Investors need to be careful when selecting high-dividend stocks. An outsized dividend yield is sometimes a sign of danger. When a stock price crashes, its dividend yield rises. Therefore, there are times when a high yield is simply the result of a collapsing share price, possibly an indication that investors are expecting a future dividend cut. Therefore, investors should exercise some caution when viewing stocks with abnormally high yields. Indeed, it’s particularly true in the MLP space, as many MLPs have cut or suspended their distributions over the past year due to falling oil prices.
While many consider blue chip stocks for their requirement, investors have options. Fortunately, a select few MLPs have excellent business models, with strong cash flow that sufficiently covers their generous distributions. Specifically, these 3 MLPs have attractive yields above 5%–and just as important, have secure payouts with room for continued payout growth.
Quality MLP #1: Enterprise Products Partners LP (EPD)
Oil and gas companies are not typically associated with long histories of distribution growth due to the underlying cyclicality of the energy business. But Enterprise Products is a notable exception, as this Master Limited Partnership has increased its unitholder distribution for 22 consecutive years.
Indeed, it’s a notable streak, as it encompasses the Great Recession of 2008-2009, the oil industry downturn of 2014-2016, and the coronavirus pandemic of 2020. Each of these downturns got associated with steep declines in oil and gas prices. But, EPD continued to increase its distribution each year regardless.
The reason for EPD’s impressive distribution growth history is its premier assets. The company possesses one of the highest-quality portfolios of midstream infrastructure assets in the country.
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It owns 50,000 miles of pipelines that transport natural gas liquids (NGLs), crude oil, natural gas, and other refined products. It also owns storage assets with 260 million barrels of NGL, petrochemical, crude oil, and refined products storage capacity. In addition, it has another 14 billion cubic feet of natural gas storage capacity. Enterprise Products also owns 21 natural gas processing facilities, 25 fractionators, 11 condensate distillation facilities, and 19 deep-water docks.
EPD is not just a high-quality MLP because of its substantial assets. The company also has a healthy balance sheet and a strong level of cash flow to protect its distribution payments to unitholders. The company has a credit rating of BBB+ from Standard & Poor’s and Baa1 from Moody’s. These are among the highest ratings in the MLP space. In addition, EPD ended 2020 with a leverage ratio (defined as net debt divided by 12-month adjusted EBITDA) of 3.5x, again much better than many other MLPs.
The company paid distributions of $1.80 for 2020, with a coverage ratio of 1.6, meaning distributable cash flow exceeded distributions by 60% for the year. Indeed, this was an extreme level of coverage, especially since 2020 was a highly challenging year for the energy industry due to the coronavirus pandemic.
How did EPD do in 2020?
Nevertheless, EPD fared well in 2020. For the full year, a distributable cash flow of $6.4 billion was a 3% decline from the prior year. And, this was a relatively mild decline, given the steep economic damage from the coronavirus pandemic. The company also retained $2.5 billion of excess distributable cash flow in 2020. Indeed, that money can be used for growth investment or to pay down debt.
EPD generates enough excess cash flow to buy back its own units, which again is a rarity from MLPs. Most MLPs need to sell new units to raise cash flow to invest in growth and maintenance capital expenditures and debt repayment, but EPD is in the unique position of being able to repurchase units. The company is in the process of a $2 billion buyback program.
Future years should also generate excess cash flow, as EPD is in the process of significantly reducing growth capital expenditures. 2020 growth capital expenditures got set at $2.9 billion. EPD currently expects growth capital expenditures of $1.6 billion in 2021 and $800 million in 2022. Even so, EPD has $3.9 billion of major capital projects under construction, which will continue to fuel the company’s strong cash flow.
EPD units have a current yield of 7.7%, which is very attractive for income investors. However, equally important is that the distribution payout is secure with underlying cash flow, along with a high likelihood of distribution increases each year.
Quality MLP #2: MPLX LP (MPLX)
MPLX LP is another midstream MLP. Operating in the midstream space means the company owns storage and transportation assets. Like Enterprise Products, MPLX has an extensive network of midstream infrastructure assets. The advantage of the midstream business model is that it provides a measure of insulation against volatility in commodity prices. It’s because midstream operators act more like toll roads in that they receive payment based on volumes stored and transported through their networks of assets.
MPLX is another quality MLP that can generate strong cash flow, even in challenging operating environments. Beyond midstream storage and transportation, MPLX also has logistics assets and offers fuel distribution services. MPLX’s leadership position across midstream and logistics provides the company with resilient cash flow, even under challenging climates such as 2020.
Last year, the company continued to generate positive cash flow and sufficient coverage of its distribution. In the fourth quarter, distributable cash flow equaled $1.15 billion. And, it came to $1.11 on a per-unit basis, which represented year-over-year growth of 12%. Distributable cash flow per unit came to $4.12 for 2020, a slight decline of 9% from $4.52 generated in 2019.
Resilient cash flow allowed the company to maintain its distribution and continue to improve its leverage ratio. As a result, MPLX ended 2020 with consolidated debt to an adjusted EBITDA ratio of 3.9, which is down from 4.1 in 2019. Keeping leverage below 4.0 is generally a good sign for MLPs. MLPX also had a strong coverage ratio of 1.46 for 2020. While this was down from a coverage ratio of 1.51 in 2019, MLPX still had a solid coverage ratio for the year.
The company’s prudent capital allocation program boosted the coverage. MLPX is aggressively reducing its spending on growth capital expenditures. To that end, in 2019, the company spent $2.5 billion on growth capital expenditures. Last year, this spending got reduced to $878 million. For sure, it reflects impressive operational flexibility on MPLX. Its renewed focus on high-grading its portfolio toward projects with stable, fee-based earnings means MPLX expects to generate excess cash flow in 2021 even after growth capital expenditures and distributions.
MPLX Growth Potential
Plus, this significant reduction in growth capital expenditures does not mean MPLX is without growth potential. The company maintains several large projects that will meaningfully add to its future cash flows. For example, it has three major projects in logistics and storage. These are the W2W Pipeline which will have a capacity of 1.5 million barrels per day of crude oil, the Whistler Pipeline, a 2 billion cubic feet per day natural gas pipeline, and the NGL Takeaway System joint venture to provide NGL takeaway capacity in the Permian Basin.
It also has two separate processing plants under construction, in the Marcellus and Delaware shales, which will boost capacity by 200 million cubic feet per day. Analysts expect the three logistics and storage projects and the Marcellus processing plant to be complete in 2021. And, it means the projects should quickly boost the company’s cash flow next year.
The company’s renewed efficiency and strong results in 2020 allowed MPLX to maintain its quarterly distribution at a rate of $0.6875 per unit. On an annualized basis, MPLX’s distribution payout of $2.75 per unit represents a current yield above 10%. Moreover, it’s an attractive yield for income investors, as the average dividend yield of the S&P 500 Index is just 1.4% right now.
Quality MLP #3: Magellan Midstream Partners LP (MMP)
Lastly, Magellan Midstream Partners LP is a midstream LP that generates two-thirds of its operating margin, with crude oil comprising one-third of the operating margin. Magellan’s competitive advantage is that it has the longest refined petroleum products pipeline system in the United States, primarily gasoline and diesel fuel. Its network consists of 9,800 miles of pipelines, 54 terminals, and 47 million barrels of storage capacity.
As a midstream operator, Magellan makes money through volumes transported and stored. However, it also can raise its tariffs regularly, thanks to the strength of its assets. For example, the company increased its average tariff by 3.5% in 2020 and expects to generate a 2% average tariff increase in July 2021. As a result, approximately 85% of the company’s future operating margin will get derived from fee-based activities.
Magellan has not been completely shielded from the downturn in the energy market over the past year. First-quarter distributable cash flow of $276.5 million was a 10% decline from $306.5 million in the year-ago quarter. While this decline was discouraging, it is noteworthy that the results came in above management expectations due to better-than-expected recoveries in refined product demand and commodity prices. Because of this, Magellan lifted its full-year guidance by $50 million to $1.07 billion.
What about future growth?
Future growth is likely for Magellan, not just because of the general economic recovery from the coronavirus pandemic but also because of its project lineup. Magellan has promising growth prospects, as it has several growth projects underway. The company invested $1.0 billion in these projects in 2019 and $355 million in 2020. It also has more than $500 million of potential growth projects under consideration.
Magellan is an attractive income investment because of its high yield, currently at 8.7%. It also has a long history of paying its distribution. The company has paid distributions for 20 years and has never cut its distribution. The payout remains secure, as Magellan expects a distribution coverage ratio of at least 1.1 for 2021. It expects the coverage ratio to return to 1.2 once the demand for refined products returns to more normalized levels.
Magellan also has no incentive distribution rights, which frees up additional cash flow for unitholder returns. Magellan is in the midst of a $750 million unit repurchase program and repurchased $277 million of its units in 2020.
Importantly, Magellan’s balance sheet is in healthy shape. Like EPD, Magellan has strong credit ratings of BBB+/Baa1 from Standard & Poor’s and Moody’s, respectively. Magellan had a 3.5 leverage ratio at the end of 2020, with a long-standing target maximum of 4.0. The company does not face a bond maturity until 2025, so its liquidity is not a concern. This helps improve the coverage of the company’s distribution.
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High-yield stocks, and Master Limited Partnerships, in particular, are appealing to income investors. With interest rates still near historic lows and the average dividend yield of the S&P 500 Index hovering near 1.5%, income investors are in a difficult position. But instead of simply buying the highest yielding stocks in the market, investors should try to avoid stocks with poor fundamentals. Companies with revenue and cash flow in decline are more likely to cut their dividends.
Meanwhile, the 3 MLPs in this article have quality business models that each generate more than enough cash flow to maintain their distributions.
MLPs were created in 1981 to allow certain business partnerships to issue publicly traded ownership interests. The first MLP was Apache Oil Company, which was quickly followed by other energy MLPs and real estate MLPs.
MLPs are taxed differently than corporations. MLPs are pass-through entities, and they are not taxed at the entity level. Instead, all money distributed from the MLP to unitholders gets taxed at the individual level. MLPs issue K-1 forms for tax reporting. MLPs held in retirement accounts may still be taxed, so it is essential for investors to assess their unique tax situations before buying MLPs.
Benefits of buying MLPs include potential tax advantages, diversification benefits within a portfolio, and high yields.
Potential headaches from buying MLPs include additional tax filing requirements, the potential for taxation within a retirement account due to unrelated business taxable income.