Yahoo Finance

NGLs, on the other hand, take a different pipeline out of processing plants to a fractionation complex, which separates the NGLs into its various streams: propane, butane, ethane, and natural gasoline. Pipelines or tankers then transport those products to storage terminals until needed by end users such as petrochemical complexes.

A quick word on master limited partnerships

There is one distinction worth noting about companies operating in the midstream sector. Some have chosen to structure as master limited partnerships (MLPs) -- which are entities that don't pay federal income taxes if they meet certain criteria -- as opposed to a traditional corporation, or C-corp. The MLP structure has some special tax advantages on both the corporate level as well as for individual investors. However, it also has some disadvantages, including making personal income taxes more complicated to file each year as well as being unsuitable for most retirement accounts. Investors therefore need to weigh the pros and cons of investing in an MLP before buying that type of pipeline company since plenty have chosen to structure as a traditional corporation.

How pipeline companies make money

Pipeline companies typically get the bulk of their revenue from three sources: fixed-fee contracts, regulated tariffs, and margin-based activities. Oil and gas companies often sign long-term, fixed-fee contracts with pipeline companies to gather oil and gas volumes from the wellhead and transport it to processing facilities. They'll also sign fixed-fee agreements for storage capacity as well as on some longer haul intrastate pipelines. These agreements enable pipeline companies to earn recurring cash flow.

The Federal Energy Regulatory Commission (FERC), meanwhile, regulates interstate pipelines, which transport oil and gas across state lines, as well as some other midstream assets such as natural gas storage complexes and LNG terminals. Part of FERC's responsibility is to set tariff rates on interstate pipelines, which are considered regulated monopolies. This process enables pipeline companies to earn a fair return on their investment while protecting customers in the process. FERC uses several rate-setting procedures such as market-based, cost-of-service, and indexed rates depending on the situation. While these tariff structures enable pipeline companies to earn steady cash flow as volumes flow through their systems, FERC can throw them a curveball now and then.

The third way pipeline companies make money is through margin-based activities, which means they earn income on the difference between the price they buy a commodity and sell the higher-value end products. For example, natural gas processing companies will purchase raw natural gas from producers, process out the NGLs, and then sell the two streams for more money since NGLs are typically more valuable than natural gas. When NGL prices are high, these commodity-based margins can be a lucrative source of income for pipeline companies. However, when commodity prices fall, it can squeeze these margins.

It's crucial that an investor understand how a pipeline company makes its money, because that will determine the overall stability of its cash flow, which is an important factor for dividend sustainability. Natural gas pipeline giant Williams Companies (NYSE: WMB), for example, generates 36% of its earnings from regulated gas pipelines; 60% from non-regulated assets backed by long-term, fixed-fee contracts; and 4% from NGL and other commodity exposure. Add it up, and 96% of Williams' earnings come from relatively predictable sources. Natural gas processing giant Targa Resources (NYSE: TRGP), on the other hand, generates about two-thirds of its income from fee-based sources and the other third from commodity margins. Targa would therefore experience a greater impact to cash flow than Williams if commodity prices took a tumble. That's why investors should concentrate on pipeline stocks with a high percentage of their cash flow from fee-based and regulated sources, with more than 85% being an ideal target.

Image source: Getty Images.

Important metrics for pipeline stock investors

Each sector in the stock market has specific metrics to help investors measure one opportunity against another. In the pipeline sector, five metrics stand out as onea investors need to know:

• Distributable cash flow (DCF): free cash flow available to pay distributions to investors.

• The distribution coverage ratio: a metric measuring how much cash a company produces above its distribution level.

• Debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization): a leverage ratio commonly used in the energy industry.

• Enterprise value (EV) to EBITDA: a valuation metric commonly used in the energy industry.

• Market capitalization to DCF or price to DCF per share: a valuation multiple commonly used for pipeline companies.

For most companies, investors focus on reported net income or earnings. Pipeline companies, on the other hand, shy away from that number because it doesn't paint the full picture. That's because pipeline companies tend to record hefty depreciation charges because of the capital expenses incurred to build and maintain their pipelines and other assets, which often causes reported net income to be much less than actual cash flows. That's why pipeline companies prefer to measure their profitability with DCF, which is the excess cash the company could distribute to investors through the dividend. Think of DCF as a proxy for free cash flow.

Another important number for pipeline investors is the distribution coverage ratio, which is DCF divided by the distribution to investors. While most pipeline companies supply this number in their earnings release, it's easy to calculate if they don't. To use a real-world example, in 2017, Targa Resources generated $851.8 million in DCF and distributed right around that same amount of money to investors, which works out to a 1.0 coverage ratio. That's a very tight level, and certainly not ideal. Most pipeline stocks target at least a 1.2 coverage ratio, while more conservative ones aim even higher. Aside from improving dividend sustainability, a higher coverage ratio means a pipeline company retains more internally generated cash to reinvest into expansion projects.

Pipelines are expensive to build, which is why most companies borrow money to help fund construction costs. That's why pipeline stocks tend to have much higher debt levels than companies in other industries do. One metric the industry uses to measure leverage is the debt-to-EBITDA ratio, which shows how many years it would take a company to pay back its debt with earnings. Most pipeline companies post this number on their investor presentations, but it's easy to figure out by dividing debt on the balance sheet by EBITDA. Ideally, this metric should be below 5.0, since that's typically within the range needed for an investment-grade credit rating, which signifies a higher likelihood that a company can meet its financial obligations even during challenging market conditions. One of the benefits of having a low leverage ratio and investment-grade credit is that it makes it cheaper and easier for a pipeline company to borrow money to fund expansion projects.

While most investors value stocks by their price-to-earnings ratio, that metric doesn't work for pipeline stocks because of the impact depreciation has on reported earnings. Pipeline investors therefore focus on two different sets of valuation metrics: EV to EBITDA and market cap (or price) to DCF (per share). The first metric includes the impact of debt, which helps investors compare pipeline companies on a more apples-to-apples basis. Meanwhile, the second one values a company based on the cash flow it's producing. These metrics are useful for spotting potential value stocks in the pipeline sector. They're also easy to calculate, since most pipeline companies publish their EBITDA and DCF forecasts each year.

The 10 largest pipeline stocks

With a better grasp of how the pipeline industry works as well as important metrics to know, it's now time to start putting that knowledge to work in analyzing pipeline stocks. Following is a list of the 10 largest publicly traded pipeline companies in the U.S. and Canada by enterprise value:

Dividend yield and enterprise value as of market close on Sept. 14, 2018.

From here, we'll drill down into three of these large pipeline stocks -- Enbridge, Kinder Morgan, and Enterprise Products Partners -- to see which one seems to have the greatest potential to generate outsize returns for investors.

Image source: Getty Images.

Enbridge: Canada's oil pipeline giant

Enbridge is the largest energy infrastructure company in North America, operating the longest, most sophisticated crude oil transportation system in the world, with more than 17,000 miles of active pipelines, which transport 28% of all the oil produced on the continent. Enbridge thus makes most of its money shipping oil, at just over 50% of its EBITDA in 2017, down from 75% in 2015 thanks to the acquisition of gas-focused Spectra Energy.

About three-quarters of Enbridge's income comes from regulated oil and gas pipelines, with another roughly 15% coming from regulated utility assets, and around 10% from long-term fee-based contracts. Overall, regulated assets and long-term contracts supply 96% of Enbridge's cash flow. In 2017, those assets generated 5.6 billion Canadian dollars ($4.2 billion) in DCF, which was enough to cover Enbridge's divided by a comfortable 1.5 times.

One of the costs of becoming the largest pipeline company in North America is that Enbridge has taken on a boatload of debt through the acquisition of Spectra Energy as well as in building new pipelines. The company expected to end 2018 with a leverage ratio of 5.0 times debt-to-EBITDA, which is a bit higher than its comfort zone. Enbridge is working to address this issue by selling assets and has already announced three deals this year, which should help ease this concern so that it can more easily fund its massive slate of CA$22 billion ($16.7 billion) of growth projects, which the company believes will fuel 10% annual dividend growth through 2020.

Finally, let's look at the valuation, which we can calculate using the company's 2018 guidance for the most current numbers:

Data as of market close on Sept. 14, 2018.

At the time of this writing, Enbridge's peer group traded at 12.2 times EV/EBITDA and 11 times DCF, implying that this stock sells for around fair value.

Add it all up, and Enbridge has the makings of a decent pipeline stock.

Kinder Morgan: The natural gas pipeline king

Kinder Morgan operates the largest natural gas pipeline network in North America, at over 70,000 miles of pipe, transporting 40% of the gas consumed in the U.S. each day. Kinder Morgan therefore makes most of its money shipping natural gas, 56% in total, with the rest coming from liquids pipelines, terminals, and oil production. Overall, predictable sources such as fee-based contracts support 90% of the company's anticipated income for 2018, with the other 10% having some exposure to commodity prices. In 2018, Kinder Morgan expects its assets to produce $4.6 billion in DCF, which is enough to cover its dividend by an ultra-conservative 2.6 times, leaving it with enough excess cash to fully fund its current slate of expansion projects with room to spare.

Kinder Morgan also currently has a bit of an elevated leverage ratio, with the company's initial expectation that it would end the year at 5.1 times debt to EBITDA. However, after selling its oil pipeline in Western Canada, that level dropped to around 4.5.

Now we'll take a peek at valuation, which we can figure out by using the company's 2018 forecast:

Data as of market close on Sept. 14, 2018.

Given that its peer group trades at 12.2 times EV/EBITDA and 11 times DCF, Kinder Morgan appears to be undervalued relative to rival pipeline stocks.

For a company that generates stable cash flow and has strong dividend coverage and an improving balance sheet, Kinder Morgan appears to be an attractive pipeline stock, especially when factoring in its valuation.

Enterprise Products Partners: The cream of the crop among MLPs

Enterprise operates one of the largest integrated midstream systems in the country, with over 50,000 miles of pipelines. However, the company makes most of its money on NGLs, which contributed 57% of the total over the past year. Overall, fee-based contracts and regulated sources provide about 90% of the MLP's income, with commodity-based natural gas gathering and processing volumes supplying the other 10%. In 2017, Enterprise Products Partners generated $4.5 billion in DCF, which was enough to cover its distribution by a healthy 1.2 times. The company plans to increase coverage to an even more conservative level so that it has more retained cash to invest in the $4.9 billion growth projects it currently has under way.

Enterprise Products Partners has one of the highest credit ratings among MLPs, backed by a leverage ratio that was 4.1 in the first quarter of 2018. That level should further improve in the coming quarters because Enterprise recently finished a large slate of expansion projects, which pushed that metric down to 3.7 after factoring in the current earnings run rate.

Enterprise Products Partners is a bit harder to value, because it won't publish guidance for 2018. However, we can still get a rough idea by looking at how it trades versus last year's numbers:

Data as of market close on Sept. 14, 2018.

Again, with its peer group trading at 12.2 times EV/EBITDA and 11 times DCF, Enterprise appears a bit overvalued at the moment.

Put everything together, and we have a top-notch MLP with improving metrics trading at a bit of an inflated price.

Taking the next step

After walking through the critical factors found in the best pipeline stocks, we can confirm that Enbridge, Kinder Morgan, and Enterprise Products Partners have almost all the characteristics an investor could want in a pipeline stock. However, Kinder Morgan does stand apart from this trio because it has the highest coverage ratio and the lowest valuation. While that should put it on an investor's short list of pipeline stocks to consider buying, they should now do a bit more work and compare it with the others in the top 10 to see if it's the best pipeline stock in the sector to buy.

More From The Motley Fool

• 10 Best Stocks to Buy Today

• 3 Stocks That Are Absurdly Cheap Right Now

• 5 Warren Buffett Principles to Remember in a Volatile Stock Market

• The $16,728 Social Security Bonus You Cannot Afford to Miss

• The Must-Read Trump Quote on Social Security

• 10 Reasons Why I'm Selling All of My Apple Stock

Matthew DiLallo owns shares of Adobe Systems, Enbridge, Enterprise Products Partners, and Kinder Morgan. The Motley Fool owns shares of and recommends Adobe Systems and Kinder Morgan. The Motley Fool recommends Enbridge, Enterprise Products Partners, Magellan Midstream Partners, and ONEOK. The Motley Fool has a disclosure policy.