Our MLP Rating system sums up the key elements for MLPs’ financial health on a scale of zero to 4. A zero indicates an MLP meets none of our holdings, a “4” indicates an MLP meets all of them. Here’s a brief description of each criterion.

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.

Commodity Price Exposure. The more reliable an MLP’s income is, the higher a payout ratio or lower a coverage ratio it can sustain. Pipeline MLPs, for example, have extremely reliable revenue as it’s based on fees. Commodity producer MLPs, in contrast, are ultimately at the mercy of commodity prices. MLPs that rely on fees for 80 percent or more of cash flow will get a point for this criteria. Those with less won’t.

Debt. With the possible exception of Fitch, credit raters have generally lost their credibility in recent years and credit ratings are of limited utility, other than for pension funds and other institutions whose charters restrict them to owning only investment grade securities. As a result, we use a combination of debt-to-capital and debt refinancing needs to award points for balance sheet strength.

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.

“By the Numbers” shows how our Portfolio recommendations stack up this month. Note that Encore Energy Partners has been replaced by Vanguard Natural Resources to reflect the merger completed on Nov. 30.

Source: Bloomberg, MLP Profits