Pipelines vs. Utilities: Why Pipelines Are the Better Bet for Now

Utilities have long been a mainstay for income investors. Stable by nature, the utilities sector is largely made up of established, cash-generating companies. Because these business are heavily regulated monopolies, returns are usually guaranteed by prices approved by public utility boards.

As older, established businesses, utilities should generate substantially more cash than they are using. Unfortunately, when we look under the hood we find that this is not currently the case. Right now, the dividends of many utilities are not sustainable on a free-cash-flow basis. Why is this? Across the country, utilities are either upgrading old infrastructures or building renewable generation capacities.

Can't go on forever

Trailing twelve month cash flow, data by Morningstar.

The above four examples are just a sample of a broader trend of utilities that are not able to pay their dividends from free cash flow due to increased capital spending. This is by no means a comprehensive list. However, all four of the above names are unable to pay the dividend from free cash flow in part because of a buildout of renewable energy infrastructure. Xcel Energy , for example, is increasing wind power from 3% to 20% of total generation by 2020. It is a very capital-intensive project, which is forcing the company to take on more debt in order to continue paying its dividend.

While many utilities, including these four, are spending large amounts on infrastructure, earnings growth for these utilities will continue to be low. These four are building out renewable generation by state mandate, and so they should have the ability to recover this cost by raising prices. We are already in tough times, however -- how much more can people be squeezed? Something has to give.

To be sure, some utilities are actually spending capital as a response to growing power demand. Take American Electric Power , which is increasing capacity to respond to steady demand growth in Texas. While AEP is spending while paying a dividend beyond its free cash flow, management expects steady consumption growth at the same time. These utilities have to be taken on a case-by-case basis. There are some good ones out there.

There's a better way
Dividend investors have a steadier option in a growing sector: pipelines. Like utilities, pipelines operate long-lived assets with a good degree of cash flow visibility. Most offer distribution yields equal to or greater than utilities. These pipelines are benefiting from increasing energy activity in the U.S. on the back of the "shale revolution." Think of these pipelines as giant toll roads whose "traffic" -- oil, natural gas, natural gas liquids, and a variety of other things -- is steadily increasing.

As master limited partnerships, pipelines' important financial metrics are non-GAAP. However, most of these names have kept their debts in check when related to EBITDA earnings, and they are more than able to pay distributions from distributable cash flow (DCF.) Have a look at the coverage of three of the bigger, safer pipeline partnerships.

KMI, EPD distribution coverage based on first six months of 2013. MWE based on 2013 guidance target.

Those income investors looking for safety should look first to Enterprise Product Partners . Enterprise yields 4.5% at the moment, similar to most utilities. It has increased its distribution yield by a compounded rate of more than 6% over the past ten years, however, and shows every indication of continuing that trend. Over the next couple of years, Enterprise will open up port facilities in Texas to export natural gas liquids. In addition, the partnership has completed a new natural gas and oil pipeline system from the brand new Eagle Ford shale of South Texas to the Gulf Coast refining complex. These developments, along with a number of others, will grow the partnership's distributions in a steady and sustainable way.

Foolish bottom line
At the moment, pipelines are a better, steadier income investment than utilities are. Pipelines are growing their incomes steadily and predictably off of increased domestic energy activity. Utilities, on the other hand, are spending capital on new infrastructure with somewhat questionable prospects for higher returns. This is particularly true for utilities that are building on renewable energy generation. Overall, pipelines are the more surefire way to go.

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The article Pipelines vs. Utilities: Why Pipelines Are the Better Bet for Now originally appeared on Fool.com.

Casey Hoerth has no position in any stocks mentioned. The Motley Fool recommends Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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