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2 Incredibly Cheap Energy Stocks

Matthew DiLallo, The Motley Fool

Investors have abandoned energy master limited partnerships (MLPs) in recent years. Several factors have caused the sector to fall out of favor, including oil price volatility, regulatory changes, and higher interest rates. As a result of these issues, most MLPs trade at historically low valuations.

In addition to those outside factors, internal issues such as weaker financial profiles have further suppressed the value of certain MLPs. The two hardest hit by all these headwinds are Energy Transfer (NYSE: ET) and Summit Midstream Partners (NYSE: SMLP), which have the lowest valuations in their respective peer groups.

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Massively cheap

Energy Transfer is one of the largest midstream MLPs in the country. The company currently operates a diversified portfolio of energy infrastructure, including 86,000 miles of pipelines for oil, natural gas, natural gas liquids, and refined petroleum products, as well as several processing and storage facilities. It collects steady fees backed primarily by long-term contracts as volumes flow through those assets, enabling it to produce predictable cash flow. The company currently returns about half of that money to investors via a distribution that yields an attractive 8.6%.

For 2019, Energy Transfer expects to haul in between $10.6 billion and $10.8 billion of EBITDA -- up 12.5% from last year at the midpoint -- from its portfolio of energy infrastructure assets. Given Energy Transfer's current enterprise value (EV) of $93 billion, the company trades at an EV-to-EBITDA ratio of 8.7 times. That's by far the lowest level in its peer group of large midstream companies. For perspective, the next cheapest competitor trades at nearly 11 times its EV/EBITDA, while its priciest peer sells for almost 14 times that metric.

One factor that seems to be weighing on Energy Transfer's valuation is that it has a higher leverage ratio compared with its peers. However, its debt-to-EBITDA metric should decline from its current level of around 4.7 times to its target range of 4.0 to 4.5 as earnings increase. Given that earnings growth should quickly erase the main concern weighing down its valuation, Energy Transfer seems to be trading at a super-cheap price these days.

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At the bottom of the heap

Summit Midstream is a much smaller MLP mainly focused on gathering and processing oil and gas for producers. Those activities tend to generate relatively predictable cash flow, since the company signs long-term contracts with drillers to support their operations. But these activities are a bit more sensitive to oil prices because drillers tend to slow their pace when crude prices drop, which causes reduced volumes to flow through Summit's systems.

Given the current expectations for oil prices, Summit Midstream is on track to produce between $295 million and $315 million of EBITDA this year. At the midpoint, that's about 7% above last year's level, which is close to the average growth rate for peers focused on gathering and processing. With Summit Midstream's current enterprise value below $2.5 billion, it implies that the MLP trades at an EV/EBITDA of less than eight times. That's by far the lowest in its peer group, where the next cheapest competitor trades at about nine times its EV/EBITDA, while the average is slightly above 10 times.

Summit Midstream's valuation is at the bottom of the barrel even though it has comparable financial metrics. Its debt-to-EBITDA ratio, for example, is currently at 4.3 times, which is only slightly higher than the peer group average of 4.1 times. Meanwhile, the company expects to generate enough cash to cover its sky-high distribution -- which currently yields an eye-popping 16.7% -- by a comfortable 1.7 times. That coverage level is well above the peer group average of 1.4 times.

The one knock against Summit Midstream is that it owes its parent $303.5 million for an acquisition the two completed a few years ago. It's not entirely clear how the company will pay that balance, which is due at the end of next year. The concern is that the MLP could fund the remaining balance by issuing new common units, which would be highly dilutive to existing investors, given how ridiculously cheap shares are these days. If the company can find a way to make that payment without diluting investors, then its valuation could skyrocket once it lifts the main weight holding it down.

Big yields and even bigger upside potential

Financial concerns are weighing on the valuations of Energy Transfer and Summit Midstream. Because of that, both could have big-time upside as those worries fade. In the meantime, risk-tolerant investors are getting paid exceptionally well to patiently wait as these companies address the issues holding them down.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.