Better Buy: Enterprise Products Partners L.P. vs. Kinder Morgan, Inc.

Despite energy production growth in North America and numerous successful initiatives at individual companies to shore up their financial positions, Wall Street has remained cautious when valuing many pipeline stocks. The result: A slew of businesses with strong cash flows are trading at historically cheap valuations. Many boast above-average dividend yields compared to the S&P 500. In other words, investors poking around the industry should find a few rare opportunities at the cross-section of income and value.

For instance, shares of Enterprise Products Partners LP (EPD 0.56%) currently yield 6.5%. Peer Kinder Morgan (KMI -0.11%) yields just 3%, although management expects to boost the dividend from $0.50 per share last year to $1.25 per share in 2020. Both companies reported stronger cash flow and lower leverage ratios in 2017 compared to 2014, just before the energy market collapsed, but their share prices have fallen 28% and 61%, respectively, in that time. A small amount of dilution in that span doesn't come close to explaining the drop.

While a strong argument can be made for buying either pipeline stock, determining which is the better buy may come down to your individual investing strategy.

Image source: Getty Images.

The matchup

There's a simple explanation for the giant difference in share performance since the end of 2014.

Enterprise Products Partners has historically been one of the more conservative pipeline companies regarding its distribution policy. It's not uncommon for peers in the industry to pay out nearly all of their cash flow to shareholders (or unitholders in the case of a master limited partnership), but the company maintains a higher coverage ratio of about 1.2. That means it retains more cash to fund growth projects from operations, which allows it to keep a healthier balance sheet and earn industry-leading credit ratings. 

Put another way, the market sees Enterprise Products Partners as being safer than its peers and better able to withstand a downturn. That makes the 6.5% yield all the more impressive, since higher yields are often an indicator of higher risk. But investors shouldn't expect the distribution to grow much in the near term. Management recently decided to reduce the quarterly distribution increases from a half-penny per share to a quarter-penny per share. Why? It wants to retain the extra cash flow to fund a larger portion of its growth projects in 2018 and 2019. As The Motley Fool's Matthew DiLallo recently noted, anything is possible after that -- from increasing distribution growth to share repurchases.

Image source: Getty Images.

If Enterprise Products Partners is the safe, high-yield stock in the industry, then Kinder Morgan is the turnaround play offering exceptional value. The company just can't seem to do enough to impress Mr. Market. It essentially maintained operating cash flow in 2017 compared to the year-ago period. It reduced its leverage ratio from 5.9 times debt to adjusted EBITDA to 5.1 times since 2015. It has big plans for driving its distribution back to historical levels by 2020.

Despite all of that, Wall Street still appears to be worried about the leverage ratio, especially considering many peers are targeting 4 times debt to adjusted EBITDA. Should that be a concern? Well, maybe, but it's worth noting that Kinder Morgan's strategy for proving Mr. Market wrong hinges on high expectations for its near-term growth projects. 

Management has told investors that the business could generate an additional $1.6 billion in earnings in the next few years. If it delivers, then Kinder Morgan's leverage ratio would drop to 4 to 4.5 times debt to adjusted EBITDA. The extra cash flow could even be used to maintain (or grow) its distribution or to pay down additional debt. The problem seems to be a lack of clear communication about that strategy. 

That requires investors to take a bit of a leap of faith in Kinder Morgan's ability to grow its earnings and cash flow in the next few years. Of course, an absurdly low valuation could make that leap easier. Here's how it stacks up to the more conservative Enterprise Products Partners.  

Data source: Yahoo! Finance.

Enterprise Products Partners is cheaper based on forward earnings, but it's expected to grow more slowly in the next five years. Nonetheless, its relative safety earns a somewhat premium valuation compared to Kinder Morgan. The fact that the smaller peer trades at just about book value pretty much summarizes Wall Street's thoughts on where the company ranks in its industry: near the bottom.

Which stock is the better buy?

While I usually make a firm pick when comparing two stocks, this matchup is different. The more conservative management team at Enterprise Products Partners provides investors with safety, which earns a premium in the pipeline industry. So, although higher yields tend to signal risk, this 6.5% yield is uniquely stable. Income investors seeking high yields and companies they don't have to babysit should feel comfortable buying the stock.

Meanwhile, what Kinder Morgan lacks in yield, it makes up for in value. Despite management's general success in cleaning up the balance sheet, the stock trades at a historically cheap valuation compared to book value and cash flow. If the company delivers on its growth projects and its goal of paying shareholders $1.25 per share by 2020 (which represents a yield of 7.6% on the current stock price), then Wall Street will have no choice but to hand it a higher valuation.

In other words, which stock is the better buy depends on your investing strategy. Investors looking for lower-risk income today shouldn't hesitate to buy Enterprise Products Partners. Investors willing to take on a bit more risk upfront for the potential for big rewards a few years from now (assuming the energy industry doesn't encounter another downcycle) could pull the trigger on Kinder Morgan stock.