution hike later this year. Buy up to 55.