2 Stocks that Make Bond Investors Look Foolish
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Natural gas prices are up 45% from their April low! Is this the start of the coming surge that just had to happen ever since the price broke below $5, $4, $3, $2? Not likely. I detailed in a mid-April piece to stay clear of E&P companies with heavy reliance on natural gas. It is still early and the context was based on a time horizon on two or three years, but the ISE- Revere Natural Gas Index has dropped 5.5% since the piece was published versus a 3.2% drop in the S&P 500.
The ISE- Revere Natural Gas Index consists of securities that derive a substantial portion of their revenues from exploration and production of natural gas and have exchange listings in North America. All is not lost for those investors with patience and a strong conviction that natural gas demand will be forthcoming. Instead of trying to catch the falling knife on some of the E&P stocks, investors may want to consider MLPs (Master Limited Partnerships) with heavy reliance on the transportation of the asset. Below are two MLPs that look attractive and derive nearly all their revenue from fixed price contracts and essentially serve as toll roads as gas goes from producer to consumer.
MLPs have become a more well-known asset class in recent years and they do have different tax treatments. Potential investors should have a firm understanding of these variables before taking the plunge. Natural gas MLPs have strong secular appeal for a number of reasons. First, they payout a substantial portion of their income in the form of dividends and have yields that exceed not only Treasuries, but Baa Investment Grade bonds (currently by about 85 basis points) while also providing GROWTH in income. Thus, investors are able to obtain a very favorable total return profile for a moderate amount of risk. Since the S&P 500 peaked on October 9, 2007, the Alerian MLP Index has produced a total return of 69%, or 12% annually, versus a 6% DECLINE in the S&P 500. Investors shouldn’t think this was a smooth 12%, because there is plenty of volatility in this asset class. This doesn’t necessarily mean elevated risk (they are not the same), but when hedge funds collapsed during the Global Financial Crises they puked out these MLPs onto the market and prices collapsed. Of course that turned out to be one great buying opportunity. Since 2010, investors have been able to invest in the Alerian Index via the ALPS ETF Trust (NYSEMKT: AMLP) and own a diversified basket of MLP operators.
Another favorable attribute to the sector, especially those that transport natural gas, is the overwhelming favorable secular trends in increased volume transportation. Natural gas volume usage will almost certainly be higher in the coming decades due the abundant supply available here in the great U.S.A. The available pipeline to transport all this future gas is underdeveloped and there will be substantial capacity increases in coming years. This is the growth component that makes this asset class hard to ignore. Today, I want to focus on two gas transportation companies that are members of the Alerian MLP Index.
Boardwalk Pipeline Partners (NYSE: BWP) is a Houston-based MLP that owns three interstate natural gas pipeline systems that span more than 14,000 miles. They are a pure-play natural gas transportation company. Hopefully, they will maintain this status as it has strong appeal from both a near-term earnings perspective and long-term secular standpoint. This natural gas concentration also presents the opportunity for outperformance relative to the Alerian MLP Index should the bullish thesis play out.
The company isn’t the largest in the space with a market capitalization of just $5.7 billion and revenues of $1.1 billion. Compare them with Enterprise Products Partners (NYSE: EPD), the largest and most diversified MLP with a market capitalization of $44 billion and revenues 10x that of Boardwalk. The stock sports a 5.1% dividend yield and is the largest constituent in the Alerian MLP Index. Getting back to Boardwalk, the size is offset by a focused company with 93% of revenues derived from fee-based, long-term contracts related to natural gas transportation. The yield on the stock is an eye-popping 7.7% and this is sustainable. This is really a pretty straightforward company with good stability. Also, the company is majority owned by Loews Corporation (NYSE: L), the diversified holding company that has produced stellar long-term returns since 1970. Loews largest holding is a 90% interest in CNA Financial. This sponsorship is a very favorable attribute and Loews has stated they will be there to provide capital should debt markets have another seize up similar to the GFC where rolling over debt was impossible for many in the investment grade arena.
So what is the catch? There really isn’t one, but BWP has a lower than average growth outlook both in capex and dividend potential. Their discretionary cash flow to net income ratio is barely above 1.0 and this means that dividends will track growth in discretionary cash flow. DCF should only rise modestly (low single-digits) due to smallish capex in the coming years. All told, you get a high-yield name that can maintain it, but not really grow it over the next five years.
The stock currently resides at $27 per share and is one of the few in the industry that is lower than its 2007 price. Part of this has to do with bad renewal rates that are 15-20% below expiring levels. The company has a weighted-average contract length of 6 years, but at the margin the renewals are a headwind. The 7% of revenues derived from storage is plummeting. You would expect this when some oil companies just burn the excess natural gas at the site because it is so cheap.
Boardwalk makes a good core holding for investors and serves as a bond-like proxy with good upside potential in the back end of the decade. Investors can clip a 7% coupon, on par with high-yield bonds, and patiently wait for the natural gas theme to play out. This is the basis of sound investment instead of an all-out bet on timing the bottom in natural gas prices.
The Growth Option?
Another option is to go to the other extreme and get one of the best dividend growth outlooks in the industry, although the future growth outlook has taken a sudden veer into the unknown. This uncertainty has created a good buying opportunity for patient investors that are looking for a favorable risk/reward scenario. El Paso Pipeline Partners (NYSE: EPB) currently trades at $33 and yields a healthy 6%. The growth outlook was one of the fastest in the industry, at more than 10%, thanks to drop downs from parent El Paso Corp. When Kinder Morgan agreed to purchase El Paso, investors sold down the stock from $38 on uncertainty in the growth outlook that had previously fueled the shares.
El Paso Pipeline Partners is another Houston-based MLP that derives nearly all their revenue from natural gas transmission. The company has over 12,000 miles of pipes in the Rocky Mountains and Southeastern U.S. After going public in 2007, they have shown strong organic growth that was complimented by purchases from its parent, El Paso Corp. The dividend has consistently grown in the mid-teens annually. Now that Kinder Morgan has completed the acquisition of El Paso, the asset drop downs will have to be shared with Kinder Morgan Energy Partners.
Investors shouldn’t be too scared; however, the company has a DCF to Net Income ratio close to 1.4x. This means that even if organic growth trends down, the company can increase dividends at a higher rate until this ratio approaches the 1.1x level. And many analysts that cover the space are anticipating steady capex growth, albeit down from industry highs, despite the new parent.
Natural gas transmission MLPs make for good sound investments over the coming decade. Both Boardwalk Pipeline Partners and El Paso Pipeline Partners merit consideration as core holdings in an investor’s portfolio. Forget the low-yielding bonds and instead take a good look at key infrastructure assets such as BWP and EPB. These stocks provide better, and in some cases much better, yields and the potential for growth in future years.
market8 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend El Paso Pipeline Partners LP and Enterprise Products Partners L.P.. 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.If you have questions about this post or the Fool’s blog network, click here for information.