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3 Incredibly Cheap Energy Stocks

By Reuben Gregg Brewer – Nov 28, 2018 at 10:22PM

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This trio should be on your short list today, despite some warts.

Even after all of the market's recent ups and downs, it remains near record levels. It's hard to find cheap stocks in this environment, but not impossible. You may have to accept some blemishes to find good deals on the sale rack, but it can be worth the risk, particularly if you like dividends. If you are looking for deals in the broader energy space today, then you need to put ExxonMobil (XOM), The Southern Company (SO), and Holly Energy Partners (HEP) on your short list. Here's a primer on each of these high-yielding and enticingly priced energy stocks.

The global energy giant

Exxon hardly needs much of an introduction, but it's one of the largest integrated oil and natural gas companies in the world. It currently offers a yield of around 4.1% backed by a dividend that's been increased every year for 36 consecutive years. That's a record that its peers simply can't match. The current yield, meanwhile, is higher than it's been since the late 1990s. And Exxon's price to tangible book value hasn't been this low since about that time, too. Exxon looks like it's on sale.   

A hand drawing a scale weighing value and price

Image source: Getty Images.

That sale is driven by the fact that its production has been falling for a couple of years. Just a couple of percentage points, to be sure, but it's going in the wrong direction. And the plan to get Exxon back to growth mode stretches out to 2025, an awfully long time to wait in an industry known for volatile price swings. This industry-leading company is worth it.   

For starters, Exxon's business is diversified across the upstream (drilling) and downstream (refining and chemicals) sectors. The two sides of the business help to smooth out the industry's inherent ups and downs, since the downstream operations tend to benefit from falling oil prices. Second, Exxon's production grew between the second and third quarter, suggesting that it has finally reached an inflection point. And that was on the strength of just one of its key growth driver, onshore U.S. drilling. As for the plans that stretch out to 2025, the third reason to like Exxon is that its long-term debt makes up just under 10% of its capital structure -- even if oil prices are weak, it won't have any trouble funding its investments.   

A nuclear nightmare

Next up is Southern Company, one of the largest electric and natural gas utilities in the United States. It owns sizable regulated utility businesses, transmission assets (midstream pipelines and long-distance electric lines), and a large renewable-power merchant operation. The current yield is around 5.1%, backed by 18 straight years of annual dividend increases.   

On the valuation front, Southern's price to sales, price to book value, and price to cash flow ratios are all below their five-year averages and the peer group average, using Utilities Select Sector SPDR ETF as a proxy for the industry. The one metric that suggests overvaluation is P/E -- which highlights one of the key headwinds facing Southern today. 

SO PS Ratio (TTM) Chart

SO PS Ratio (TTM) data by YCharts.

Southern's earnings have been hampered in recent years by one-time charges associated with a large nuclear power project, known as Vogtle, pushing earnings lower and the P/E higher. The most recent hit being a $1.1 billion charge in the second quarter. The Vogtle project is well over budget and long delayed at this point. In fact, Southern recently agreed to shoulder more of the burden than its partners on the nuclear build if costs rise further in the future. That's bad news, but the agreement pretty much guarantees that Vogtle will be completed (that wasn't a given a few months ago). This nuclear issue is a huge overhang on the stock.   

Underneath this big project, however, is a generally well-run utility. And while leverage is elevated right now, largely because of construction costs, Southern expects its spending plans (which go well beyond the Vogtle project) to help support earnings and dividend growth of around 4% to 6% a year. Add that to the yield, which is at the high end of the industry, and Southern is a good option for income investors who can handle a little near-term uncertainty related to the Vogtle construction effort.   

Potentially near the end

Last up is a more aggressive option, Holly Energy Partners. This master limited partnership is controlled by refiner HollyFrontier (HFC) and owns midstream assets like pipelines. The yield is a whopping 9.2% backed by 14 consecutive years of annual distribution increases, and is near the highest levels in the partnership's history.   

The problem here is that Holly Energy's growth has long been driven by acquisitions from parent HollyFrontier (known as drop downs). And HollyFrontier is pretty much out of assets to sell to Holly Energy. That means the partnership needs to find new ways to grow. So far, that's meant expansion projects, but they have been relatively small. It needs bigger projects or acquisitions to really push the needle. The problem with that: Capital markets aren't very accommodating right now, so finding the cash for big moves could be hard. Meanwhile, Holly Energy is projecting distribution coverage of just 1 times for the year, which doesn't provide much room for error. Coverage has been below 1 in recent quarters.     

This is not a great option for risk-averse investors. However, Holly Energy historically has done a good job of rewarding investors and deserves some leeway as it shifts gears to what is, effectively, a new business model. Leverage, meanwhile, is toward the low end of the industry, so this isn't a situation where management has stretched the balance sheet until it is out of financial options. Meanwhile, built-in price increases on many of its contracts suggest that growth (albeit slow growth) will continue.

HEP Financial Debt to EBITDA (TTM) Chart

HEP Financial Debt to EBITDA (TTM) data by YCharts.

Sure, that may mean a notable slowdown in distribution growth, but an outright cut seems to be a relatively low-probability event at this point. That said, there is a possibility that HollyFrontier steps in to buy Holly Energy, which would likely require a premium price. But it would still be a steal for HollyFrontier since Holly Energy is down around 33% from its price peak in 2013.

Holly Energy now borders on a special situation -- which stresses the point that it's not appropriate for conservative investors. If you have a strong stomach, however, you might want to take a closer look.

Time for some deep dives

If you are looking for value in the energy sector, Exxon, Southern Company, and Holly Energy are three stocks that should entice you to do some additional research. All three have issues they are dealing with, but the issues don't appear as bad as the market seems to suggest based on their stock prices. Exxon is, by far, the most conservative option of the trio, with Holly sitting at the opposite end of the risk spectrum. But if you take the time, you'll likely find that one or more of these energy stocks could be a good fit for your portfolio.

Reuben Gregg Brewer owns shares of ExxonMobil and Southern Company. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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