3 Reasons to Avoid These 2 High-Yield Energy Stocks and Buy Magellan Midstream Partners Instead

Source: Energy Transfer Partners

Warren Buffett once said "Only when the tide goes out do you discover who's been swimming naked."
The worsening energy crash has certainly proven the wisdom of these words with almost all midstream MLPs, most of which funded growth with excessive borrowing and are now facing the worst price collapses since the financial crisis.

MMP data by YCharts

Yet as you can see Magellan Midstream Partners (MMP), though still hit hard over the past year, has help up admirably when compared with far larger pipeline competitors such as Plains All American Pipeline (PAA 6.24%) and Energy Transfer Partners (ETP).

While true that Plains All American and Energy Transfer are trading at far lower absolute valuations, Magellan Midstream Partners' full year 2015 results clearly demonstrate why, to again quote the oracle of Omaha, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Let's take at look at three reasons why Magellan Midstream Partners is indeed so much better than its rivals, and why it represents such a fantastic long-term income growth opportunity.

Business model designed to weather any storm

Source: Magellan Midstream Earnings Release

Magellan Midstream's management is one of the best in the business. Rather than focus on growth at any price, it has always been laser focused on only investing in a diversified mix of extremely profitable assets that can sustain a generous and sustainably growing distribution, no matter what energy prices are doing.

Last year's growth was courtesy of $747 million in organic growth capital investment and acquisitions. Management is expecting to spend another $900 million to complete its growth projects already in progress, with $800 million of that occurring in 2016. Further future growth will be provided by over $500 million in potential projects Magellan Midstream is evaluating as well as future acquisitions.

One of the best, most secure, payout profiles in the industry

Source: Yahoo Finance, Fastgraphs, earnings presentations, management guidance, 10-Ks

The primary reason that Energy Transfer Partners and Plains All American Pipeline are offering such astronomical yields (and distribution growth prospects so much weaker than Magellan's) is because Wall Street has lost confidence in their ability to maintain, much less grow their payouts given current market conditions and the prospect of energy prices remaining low into 2017 or longer.

What about the long-term fixed contracts that are the backbone of the midstream MLP industry? Aren't they supposed to essentially make pipeline operators' cash flows immune to commodity prices?

Theoretically yes, however such contracts don't always contain minimum volume commitments, so crashing energy prices and producers' cutting back on production can still threaten a portion of an MLP's DCF. With both Energy Transfer Partners and Plains All American struggling -- and recently failing -- to maintain a minimum sustainable coverage ratio of 1.0, even small decreases in volume can threaten the long-term security of their payouts.

In contrast Magellan Midstream's conservative payout growth policy, which emphasizes retaining a large amount of DCF each year, not only gives the market far more confidence in the security of the MLP's payout, but also its growth prospects.

However, a superior distribution profile is just one reason that Magellan is such a superior income growth choice at today's valuation.

Conservative, quality management means no liquidity worries

MMP Shares Outstanding data by YCharts

Most MLPs payout such a large proportion of their DCF because, at least for the last half decade, high energy prices, soaring unit prices, and historically low interest rates have made growth capital funding via equity and debt markets extremely easy.

As you can see in this chart both Plains All American Pipeline and Energy Transfer Partners have made aggressive use of both funding sources, which has allowed them to grow their payouts over the years without retaining excess DCF to grow. Now that debt and equity financing are harder to come by, investors are fearful that both Plains All American and Energy Transfer Partners might have to slash their distributions to pay for capita expenditures and paying down debt out of their DCF.

Magellan Midstream's strategy, courtesy of the fact that it bought out its general partner during the financial crisis at rock bottom prices, has no incentive distribution right fees and can thus hold onto far more DCF. When combined with management's focus on only investing in the most profitable projects (resulting in lower capital expenses), the MLP has been able to achieve solid growth while relying far less on external funding.

With a stable unit count (which makes growing the distribution easier in the long-term), and one of the strongest balance sheets in the industry, Wall Street is valuing Magellan at a relative premium to its more financially distressed peers, as it should.

Bottom line
The worst energy crash in half a century has made clear that wise income investing requires a focus on quality over quantity. Thanks to its conservative, long-term focused management team, Magellan Midstream Partners' is one of the today's best situated dividend growth opportunities in the entire energy sector.

Which is why, despite a much lower yield, I highly recommend that dividend investors choose it, over much cheaper valued competitors such as Energy Transfer Partners and Plains All American Pipeline.