Published by Nick McCullum on July 30th, 2017
Master limited partnerships – or MLPs, for short – are some of the most tax-efficient vehicles for investors looking to generate portfolio income in a taxable investment account.
Accordingly, these securities are often sought by retirees and other yield-hungry investors.
The sheer number of master limited partnerships today means that high-yield investors can create plenty of diversification using MLPs alone. You can see the full list of all 100+ publicly traded MLPs here.
With that said, there are some notable differences between investing in MLPs versus common stocks that investors should keep in mind.
One occurrence that sometimes affects MLPs is an acquisition by their general partner.
An MLP’s general partner is a part-owner of the business whose employees actually operate the MLP’s assets (since MLPs themselves technically have no employees).
This leaves the MLP’s investors to determine whether the general partner makes an equally appealing investment as the MLP did prior to the acquisition, since these acquisitions are typically completed on a stock-for-stock basis.
One recent example of this phenomenon is ONEOK Partners (OKS), which was recently acquired by its general partner ONEOKE Inc. (OKE).
This transaction created many new owners of ONEOK Inc. that previously held the publicly-traded units of ONEOK Partners. This, in turn, has created curiosity about the long-term investment prospects of ONEOK Inc.
ONEOK Inc. fits our description of a blue chip stock – a company with:
- 100+ year operating history and
- 3%+ dividend yield
Previous ONEOK Partners investors should appreciate ONEOK’s status as one of the few blue chip stocks – these companies are established, and generally, appeal to conservative investors seeking income. You can see the full list of blue chip stocks here.
With the previous owners of ONEOK Partners in mind, this article will analyze the investment potential of ONEOK Inc. in detail and determine whether previous unitholders of ONEOK Partners should hold the stock or look elsewhere for an MLP alternative.
ONEOK Inc. was previously a holding company whose main ownership interest was the general partner and a 41.2% total interest of ONEOK Partners.
After the acquisition of ONEOK Partners, ONEOK Inc. (hereafter referred to as ONEOK) is an extensive midstream energy corporation with a wide base of assets across the United States.
In total, ONEOK owns and operates a 37,000-mile network of pipelines that transfers natural gas and natural gas liquids (NGLs) from suppliers in attractive energy basins to refineries for development. A map of ONEOK’s asset base can be seen in the following diagram.
Source: ONEOK Inc. May 2017 Investor Update, slide 9
ONEOK is listed on the New York Stock Exchange under the ticker OKE and has a current market capitalization of $24.5 billion, making it quite large relative to other energy MLPs such as Genesis Energy (GEL) or Buckeye Partners (BPL).
Current Events & Growth Prospects
As this article’s introduction insinuates, the most important event for current shareholders of ONEOK is the company’s recent acquisition of its master limited partnership ONEOKE Partners.
This transaction was originally announced on February 1, 2017, and saw the two entities enter into a definitive agreement under which ONEOKE was to acquire all of the publicly-traded units of ONEOK Partners that it did not already own.
Prior to the merger, ONEOK owned about 41% of ONEOK Partners (including its general partner interest).
Importantly, the transaction was immediately beneficial to the existing unitholders of ONEOK Partners.
The transaction price represented a 22.4% premium to ONEOK Partners’ closing price on January 27, which was the last trading day of the week prior to the announcement (released on a Wednesday).
There were many benefits for ONEOK shareholders, too. Because of operating losses incurred previously, ONEOK now expects to pay no cash income taxes through at least 2021, which boosts its near-term cash flow profile.
Source: ONEOK Inc. May 2017 Investor Update, slide 6
The new ownership structure also eliminates incentive distribution rights, which is a contractual arrangement between an MLP and its general partner that see the general partner receive an increasing proportion of cash flow as the MLP increases its distribution above some pre-specified base rate.
The most important benefit of ONEOK’s acquisition of ONEOK Partners is the imapct on the pro-forma company’s dividend. ONEOK now expects fantastic dividend growth over the next several years.
Specifically, the corporation is expecting 9%-11% annualized dividend growth through 2021, a win for shareholders. And, ONEOK recently announced a 21% dividend increase following the close of the transaction, beginning its new dividend growth trajectory in earnest.
Source: ONEOK Inc. May 2017 Investor Update, slide 7
Conservative investors should note that ONEOK is now targeting a dividend coverage ratio of 1.2x following the transaction close, which means its new dividend payments should be well-covered by distributable cash flow.
To be clear, both entities were in no danger of a dividend or distribution cut prior to completing this transaction; ONEOK Inc. and ONEOK Partners reported dividend & distribution coverages ratios of 1.27x and 1.10x in the most recent quarter, respectively.
Rather, instead of improved distribution coverage, the merger offers excellent distribution growth, with 9%-11% growth through 2021.
To sum up, ONEOK’s combination of excellent dividend yield (5.3% yield at current prices) and robust dividend growth means that investors can reasonably expect double-digit returns from today’s price.
Competitive Advantage & Recession Performance
ONEOK’s most important competitive advantage is the recession-resistant nature of its earnings stream.
The majority (~90%) of ONEOK’s 2017 net income will be generated by long-term, firm-based, frac-or-pay or ship-or-pay contracts.
These contracts imply that ONEOK’s counterparties must accept its transported product, or pay a significant cancellation fee.
Even in a severe oil downturn, ONEOK will continue to generate revenue as demand goes down but it begins to collect cancellation fees from its counterparties.
Source: ONEOK Inc. May 2017 Investor Update, slide 10
With that said, ONEOK is certainly not the most recession-resistant stock covered on Sure Dividend. The company had a debt-to-EBITDA ratio of 5.2x at the conclusion of its fiscal 2016, and although the company plans on reducing this ratio moving forward, this is still higher than we’d like.
Source: ONEOK Inc. May 2017 Investor Update, slide 21
While ONEOK has shown the ability to grow through various operating environments (dividends have increased each year since 2002), its high leverage ratios suggest that it may face trouble in a prolonged downturn.
Valuation & Expected Total Returns
While ONEOK’s recent transaction has meaningfully changed its business structure, we can still compare the security’s current valuation to its long-term average to see if today’s price is a buying opportunity.
However, assessing ONEOK’s valuation can prove to be tricky.
Since ONEOK (both the corporation and the MLP) is in the business of owning and operating long-lived energy infrastructure assets, the company incurs substantial non-cash depreciation charges which artificially impair its ability to be analyzed using the traditional price-to-earnings ratio.
The most simple and straightforward solution to this dilemma is to compare ONEOK’s current dividend yield to its long-term historical average dividend yield.
ONEOK closed Friday’s trading at a share price of $56.46, and the company currently pays an annualized dividend of $2.93 for a forward yield of 5.3%. The following diagram compares this yield to ONEOK’s long-term average.
While the best time to buy ONEOK would have been during the Great Recession of 2007-2009 or the mini bear market of early 2016, the company is currently trading at a discount relative to its 10-year average dividend yield of 4.4%. ONEOK looks like a solid value today.
ONEOK’s slightly elevated dividend yield of 5.3% combined with its target of 9%-11% distribution growth through 2021 means that investors have a very good chance of achieving double-digit total returns for the foreseeable future.
This suggests that previous unitholders of ONEOK Partners should continue to hold their new ONEOK common shares.
However, there is one factor that we haven’t considered: the tax benefits of investing in MLPs through taxable investment accounts.
Regular corporate dividends (including those paid by ONEOK Inc.) are not as tax favorable as those declared by an MLP like ONEOK Partners.
In a tax-advantaged account like a 401(k), this difference does not matter. For investors buying in a taxable account, consult a tax professional for the precise details of your new investment arrangements.
ONEOK Inc. appears well-positioned to deliver double-digit annualized total returns moving forward.
The company pays a safe 5.3% dividend and is expecting 9%-11% dividend growth through 2021 after its acquisition of ONEOK Partners.
However, ONEOK Inc.’s dividends are not as tax-favorable as ONEOK Partners’ distributions were. Accordingly, previous ONEOK Partners investors that were primarily seeking tax-efficient portfolio income might prefer to re-allocate their funds to another high-yield master limited partnership.