The Smartest High-Yield Energy Stocks to Buy With $1,000 Right Now

When looking for high-yielding dividend stocks, one of the best places to look is in the energy midstream space. Many of these companies are structured as master limited partnerships (MLP), which pass on their profits to their shareholders and, as such, do not pay corporate taxes.

As a result, most pay 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 inventory is sold and reduces the owner’s cost basis. This is a nice perk, although it does add some paperwork at tax time.

The medium sector as a whole has seen many changes over the past decade. In the past, firms often had a general partner (GP) and limited partner (LP) structure which was ultimately more beneficial to the GP. The way it worked was that the GPs would own what are called Incentive Distribution Rights (IDRs), while the LP would pay the GP a percentage of their distributions when they reached certain points.

This became very beneficial to the GP because once the MLPs reached a high 50/50 split, the GP would get half of the incremental distribution payment. For example, if a company increased its distribution by $0.02 per unit and that equates to $10 million (500 million units outstanding at $0.02), it would also have to send the GP $10 million of additional dollars under the IDR agreement. This structure also encouraged LPs to fund growth by issuing more equity, since the more units the LP had, the bigger the dollar payouts would be as well.

This structure has generally been eliminated, and as a result, MLPs are in better financial shape, with less leverage and being able to grow their business through free cash flow. However, the stock is surprisingly trading at a discount today compared to where it was trading under the old, unfavorable model. Between 2011 and 2016, MLPs traded at an average multiple of 13.7 in business value-to EBITDA (earnings before interest, taxes, depreciation and amortization), the most common way to value these stocks.

Today, companies in the sector are trading at much lower valuations even though the sector as a whole is in a much better place. This, coupled with the increased demand for power 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 midrange space with its large built-in 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 between 3% and 5% annually.

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 maintenance capital expenditures). And it generated more than $165 million in free cash flow after paying distributions.

Energy Transfer also has some of the best growth opportunities in the midstream space. This is due in part to its strong presence in the Permian Basin, which gives 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 to transport the associated natural gas out of the basin. This leads to very cheap regional prices and makes Texas an ideal area to build data centers.

Energy Transfer also has the pipeline infrastructure to carry natural gas from the Waha Hub in West Texas to other locations. As such, it said last quarter it received incoming applications seeking 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 pipeline project that it said will help support data center growth in Texas.

All in all, Energy Transfer combines economic value with solid, well-covered distribution at a historically attractive price.

Pipelines leading to the processing plant. — Image source: Getty Images

Even during the days of the old MLP model, Business product partners (NYSE: EPD) was always one of the most shareholder-friendly companies in the MLP space. It removed its IDRs from 50% in 2002 in favor of a top division of 25% and then completely removed them and collapsed its structure in 2011. The company has also always taken a more conservative approach with leverage and has maintained a solid balance sheet.

This has allowed the company to increase its distribution for 26 consecutive years through different economic and energy cycles. The stock is currently yielding 6.4% and trading at an attractive EV/EBITDA multiple of 10.

The company is currently starting to ramp up growth given the opportunities it sees. After reducing its growth capital expenditures (capex) to $1.6 billion in 2022 after the height of the pandemic, it will spend between $3.5 billion and $4 billion in 2024. The company has earned an average annual return of 12 % of its growth capital, which paves the way for a strong increase in EBITDA in the coming years.

Enterprise Products Partners is also well positioned to benefit from the growing AI and data center energy needs with a strong presence in Texas, particularly in the cities of Dallas and San Antonio, both of which are seeking become data centers. The company said AI-driven energy demand was one of the most promising signs it has seen in the natural gas sector in a long time, and it had some of the best assets to capitalize on this trend.

All in all, Enterprise Products Partners has proven to be a model of consistency and has plenty of opportunity 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 one disclosure policy.

The Smartest High-Yield Energy Stocks to Buy With $1,000 Right Now was originally published by The Motley Fool

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