With interest rates near zero and the stock market sitting near record highs, income investors are in a very difficult position. The S&P 500 Index, on average, currently yields less than 2%, while the 10-year U.S. Treasury yields just 0.69% right now.
But investors can still find high-quality securities with high dividend yields. For example, Energy Transfer LP (ET) is a high-yield Master Limited Partnership yielding over 18%. Its extremely high yield has caught the attention of institutional investors, such as Appaloosa Management, a hedge fund with over $3 billion in assets under management.
While Energy Transfer faces risks, specifically weak commodity pricing and the potential for a severe recession in the United States, the company continues to generate enough cash flow to maintain its hefty distribution.
Energy Transfer is a midstream oil and gas Master Limited Partnership, or MLP, which means it operates pipelines and terminals that store and transport energy products. The company has a large asset network consisting of total gathering capacity of nearly 13 million Btu/day of gas, and a transportation capacity of 22 million Btu/day of natural gas and over 4 million barrels per day of oil.
The midstream model is relatively attractive in comparison to upstream exploration and production firms, because upstream producers are much more reliant on the price of oil and gas. In times like the current environment, in which commodity prices are low, midstream operates fare relatively well because their cash flow is dependent more on volumes transported and stored.
This explains why Energy Transfer has so far been able to maintain its hefty distributions, while so many exploration and production energy firms have cut or suspended their dividends over the past year.
Gushing Cash Flow and Distributions
To be sure, Energy Transfer is not completely unaffected by the coronavirus pandemic. After all, a pronounced economic downturn will lead to a decline in demand for oil and gas. This has had a notable impact so far in 2020. In the most recent quarter, Energy Transfer reported a 14% decline in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) compared with the same quarter last year. Distributable cash flow declined by 21%.
However, the company achieved a strong distribution coverage ratio of 1.54x for the quarter, which generated excess cash flow of $448 million beyond distributions for the quarter. This means Energy Transfer generated approximately 54% more distributable cash flow than it needed to pay its quarterly distribution. It is a very good sign that Energy Transfer can maintain such a high coverage ratio, particularly in a challenging environment.
While there is never a guarantee when it comes to high-yield stocks, there is good reason to believe the distribution is secure. Assuming the U.S. economy hit bottom in the second quarter and is on the road to recovery, demand for oil and gas should recover as well. In addition, Energy Transfer is aggressively scaling back on growth investment to preserve cash. To that end, the company further reduced its growth capital expenditures by an additional $200 million.
Investors need to exercise caution when it comes to buying Master Limited Partnerships. The asset class carries its own unique risk factors and tax consequences which investors should understand before buying. But for income investors in search of yield, the MLPs can be an attractive option. Energy Transfer is one of our top-rated MLPs due to its extremely high yield, but also its strong assets and high level of distribution coverage.
Bob Ciura has worked at Sure Dividend since October 2016. He oversees all content for Sure Dividend and its partner sites. Bob received a Bachelor’s degree in Finance from DePaul University, and an MBA with a concentration in Investments from the University of Notre Dame.
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