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Beware master limited partnerships’ taxes

Tuesday, May 26th, 2015

A few weeks ago, I received a call on my radio show about the company Alliance Resource Partners LP. In reality, this is not a company; it is what is known as a “master limited partnership.”

Let me explain what attracted me to Alliance Resource Partners LP (Nasdaq: ALRP) and why I thought it had merit, and then I will give you my conclusion.

Beginning with the evaluation ratios, which gives you a good idea what a business is worth, the price-to-earnings ratio is very attractive at 6.8. Price to sales is 1.0, which is more expensive than the industry average of 0.68.

Looking at what investors pay for the tangible book value, I discovered that also was more expensive than the industry average of 1.95, with the company coming in at 2.24. You want the valuation ratios lower for the company in which you're investing.

Lastly, the price to cash flow didn't look good at 3.7, far below the industry average of 5.8.

What attracts investors to master limited partnerships is the high dividend yield and this partnership is no exception, paying an 8.5 percent dividend. The partnership uses only 55 percent of its earnings to pay out that dividend, a nice thing to see.

Looking at sales growth year over year, Alliance Resource Partners looks good with its revenue up by 5.4 percent — far better than the industry average growth of 1 percent.

What I also liked was that earnings per share grew by 22.9 percent, far better than the industry growth of 15.1 percent for the same time period.

Always important is the financial strength of a company, which can be found on its balance sheet. Of concern to me was a current ratio of 0.86, which is far below the industry of 1.25.

What could make an investor feel a little more comfortable is a low debt to equity. This partnership is not too bad at 83.0, compared with the industry average of 144.0.

Management’s effectiveness should always be a concern for investors and this partnership shines very well, with a return on equity of 27.9 while the industry is a negative 5.7.

It is also nice to discover a company that, after paying all its bills and expenses, gives the investor a nice profit margin, and that is what you'll find here, with a profit margin of 21 percent — far better than the industry average of negative 3.72 percent.

The efficiency of the management of this partnership proves to be better than the industry average. First off, I see a receivable turnover of 12.0, which is better than the industry average of 10.1. Also important is the inventory turnover of 15.5 for Alliance, which is also better than the industry average of 12.4.

Looking at the generally accepted accounting principles for earnings estimates going forward to December 2016, the average earnings-per-share estimate is $3.52. Using a forward PE of 16.5, what you have is a target sell price of $58 per share — a nice gain from the current price of about $31 a share.

So why wouldn’t I recommend you jump all over this partnership, which has very good-looking fundamentals and a great dividend yield?

The reason is master limited partnerships are taxed differently from corporations. I spoke with my good friend and tax professional Tracey Gaines about the taxation of MLPs. We discussed such things as how the current dividend is not taxed but reduces your cost basis, which can lead to major tax bills down the road when you least expect it.

To explain more, if you were to invest $50,000 into this partnership and collected dividends of $20,000 over that time frame, when you sold the investment, you would have a tax bill based on a $20,000 gain.

That may not be that bad except for the big surprise about the tax bill. What really got me was because this is a partnership, you can be taxed on money that you didn't even receive, which is known as “phantom income.”

Another point is because this is a partnership, you cannot do your tax return until you receive your K1 from the partnership. Many times these are late and you have to file an extension past April 15, another inconvenience and perhaps something else that the financial adviser did not know or tell you.

Also, even in an IRA there could be certain distributions from business income that could be taxed inside in your IRA because this is a partnership — which was a complete surprise to me.

So I always recommend that if you don't understand something, try to get the information and understand it completely, which includes calling your tax professional. And if you don't understand the investment and, in this case, a master limited partnership, no one can tell for sure what the future distributions could be.

I again recommend staying away from master limited partnerships, even ones like Alliance Resource Partners, which looks good but you just don't know what is down the road.

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