Far too often, investors buy things that they don't fully understand. Wall Street often helps this unfortunate outcome along with its hype machine, pushing whatever hot product is selling best, regardless of whether it is good for investors to own or not. Human nature, which often leads people to flock like lemmings, doesn't help any. Don't be one of the crowd; make sure you know what you own.
That couldn't be any simpler to do, either, when you look at the high-yield midstream sector. And names like Kinder Morgan (NYSE:KMI), Enterprise Products Partners (NYSE:EPD), and Magellan Midstream Partners (NYSE:MMP) are top players to examine today.
1. Back on a solid path
Kinder Morgan owns and operates midstream pipelines, processing facilities, and transportation assets. But what exactly does that mean? Simple: It helps move oil and natural gas from where they are drilled to where they eventually get consumed in their various forms. Sure, there are nuances underneath that big-picture view, but that's the crux of the business.
Also important, however, is that Kinder Morgan largely gets paid for the use of its assets via fees. Often-volatile commodity prices aren't that big an issue.
For example, in 2020, when oil prices plunged, Kinder Morgan's distributable cash flow (DCF) only dropped 8%. It was able to increase its dividend despite the headwinds, thanks to the fact that its DCF in 2020 covered its dividend by a huge 1.9 times. To be fair, the company has a bit of a sordid history when it comes to dividends. Notably, it told investors to expect a dividend hike of as much as 10% in 2016, and then, just a couple of months later, cut the dividend. It was the best move for the company, but really conservative dividend investors might want to pass it by for this reason.
That said, with a $37 billion market cap, it is one of the largest midstream players in North America. And it has taken a much more conservative approach to the dividend of late, noting that it chose to increase the payment just 5% in 2020 to ensure it didn't have to suffer the embarrassment of another dividend cut. If you are willing to see Kinder Morgan as a simple company that's turned an important dividend corner, its 6.5% dividend yield could be a good fit for you.
2. A great yield and dividend record
Next up is Enterprise Products Partners, which -- with a $50 billion market cap -- is even bigger than Kinder Morgan. But like the above company, Enterprise basically gets paid fees for helping to move oil and natural gas around the world. And it offers investors a giant 7.7% distribution yield backed by a DCF coverage ratio of around 1.6 times. Like Kinder Morgan, Enterprise managed through 2020 without too much difficulty (distributable cash flow fell just 3%), and it upped its dividend again. That said, Enterprise has a 24-year streak of annual distribution increases under its belt. It's appropriate for investors that are put off by Kinder Morgan's 2016 dividend cut.
There is one small wrinkle here: Enterprise is a master limited partnership (MLP). Thus it is a bit more complex than a regular corporate structure, in that unitholders are treated as part owners of the business for tax purposes. That means that things like depreciation flow through to the unitholder, offering tax-advantaged income. But it also means that investors have to deal with a Schedule K-1 come tax time. That's a complication that might lead to you seeking out a tax specialist, but it doesn't actually change anything about the underlying simplicity of what Enterprise does. And that big, well-covered 7.7% yield is ample compensation for the extra time you'll spend doing your taxes.
3. Cutting it a little closer
The last name up is Magellan Midstream, which like Enterprise is an MLP. However, it is much smaller, with a market cap of just $10 billion or so. It also has a long history of operating with a much tighter DCF coverage ratio, which it targets at around 1.2 times over the long term. Historically, that's been considered a strong coverage ratio in the industry, but things have changed a little bit lately, noting the larger coverage numbers for both Kinder Morgan and Enterprise. Which helps explain Magellan's larger 8.4% distribution yield from a roughly similar, simple to understand, fee-based business.
There are some other factors that make Magellan attractive here. For example, it has long operated with one of the most conservative balance sheets in the industry. Specifically, its ratio of financial debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) is lower than both of its peers above. That provides a solid foundation for its distribution, which has been increased every year since its 2001 initial public offering. Although its annual streak isn't as long as the one Enterprise has put up, it is hard to suggest that Magellan has let investors down when it comes to distributions.
That said, investors need to recognize that this MLP doesn't have as much leeway on the distribution front as Enterprise, which is a big reason its yield is so high. It's probably worth a look for more-aggressive types right now.
Easy-to-grasp high yields
Kinder Morgan, Enterprise, and Magellan are all pretty simple to understand as businesses: They get paid fees to move oil and natural gas. That's the good news. The bad news is that part of the reason for their high yields today is that they are firmly entrenched in the carbon energy sector, which is out of favor in a world looking to reduce carbon emissions. That's actually an opportunity, however, because energy transitions take time, and the one being enacted today will be decades in the making in a growing world that's increasingly desperate for cheap energy.
In fact, demand for oil and gas, on an absolute basis, is more likely to rise over the next 20 years or so than fall, even as the world goes green. And you get to collect fat dividends from simple-to-understand businesses all along the way if you can see past the clean energy zeitgeist that's unnerved other investors.