- The evolution of MLP business models and the need to attract new investors requires a fresh approach to MLP valuation metrics.
- Historically, valuation metrics have been largely yield-focused, whether using yield alone, using yield and distribution growth as an estimate for total return, or comparing MLP yields relative to bonds or other equities.
- MLP valuation metrics should increasingly shift from yield and distributable-cash-flow-based methods to more recognized approaches such as EV/EBITDA and free cash flow yield to facilitate comparison among other sectors.
The MLP space has changed significantly in recent years with consolidations, distribution cuts, a shift away from raising equity, and a focus on positioning for sustainability instead of growth at all costs. The ripple effects of these changes have been widespread, but the focus of this piece is on the implications for valuation. MLPs have become more total-return focused than in the past, which not only makes yield-focused valuation metrics less meaningful but has also caused a shift in the investor base. This piece explores historical valuation metrics and the valuation tools that are expected to become more prevalent going forward as MLPs increasingly compete with other sectors for generalist investor dollars. The Alerian MLP Infrastructure Index (AMZI) is used throughout to represent MLPs in valuation approaches.
Today’s piece is an abbreviated version of our recently published white paper by the same title. Please see the white paper for more detail, charts, and individual MLP valuations.
Historically, MLP valuations focused largely on yield and distributable cash flow.
Despite offering other attractive characteristics such as real asset exposure and diversification, investors have historically focused on yield as the primary benefit of investing in MLPs. Accordingly, valuation metrics have been largely yield-focused, whether using yield alone, using yield and distribution growth as an estimate for total return, or comparing MLP yields to bonds or other equities. The ease of calculating yield also supported its widespread adoption. While yield is a useful metric for investors, it is somewhat limited as a valuation tool, particularly when it comes to comparability with other sectors. For example, looking at yield alone, MLPs will appear attractive relative to many other sectors, but that does not necessarily mean MLPs are a better value.
One of the most common ways that investors have historically valued MLPs is by comparing their yield to that of the 10-year Treasury. The greater the spread between the two yields relative to a historical mean or median, the more attractive the valuation for MLPs. The dividend discount model (DDM) has also been commonly used to value individual MLPs. This model discounts all future expected distribution payments to their present value to calculate the MLP’s intrinsic value. Arguably, the DDM is still useful today, particularly with needed distribution cuts largely behind the MLP space. Finally, MLP valuation metrics have often been based on distributable cash flow (DCF). DCF is a measurement of the cash that a partnership generates in a period that is available for distribution to unitholders. As a non-GAAP, MLP-specific metric, valuations based on DCF can create challenges. First, DCF is not readily comparable to other sectors, and moreover, DCF can be reported differently among MLPs due to different treatment of certain items or company-specific nuances. For generalists or new MLP investors, the nuances of DCF and lack of comparability likely make DCF-based metrics less appealing.
Widely comparable valuation methods should gain traction going forward.
MLP valuations should evolve with the changes to the MLP business model and investor base. Yield and DCF-based metrics still have a place in the conversation, but more comparable valuation metrics should gain in prevalence over time. Why? MLPs need to attract new investors, including generalist institutional investors that are evaluating many sectors.
Enterprise value to forward EBITDA (EV/EBITDA) has been used historically for MLPs and facilitates comparison with other sectors. Sum-of-the-parts valuation approaches used to compare MLPs also rely on EV/EBITDA. Energy Transfer (ET) has incorporated a valuation slide with EV/EBITDA multiples in its investor presentation. Typically, investors compare current enterprise value to forward (or future year) expected EBITDA. In the chart below, Bloomberg consensus 2020 EBITDA estimates are used as the denominator, and the weighted average EV/2020 EBITDA for the AMZI is compared against Utilities, represented by the S&P 500 Utilities Index (S5UTIL), and the S&P 500. On a forward EV/EBITDA basis, MLPs, as represented by the AMZI, are currently trading at a discount relative to Utilities and the S&P 500. Notably, MLPs are also trading below their historical ten-year average forward EV/EBITDA, while Utilities and the S&P 500 are trading at premiums relative to history.
Going forward, free cash flow (FCF) yield should become a more important metric for valuing MLPs, particularly as capital spending moderates from the hefty levels of recent years as long-lead projects come online. Enterprise Products Partners (EPD) included a slide in its analyst conference presentation highlighting its growth in FCF. FCF yield is calculated by dividing FCF by a company’s market capitalization, allowing for comparison among different entities. The chart below shows current free cash flow yield based on estimated 2020 FCF per Bloomberg. REITs, as represented by the Real Estate 50 Index (FNR5), are included for additional context. While the AMZI screens favorably relative to other sectors, the 2020 FCF yield also represents a notable improvement relative to recent history. In 2016, absolute FCF for the AMZI was negative. The improvement in FCF for MLPs reflects both growing cash flow from operations and improving capital discipline.Price-to-earnings (P/E) is another metric frequently cited across sectors for valuation purposes. Setting aside relative weakness in net income compared to preferred cash-flow-based metrics, earnings per share (unit) tends to be less meaningful for MLPs. MLPs tend to have high depreciation, which results in low earnings. While acknowledging the shortcomings of the P/E ratio for MLPs, we include below the weighted average P/E ratio for the AMZI relative to Utilities and the S&P 500 for context based on 2020 estimated earnings.Investors may look at additional return-based metrics to compare among MLPs or to compare MLPs with other sectors, including return on invested capital (ROIC) and return on equity (ROE). ROIC is an indication of how well a company is using its debt and equity to generate profits. ROIC can be a useful gauge to measure value creation from acquisitions and as a check on whether company returns align with management’s commentary on organic project returns. ROE, which compares net income to shareholder equity, will not be relevant for those MLPs with high depreciation and hence low income. EPD includes a chart of its historical unlevered ROIC and ROE in its investor presentation to highlight its returns on capital. ROIC can further be compared to a company’s weighted average cost of capital (WACC) to measure whether companies are creating value. Returns should exceed a company’s cost of capital. ROIC and ROE are useful as widely accepted and understood metrics, but each sector may have its own expected ranges, limiting broad comparisons.
The MLP business model and capital allocation strategy has changed significantly over the last five years, which has also led to an evolving investor base. Income remains a key tenet of MLP investing, but yield-based valuation metrics do not necessarily allow for a sufficient appreciation of the positive developments in the space (lower leverage, higher coverage, self-funding equity) or a useful comparison with other sectors. The new institutional and generalist investors that MLP management teams are targeting will want to compare MLPs with other sectors using familiar valuation metrics. As a result, MLP valuation metrics should increasingly shift from yield and DCF-based methods to more recognized approaches such as EV/EBITDA and FCF yield.