If you're looking at energy stocks for your portfolio, now's a good time to examine out-of-favor names. Our Motley Fool investors did just that and picked out midstream giant Kinder Morgan Inc. (NYSE:KMI) and smaller peer Magellan Midstream Partners, L.P. (NYSE:MMP) as prime candidates to consider. Both have seen their prices fall along with the broader midstream industry despite positive developments in their respective operations. Shifting gears a little bit, renewable power-focused Pattern Energy Group Inc. (NASDAQ:PEGI) also made the list. It has a huge yield that investors seem worried it can't support, but when you consider the risk/reward trade-off, it looks like it's time to think about jumping in. Here's why.
Patience should pay off
Matt DiLallo (Kinder Morgan): Pipeline stocks have become unpopular with investors in recent years due to the downturn in the oil market. Because of that, shares of pipeline giants like Kinder Morgan have fallen sharply despite little change in their underlying business. In fact, shares of this natural gas pipeline giant are down a stunning 60% over the past three years even though its cash flow will only be about 4% off the peak this year. Because of that sell-off, Kinder Morgan trades for around eight times cash flow, which is just an insanely cheap valuation considering that its peer group average is about 12 times cash flow.
It's a discount that has its management team stumped. They're doing everything in their power to address the situation, including returning more cash to investors through a much higher dividend as well as buying back some of its deeply discounted stock. They also continue to invest in high-return growth projects and have nearly $12 billion of expansions underway that have the company on pace to grow earnings by at least $1.6 billion over the next several years. The expectation is that this combination of earnings growth and increasing cash returns to investors will boost the valuation over time.
While owning Kinder Morgan requires patience, now is as good a time as any to consider buying the pipeline giant's stock. Not only is it trading near its lowest price in two years, but the company is about to increase its dividend 60%. As a result of that combination, patient investors will get paid around 5% annually while they wait for the company's valuation to start heading higher.
A risk/reward investment on the future of energy
Jason Hall (Pattern Energy Group Inc.): Since the company reported fourth-quarter earnings on March 1, shares of Pattern Energy are up a solid 7% as investors have steadily increased interest in the renewable independent energy company. But even with this nice rebound, Pattern's stock price is still down almost 31% from the 12-month high.
Despite that, I think Pattern Energy has the makings of a long-term winner. It has a major shareholder in charge in CEO Michael Garland, something that helps align management with the rest of us. Garland is also CEO of Pattern's privately held affiliate, Pattern Development, a major renewable energy project developer. This helps provide Pattern Energy with a substantial pipeline of new projects to invest in and acquire over time. Lastly, renewables are steadily getting cheaper, something that is already starting to disrupt how utilities think about sourcing their electricity, and replacing existing fossil-fuel and nuclear production.
Last year, Pattern Energy increased power production by 14% to 7.8 gigawatt hours, operating cash flow by 33%, and cash available for distribution (an adjusted cash flow measure) by 10%. But the company could just be getting started. It recently announced plans to expand its investments beyond wind projects and take advantage of the growing demand for solar and energy storage.
With a 9.2% yield at recent prices, it looks like the market thinks management may struggle to grow cash flows going forward. And while it's far from a certainty, my analysis says the risk is worth the potential rewards. That's why I recently bought more shares, and think you should consider doing the same.
Slow, steady, and on sale
Reuben Gregg Brewer (Magellan Midstream Partners, L.P.): Magellan Midstream Partners owns the pipes and other assets that move oil, natural gas, and refined products around the United States. Magellan is largely a toll taker, with 85% of its operating margin derived from fee-based businesses. The partnership structure, meanwhile, is designed to throw off cash to unitholders -- Magellan's yield is a robust 6% backed by 18 years' worth of annual increases.
Right now, however, investors have soured on the midstream space, pushing Magellan down around 30% from the highs it reached in 2014. The units are off by more than 15% so far this year. That's pushed the yield to its highest levels since the start of this decade. The partnership's enterprise value-to-EBITDA ratio, in the meantime, is below its three-, five-, and 10-year medians. So, in many ways, Magellan looks relatively cheap.
The thing to keep in mind is that the current negative investor sentiment hasn't changed anything about the fundamentals of Magellan's business. The tolls it charges will just keep rolling in, and Magellan intends to spend roughly $1.1 billion on expansion projects in 2018 and 2019. These projects either have customers lined up or demand supports the spending. The investments are projected to support 8% distribution growth in 2018, with a similar hike likely in 2019. That's nearly three times the historical rate of inflation growth.
I'm sure you can find higher yields and faster-growing energy companies. But the mix of growth, safety, and income provided by Magellan should win this midstream partnership a spot on your shortlist today.
It's hard to go against the grain on Wall Street. But sometimes the best investment ideas are found when you take the risk to think differently than the crowd. Kinder Morgan, Magellan, and Pattern Energy are all off the beaten path today. But if you're looking for some good energy stocks to buy, that's where the best opportunities live. Take a little time to get to know this trio, and one or more should find their way into your portfolio today.
Jason Hall owns shares of Pattern Energy Group. Matthew DiLallo owns shares of Kinder Morgan. Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool recommends Magellan Midstream Partners. The Motley Fool has a disclosure policy.