These Two Investments Yield 15% and 18%

A high yield sends two immediate, but opposing, messages: Here’s an opportunity to boost income on the cheap, and here’s an opportunity to slice portfolio value catching a falling knife.high-yield energy mlps

Most investors see high yield in energy MLPs and they see Jason from the “Friday the 13th” movies.

[ad#Google Adsense 336×280-IA]They see a lot of slicing and dicing of portfolio value.

I can’t say they’re unreasonable.

The pump-and-dumpers – the upstream MLPs that drill for oil and natural gas and send it to market – are in a world of hurt.

It’s a tough business if you have $10 billion in long-term debt, an equity market cap of $347 million, $345 million of cash on hand, $583 million in annual interest expense, $2 billion in annual losses, and no yield to speak of.

Under such a scenario, you can be sure your unit price will be quoted in cents instead of dollars. Linn Energy (NASDAQ: LINE) investors know what I speak of.

But not all high-yield energy MLPs are alike. You can find better risk-reward scenarios in the downstream and midstream segments.

Swimming Against the Stream

Energy Transfer Partners (NYSE: ETP) is a midstream MLP that offers one of the highest yields, at 18%, in the segment. ETP’s business centers on natural gas. It’s one of the largest pipeline and storage providers in the United States.

Natural gas prices have tanked along with oil prices. Despite the lousy price its customers have received for natural gas over the past year, ETP has continually raised its distribution. Indeed, the last nine quarters have produced nine consecutive distribution increases.

When your distribution is priced to yield 18%, investors obviously have a few concerns. Distribution coverage is high on the list. In the last reported quarter, ETP’s distribution was covered only 0.84 times by distributable cash flow (DCF). ETP raised the distribution anyway.

To raise the distribution when cash flow fails to cover the distribution seems reckless. But is it?

Maybe not; ETP is in better shape than most of its competitors.

For one, ETP’s debt-to-EBITDA ratio, at 4.5 times, is better than most oil and gas pipeline and storage companies. ETP is also better financed. Unlike its competitors, ETP hasn’t had to issue new equity in order to fund capital projects. ETP also has significant cash on hand because it sold $5.7 billion in assets to affiliate companies, namely Sunoco LP (NYSE: SUN), last year. ETP also picked up a substantial equity stake in Sunoco, which it can sell if it needs additional cash.

Because capital projects are funded for 2016, ETP management expects that not only will it maintain the distribution, but it will continue to raise it.

“We have continued our distribution increases and we’re determined to maintain these increases through this challenging cycle,” said ETP Director Jamie Welch at the November analysts meeting.

Few investors believe ETP can maintain its current distribution, much less grow it, but ETP has proven the skeptics wrong. We’ll find out if can continue to do so when it declares its next distribution in a couple weeks.

Bet on Calumet

Based on its 15% distribution yield, Calumet Specialty Products (NASDAQ: CLMT) is also priced for failure. Calumet is a downstream energy MLP focused on two primary businesses: oil refining and specialty products manufacturing. The former business refines oil into gasoline, diesel, asphalt and heavy fuel oils. The latter business turns refined oil feedstock into lubricants, waxes, solvents and mineral oils.

The crack spread is Calumet’s issue, and it has weighed on recent performance. The crack spread refers to the spread between oil and its refined components (think of the price spread between gasoline and oil). The spread has contracted in recent months. Calumet generates roughly 40% of its gross profits from fuel sales. A tightening crack spread could crimp gross profits.

More important, a tightening crack spread could crimp DCF. For the first nine months of 2015, DCF has easily covered the distribution by 1.4 times. But in the latest reported quarter, the coverage ratio dropped to 1.1 times.

That said, Calumet should see its cash account swell this year. Over the past two years, Calumet has endured an abnormally high level of capital expenditures to fund organic growth projects that were completed at the end of 2015. Capital expenditures should be significantly lower in 2016. What’s more, these projects should come fully online this year. This means more cash should flow into Calumet’s coffers.

Calumet units are priced for a distribution cut, but the company continues to prove the skeptics wrong. This week, it declared its next quarterly distribution, which will be paid Feb. 12. Calumet didn’t raise the distribution, but it did maintain the $0.685 per unit payout.

Yes, high-yield MLPs present risky terrain, but in some cases the potential reward for traversing the terrain is worth the risk.

— Steve Mauzy


Source: Wyatt Investment Research