When seeking high-yield dividend stocks, one of the best places to look is in the midstream energy space. Many of these companies are structured as master limited partnerships (MLPs), which pass through their profits to their unitholders and as such don’t pay corporate taxes.
As a result, most pay out very generous distributions, which are similar to dividends, but much of the payout is considered a return of capital. This portion is tax deferred until the stock is sold and reduces the owner’s cost basis. This is a nice benefit, although it does add some paperwork come tax time.
The midstream sector as a whole has gone through a lot of changes over the past decade. In the past, companies often had a structure of a general partner (GP) and limited partner (LP) that ultimately was more beneficial to the GP. The way it worked was that GPs would own what are called incentive distribution rights (IDRs), while the LP would pay the GP a percentage of its distributions when they hit certain points.
This became very beneficial to the GP because once MLPs hit a 50/50 high split, the GP would get half of the incremental distribution payout. For example, if a company raised its distribution by $0.02 per unit and that was equal to $10 million (500 million units outstanding times $0.02), it would also have to send the GP an additional $10 million under the IDR agreement. This structure also encouraged LPs to fund growth through issuing more equity, as the more units the LP had, the bigger the dollar payments would also become.
By and large, this structure has been eliminated, and MLPs are generally in better financial shape as a result, carrying less leverage and being able to grow their business through free cash flow. However, the stocks surprisingly trade at a discount today compared to where they traded under the old, unfavorable model. Between 2011 and 2016, MLPs traded at an average multiple of 13.7 in enterprise-value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization), the most common way to value these stocks.
Today, the companies in the sector trade at much lower valuations despite the industry as whole being in a much better place. This — along with increasing power demand from artificial intelligence (AI) hardware in data centers — creates an excellent buying opportunity. Let’s look at two great MLPs to buy right now.
Despite having some of the best assets in the midstream space with its large integrated system, Energy Transfer(NYSE: ET) is one of the cheapest MLPs in the space, trading at a forward EV/EBITDA multiple of 8.5. It currently has a forward yield of 6.4% and expects to increase its distribution by 3% to 5% a year.
Its distribution is also well covered, with a coverage ratio of 1.8 times last quarter based on its distributable cash flow (operating cash flow minus capital expenditures for maintenance). And it generated free cash flow of over $165 million after paying distributions.
Energy Transfer also has some of the best growth opportunities in the midstream space. This stems in part from its strong presence in the Permian Basin, giving it access to some of the cheapest natural gas in the country. The Permian is primarily drilled for oil, and there have long been capacity constraints for transporting the associated natural gas out of the basin. This leads to very cheap regional pricing and makes Texas an ideal area to build data centers.
Energy Transfer also has the pipeline infrastructure to take natural gas from the Waha Hub in western Texas to various other locations. As such, it said last quarter that it saw inbound requests looking to connect about 45 power plants in 11 states to its pipeline system and more than 40 proposed data centers in 10 states.
The company also announced a new $2.7 billion Permian gas takeaway project that it said will help support data center growth in Texas.
All in all, Energy Transfer combines a cheap stock with a robust, well-covered distribution trading at a historically attractive price.
Image source: Getty Images
Even during the days of the old MLP model, Enterprise Products Partners(NYSE: EPD) was always one of the most stockholder-friendly companies in the MLP space. It eliminated its 50% IDRs way back in 2002 in favor of a 25% high split and then completely eliminated them and collapsed its structure in 2011. The company has also always taken a more conservative approach with leverage and maintained a strong balance sheet.
This has allowed the company to raise its distribution for 26 straight years through various economic and energy cycles. The stock currently yields 6.4% and trades at an attractive EV/EBITDA multiple of 10.
The company is currently beginning to ramp up growth given the opportunities it is seeing. After reducing its growth capital expenditures (capex) to $1.6 billion in 2022 following the height of the pandemic, it will spend around $3.5 billion to $4 billion in 2024. The company has averaged a 12% annual return on its growth capex, which paves the way for strong EBITDA increases in the coming years.
Enterprise Products Partners is also well positioned to benefit from the increasing power needs related to AI and data centers with a strong presence in Texas, especially around the cities of Dallas and San Antonio, both of which are looking to become data center hubs. The company said the power demand coming from AI was one of the most promising signals it has seen in the natural gas sector in a long time, and that it had some of the best assets to be able to benefit from this trend.
All in all, Enterprise Products Partners has shown itself to be a model of consistency and has a lot of opportunities while trading at an attractive valuation.
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Geoffrey Seiler has positions in Energy Transfer and Enterprise Products Partners. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.
The Smartest High-Yield Energy Stocks to Buy With $1,000 Right Now was originally published by The Motley Fool
Heather Ochoa is a news writer at the Failsafe Podcast. She has been writing about politics, health, business, parenting and finance for over a decade. She also loves to go hiking in her free time.
