Avoid These 2 High-Yield Energy Stocks and Buy Magellan Midstream Partners Instead

By Markets Fool.com


Source: Energy Transfer Partners/

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Warren Buffett once said, "Only when the tide goes out do you discover who's been swimming naked."

Theworsening energy crash has certainly proved the wisdom of these words with almost all midstream MLPs, most of which funded growth with excessive borrowing and are nowfacing the worst price collapses since the financial crisis.


MMP data by YCharts

Yet Magellan Midstream Partners has held uprelatively well when compared with far larger pipeline competitors such as Plains All American Pipeline and Energy Transfer Partners .

Plains All American and Energy Transfer are trading at far lower valuations. However, Magellan Midstream Partners' full-year 2015 results clearly demonstrate why, to again quote the Oracle of Omaha, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

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Let's look at three reasons Magellan Midstream Partners is indeed so much better than its rivals, and why it represents such a fantastic long-term income growth opportunity today.

Business model designed to weather any storm

Metric 2014 2015 Change
EBITDA $1.078 billion $1.172 billion 8.7%
Distributable cash flow (DCF) $881 million $943 million 7%
Annual distribution per unit $2.78 $3.14 12.9%
Distribution coverage ratio (DCR) 1.55 1.42 (8.4%)

Source: Magellan Midstream earnings release.

Magellan Midstream's management is one of the best in the business. Rather thaninvest in growth projects with potentially dubious profit margins, itonly spendscapital on a diversified mix of extremely profitable assets that canmaintain a generous and sustainably growing distribution, no matter what energy prices are doing.

Last year's growth was courtesy of $747 million in organic growth capital investment and acquisitions. Management is expecting to spend another $900 million to complete its growth projects already in progress, with $800 million of that occurring in 2016. Further future growth will be provided by over $500 million in potential projects Magellan Midstream is evaluating as well as future acquisitions.

One of the best, most secure payout profiles in the industry

MLP Yield Trailing 12 Month Coverage Ratio ProjectedLong-Term Annual Payout Growth
Magellan Midstream Partners 4.9% 1.42 10% in 2016; "at least 8%" in 2017
Plains All American Pipeline 14.3% 0.88 0.9%
Energy Transfer Partners 14.6% 0.98 4.3%

Sources: Yahoo! Finance, Fastgraphs, earnings presentations, management guidance, 10-Ks.

The primary reason Energy Transfer Partners and Plains All American Pipeline are offering such astronomical yields is that Wall Street has lost confidence intheir ability to maintain, much less grow, their payouts given current market conditions and the prospect that energy prices could remain low for several years.

But what about the long-term fixed contracts that are the backbone of the midstream MLP industry and aresupposed to make pipeline operators' cash flows immune to commodity prices?

Not all suchcontracts contain minimum volume commitments,so crashingenergy prices and producers' cutting back onproductioncanstill threatena portionof an MLP's DCF.With both Energy Transfer Partners and Plains All American struggling -- and recently failing --to maintain a minimum sustainable coverage ratio of 1.0, even small decreases in volume can threaten the long-term security of their payouts.

In contrast Magellan Midstream's conservative payout growth policy, which emphasizes a large excess DCF cushion, gives the market far more confidence in not only the security of the MLP's payout, but also in its growth prospects.

However, a superior distribution profile is just one reason Magellan is such a superior income growth choice.

Conservative, quality management means fewer liquidity concerns


MMP Shares Outstanding data by YCharts

Most MLPs pay out such a large proportion of their DCF because, at least for the past half-decade, high energy prices, soaring unit prices, and historically low interest rates have made growth capital funding via equity and debt markets extremely easy.

Both Plains All American Pipeline and Energy Transfer Partners have made aggressive use of both funding sources, which has allowed them to grow their payouts over the years without retaining excess DCF. Now that debt and equity financing are harder to come by, investors are fearful that both Plains All American and Energy Transfer Partners might have to slash their distributions to pay for growth projects as well as paying down debt out of their cash flows.

Magellan Midstream's strategy, courtesy of its having bought out its general partner during the financial crisis at rock-bottom prices, has no incentive distribution rights fees and can retain far more cash flow. When combined with management's focus on only investing in the most profitable projects, the MLP has been able to achieve solid growth while relying far less on external funding.

With a stable unit countmaking long-term distribution growth easier, and one of the strongest balance sheets in the industry, Wall Street is correct to value Magellan Midstream Partners at a relative premium to its more financially distressed peers.

Bottom line
The worst energy crash in half a century has made it very clear that wise income investing requires a strong emphasis on quality. Thanks to its conservative, long-term-focused management team, Magellan Midstream Partners' is one of thetoday's bestsituated dividend growth opportunities in the energy sector.

Which is why, despite a much lower yield, dividend investors choose Magellan Midstream Parters over much cheaperseeming competitors such as Energy Transfer Partners and Plains All American Pipeline.

The article Avoid These 2 High-Yield Energy Stocks and Buy Magellan Midstream Partners Instead originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Magellan Midstream Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.