In This Issue

• Answers to your questions about the MLP Profits Safety Rating System, first thoughts about third-quarter earnings numbers, the state of carried interest legislation, the best portfolio buys now, and where to set dream buy orders for high-priced picks.

The books are now officially closed on third-quarter 2010. While we wait on companies to report, it’s a great time to look again at the make-or-break numbers we use to rate master limited partnerships (MLP).

How They Rate posts an MLPP Safety Rating based on four criteria. The more of these an MLP meets, the more secure and stable is its distribution. MLPs meeting all four criteria, for example, draw our highest rating of “4” for safety. Those meeting none of the criteria draw our lowest rating of “0”. Here are the criteria in brief:

Percentage of Fee-Based Income. MLP income based on fee-for-service is not directly impacted by energy prices. As such, it’s steadier and more reliable in times of economic weakness, such as what we’ve seen in North America since mid-2008. Best of all is revenue that comes from capacity payments. That is, the customer pays whether they use the pipelines, energy storage or processing facility or not.

The more an MLP relies on fee-based income, the more secure its distribution. Consequently, under our safety rating system, we award one point for any MLP that derives 75 percent or more of its revenue from fee-based businesses. These include ownership of pipelines, energy storage systems, energy processing facilities or anything else that generates steady revenue whether oil is at $100 or $25 a barrel.

All of the MLPs in the Conservative Holdings rely almost entirely on fee-generating assets. That’s a big reason why they’re our safest recommendations. Like any other equity, their prices go up and down. But as they proved during the last bear market, they can continue growing cash flow even under the worst possible circumstances, as their revenue remains secure.

In contrast, the more an MLP relies on income that’s affected directly by energy prices, the more volatile its distribution will be over time. That can be a very good thing and our Aggressive Holdings–which derive almost all of their income from commodity price-related revenue–offer a lot of upside because of it. But those interested in safety will want to pay attention to this key criterion. Commodity price-affected sources of income at MLPs include energy production, gas gathering, processing that depends on price spreads between refined and unrefined energy and even shipping rates.

Payout Ratio/Coverage Ratio. The payout ratio compares the distribution to the income that pays for it. The greater the margin between income and the distribution, the safer the payout and the more likely it is to grow. For MLPs, the key measure of income is distributable cash flow (DCF). MLPs’ unique structure allows them to minimize earnings per share (EPS), the measure of profitability for ordinary corporations. DCF factors in this ability to shelter income from taxes by adding back in those tax avoidance items, which are mainly accounting expenses that involve no outlay of cash. Maintenance capital expenditures are taken out of cash flow, as they represent cash needed to run the business and maintain equipment.

Most MLPs express the payout ratio by dividing DCF by the distribution as a “coverage ratio.” That’s basically the inverse of what most corporations do, which is expressing the distribution as a percentage of income. The result, however, conveys the same information. That is a coverage ratio of 1.25, for example, is equivalent to a payout ratio of 80 percent. A higher coverage ratio/lower payout ratio is preferable to a lower coverage ratio/higher payout ratio.

We take our analysis one step further, however. The more reliable an MLP’s income is, the higher a payout ratio or lower a coverage ratio it can sustain. Consequently, we use a two-tiered system. We’ll give a fee-based MLP a point for payout coverage of 1.1 to 1 or better, but we’ll only give a commodity leveraged MLP a point if coverage is 1.25 or better.

Debt. Fitch, Moody’s and S&P rate only a handful of the larger MLPs. And even the strongest, like Enterprise Products Partners LP (NYSE: EPD), are barely investment grade. That hasn’t hurt their ability to raise capital this year: Enterprise actually has a bond maturing in 2068–58 years from now–with a yield-to-maturity of just 6.85 percent. But as credit market conditions change, it’s important to keep a handle on debt levels of MLPs.

As with the payout/coverage ratio, MLPs that rely on fee-based income have a much wider margin for error than do MLPs that depend more heavily on commodity prices. As a result, we’re willing to tolerate ever, the cost of debt will rise again, and MLPs with high debt levels will be penalized for being overly aggressive. We give each fee-focused MLP a point under our safety ratings system if debt is 60 percent or less of total capital. For those more dependent on commodity prices, the threshold is 50 percent.

Dividend Growth. Consistently growing distributions not only increase your income stream. They’re also the surest catalyst for higher MLP unit prices over time. We prefer management to lift the distribution each quarter but generally award a point for any company that has increased its payout at least once in the past 12 months.

Note this is another point on which fee-based MLPs have generally outperformed commodity price-sensitive MLPs over the past year. With rare exceptions, such as EV Energy Partners LP’s (NSDQ: EVEP), most commodity-price sensitive MLPs have been fortunate to hold their payout levels steady, given the crash in oil and gas prices. We expect to see distribution growth perk up again for this group in 2011, as MLPs boost their output and oil prices remain strong. Growth could become particularly robust if and when natural gas prices revive.

Again, that’s a potential catalyst for more capital gains in our Aggressive Holdings particularly. But as with all things MLP, the greater the focus on fees the steadier the results.

Reading the Numbers

The MLPP Safety Ratings currently shown in How They Rate reflect second-quarter numbers. Over the next several weeks they’ll be updated to reflect third-quarter numbers.

Again, fee-based MLPs are virtually certain to score more highly than commodity price-sensitive MLPs. That doesn’t mean they should necessarily be bought, any more than lower-rated fare should be sold. But it does mean that anyone who owns them should be conscious of the risks–as well as the greater potential rewards and (quite often) higher yields.

This differentiation is why we’ve essentially split our model portfolio into three parts. The Aggressive Holdings derive the lion’s share if not all of their income from businesses that are heavily influenced by commodity prices. Conservative Holdings are basically not directly exposed to commodity price swings. Finally, Growth Holdings are mainly fee-based but have significant commodity price exposure that will affect DCF.

Our assumption is that most investors will pick some from each group, which is basically what our mutual fund pick Kayne Anderson Energy Total Return Fund (NYSE: KYE) does on a regular basis. That’s in fact why we list Kayne as a Growth Holding–some of its portfolio is commodity price-sensitive while some isn’t.

Investing is a highly personal exercise. Everyone has his or her own risk tolerance and goals and should invest accordingly. Note that our advice is still to generally avoid MLP investments that aren’t focused on energy, for two reasons.

First, there are just too many examples of failure outside of energy. Companies organized as MLPs and therefore committed to paying out most of their cash flow, even though their core businesses were ill-suited for this.

Most of these outfits were cleared out by the debacle of late 2008, when they were forced to rely on their own resources in a contracting economy. But there are still some out there paying out cash flow in distributions that’s badly needed for the underlying business to function long term. They may survive for a time and pay out yields that appear attractive on the surface. But they’re at constant risk to follow the example of bankrupt and now delisted US Shipping Partners LP. Even secured creditors recovered only 70 to 80 percent of their investment in that debacle.

The second reason to avoid non-energy related MLPs is the continuing possibility of a new tax on carried interest. With Congress now adjourned for campaigning, the hedge fund managers targeted by the leading legislative effort on this issue have dodged a bullet, at least for the time being, as have the non-energy-related MLPs that were also in danger of losing tax status.

However, that still leaves the “lame duck” Congressional session to follow Nov. 2 elections as an avenue to pass a new tax. And no matter who’s in charge of Congress come January, Uncle Sam is going to be hard up for money with few easy ways of getting it, either by cutting spending or raising taxes. That’s certain to keep carried interest taxes on the agenda, particularly with a bill already passing the House of Representatives. And that’s a potential disaster for any MLP not related to energy.

In contrast, as we’ve pointed out here, MLPs that are involved with energy-related activities have been specifically excluded from the House bill. This also includes the general partner interests, whose takeovers were the subject of the Sept. 17 MLPP, General Partners for Sale.

That’s no guarantee energy focused MLPs won’t be added back in to a future version. But energy-related MLPs do enjoy considerable support even among Democrats in Congress. And the likely new makeup of the national legislature isn’t likely to favor an expanded MLP tax, either.

Here’s when we expect to see earnings reports for our Portfolio MLPs. We’ll be updating them each week as they appear–and with alerts if the numbers necessitate a change in our advice.

Conservative Holdings

• Enterprise Products Partners LP (NYSE: EPD)–Oct. 26
• Genesis Energy Partners LP (NYSE: GEL)–Nov. 5
• Kinder Morgan Energy Partners LP (NYSE: KMP)–Oct. 20
• Magellan Midstream Partners LP (NYSE: MMP)–Nov. 2
• Spectra Energy Partners LP (NYSE: SEP)–Nov. 5
• Sunoco Logistics Partners LP (NYSE: SXL)–Oct. 26

Growth Holdings

• DCP Midstream Partners LP (NYSE: DPM)–Nov. 5
• Energy Transfer Partners LP (NYSE: ETP)–Nov. 9
• Inergy LP (NSDQ: NRGY)–Nov. 30
• Kayne Anderson Energy Total Return Fund (NYSE: KYE)–N/A
• Targa Resources Partners LP (NSDQ: NGLS)–Nov. 4
• Teekay LNG Partners LP (NYSE: TGP)–Dec. 8

Aggressive Holdings

• Encore Energy Partners LP (NYSE: ENP)–Oct. 27
• EV Energy Partners LP (NSDQ: EVEP)–Nov. 9
• Legacy Reserves LP (NSDQ: LGCY)–Nov. 4
• Linn Energy LLC (NSDQ: LINE)–Nov. 4
• Navios Maritime Partners LP (NYSE: NMM)–Oct. 29
• Penn Virginia GP Holdings LP (NYSE: PVG)–Nov. 4
• Regency Energy Partners LP (NSDQ: RGNC)–Nov. 9

Portfolio Roundup

The third quarter was overall very positive for total returns on our favored MLPs. In fact, we’ve seen several push out to new all-time highs, as interest in them has swelled.

Some of this has been due to our picks continued solid performance as businesses. As we’ve reported in recent weeks, the best MLPs have had no problem issuing both debt and equity capital this summer, some at the lowest cost in their history.

Our picks certainly demonstrated in late 2008 and early 2009 that they can get along just fine without cheap capital. But access to it now means that numerous projects are suddenly compelling as cash generating opportunities, including very low risk ones. That’s set the stage for faster distribution growth going forward, even as management continues to strengthen balance sheets.

Buying driven by ever-brightening business conditions, however, is at best only half the story. Rather, it looks to us as though MLP returns are in large part being fueled by technical and emotional factors. These include the recent creation of sector exchange traded funds and closed-end funds, which has soaked up supply.

On the market emotion side, they include worries about a steep surge in investor taxes on dividends starting Jan. 1, 2011 when the Bush tax cuts expire, as MLPs’ distributions won’t suffer any additional levies. And MLPs are also likely gaining adherents as trusted dividend payers in what’s still a very uncertain overall marketplace.

Our Portfolio tables show each pick’s total return since the date of our initial recommendation. These dates are shown in the second column from the left in the tables. Total return is total distributions plus received, plus any appreciation in the MLP’s unit price. These returns are updated throughout the day along with MLP unit prices and yields.

The first issue of MLP Profits was dated May 26, 2009. As a result, the oldest recommendations we have date to that point. The most recent addition to the Portfolio was Aggressive Holding Penn Virginia GP Holdings LP (NYSE: PVG), in the May 21, 2010 issue. It’s up about 46 percent, in part thanks to a takeover offer from Penn Virginia Resource Partners LP (NYSE: PVR), of which it’s the general partner.

Under the terms of that deal, each unit of Penn Virginia GP Holdings will be exchanged for 0.98 units of Penn Virginia Resource Partners. That’s a takeover value of approximately 5.3 percent above Penn Virginia GP Holdings’ current price. In addition, Penn Virginia GP Holdings owners will get an effective 18.1 percent boost in their current quarterly distribution of 39 cents per unit. The union is still awaiting unitholder approval, which will be voted on in a special meeting later this year.

That’s not a 100 percent sure bet, given that seven law firms have already launched “investigations” of the terms of the deal. And it may be that the GP will have to up its offer slightly to secure easy approval. To date, however, every LP takeover of a GP has been successful. And the three others now in progress appear to be sailing through, including Enterprise Products Partners’ buyout of Enterprise GP Holdings (NYSE: EPE) and Inergy LP’s (NYSE: NRGY) merger with Inergy Holdings LP (NYSE: NRGP).

Inergy LP has set Nov. 2 for a vote by unitholders on its GP takeover. Management states that 57.9 percent of units of Inergy Holdings have already pledged to vote “yes,” which should assure passage. Meanwhile, the support of the heirs of the late Chairman Dan Duncan through EPCO makes any attempt to overturn Enterprise Products Partners’ GP takeover very much an uphill battle at best.

As it was only announced Sept. 21, the Penn Virginia Resource Partners-Penn Virginia GP Holdings union has a few more hurdles to cross, the first of which will be a pass from the Securities and Exchange Commission.

But with odds favoring eventual approval and given the rising value of its primary asset–the GP interest in Penn Virginia’s coal royalties and midstream energy infrastructure–Penn Virginia Resource Partners LP is a worthy buy up to our target of 24.

Another MLP worth buying at its current price is Targa Resources Partners LP (NSDQ: NGLS). Management last week announced the successful completion of an asset drop down from parent Targa Resources, consisting of a 76 percent stake in Venice Energy Services Company. The $175.6 million purchase–including cash acquired by the LP–is expected to immediately boost Targa’s quarterly distribution by a penny a unit, pushing the annualized payout rate to $2.15. The change will be effective with the November payment and pushes the yield to 7.7 percent based on Targa’s recent unit price. Buy Targa Resources Partners LP up to 28 if you haven’t yet.

We’re increasing the buy target on two MLPP Portfolio holdings. EV Energy Partners has closed its previously announced acquisition of oil and gas properties in the Mid-Continent region from Petrohawk Energy Corp (NYSE: HK). The $119.9 million deal is accompanied by a series of hedging moves designed to lock in cash flow from the properties. That should ensure distributions continued to rise at EV, as they have for 14 consecutive quarters or every reporting period since the LP’s inception. Buy EV Energy Partners LP up to 36 if you haven’t yet.

Finally, Spectra Energy Partners LP (NYSE: SEP) is getting a buy-target boost, to a valuation largely earned by distribution growth, as management has now boosted 12 consecutive quarters and every one since inception. Parent Spectra Energy (NYSE: SE) has planned $1 billion in annual capital spending through 2012 and now intends to extend that rate through 2014. Areas of focus include all of the fastest-growing shale development areas in North America.

One way Spectra Energy will maximize the cash flow from these mostly fee-for-service assets is to drop many of them down to Spectra Energy Partners. The MLP format allows more cash flow to be sheltered for the parent. And it means a continuing rising stream of distributions for the LP. Spectra Energy Parters’ current yield is on the low side at a little less than 5 percent. And the unit price is within a stone’s throw of the all-time high reached July 26, 2010. But Spectra Energy Partners LP would be a buy on any dip to 32.

Above that level, would-be buyers need to be patient. And the same goes for any other MLP trading above our buy targets. Sure prices have been on an upward tear the past several months. But as we’ve seen time and again this year, unit prices can be extremely volatile.

Any surge in the fear level of this market can take prices down quickly, though anything deep would likely be short-lived and a time to play offense. Waiting for our buy targets to be reached can take time and the temptation will be to buy in at the higher price, just as fear has pushed investors to bail out several times over the past two years. But that’s how we’re going to build wealth in a business that’s far steadier than the market has treated it the past two years.

If you want to really play offense, the best course is to set dream buy prices. In past issues, we’ve published such a list for our recommendations, i.e. levels that could be reached in a widespread selloff and would represent extreme value in that case. Here it is again.

Again, our advice is to enter buy limits on any of these you’d like to own. If you’re filled, you’ll own some very high-quality merchandise at very low prices. And the worst that will happen is these prices stay above those levels and your order isn’t filled. That’s no pain and the prospect of truly outstanding gains.

Conservative Holdings

• Enterprise Products Partners LP (NYSE: EPD)–30
• Genesis Energy Partners LP (NYSE: GEL)–16
• Kinder Morgan Energy Partners LP (NYSE: KMP)–60
• Magellan Midstream Partners LP (NYSE: MMP)–40
• Spectra Energy Partners LP (NYSE: SEP)–25
• Sunoco Logistics Partners LP (NYSE: SXL)–50

Growth Holdings

• DCP Midstream Partners LP (NYSE: DPM)–28
• Energy Transfer Partners LP (NYSE: ETP)–40
• Inergy LP (NSDQ: NRGY)–30
• Kayne Anderson Energy Total Return Fund (NYSE: KYE)–20
• Targa Resources Partners LP (NSDQ: NGLS)–22
• Teekay LNG Partners LP (NYSE: TGP)–20

Aggressive Holdings

• Encore Energy Partners LP (NYSE: ENP)–10
• EV Energy Partners LP (NSDQ: EVEP)–25
• Legacy Reserves LP (NSDQ: LGCY)–18
• Linn Energy LLC (NSDQ: LINE)–15
• Navios Maritime Partners LP (NYSE: NMM)–14
• Penn Virginia GP Holdings (NYSE: PVG)–16
• Regency Energy Partners LP (NSDQ: RGNC)–20