Fear Creates Opportunity: DCP Midstream Partners (NYSE:DCP)
Markets have been in risk-off mode. High-yield stocks are being sold across the board, especially anything related to the energy sector. In many cases, the share price drops are justified, afterall crude prices are down about 65% year to date ‘YTD’, natural gas is down about 23% YTD, and NGL prices are down about 55% YTD. There are other situations however where firms aren’t as tied to commodity pricing and have stable risk profiles, yet their share prices also dropped with little regard for the firm’s underlying finances or cash flows.
DCP Midstream (DCP) has seen its share price get devastated. It is down 84% YTD vs. the S&P 500 at -24%. In DCPs case commodity price declines and the coronavirus crisis will impact its operations, but not to the degree implied by its price drop. It is true that DCP’s high debt level and capex spending could have become problematic; however, we think their recent 50% cut in the common dividend and 75% cut in capex both prudent and sufficient. Furthermore, we think these moves make DCP preferred an attractive pick for income investors.
Entertainment and Travel related companies are seeing their operations shut down due to COVID-19. Once hedges run out, upstream oil focused companies will also be devastated by low commodity prices. These low prices are a result of less demand due to COVID-19 shut-downs in combination with Russia-Saudi Arabia sponsored oversupply.
However these challenges will not hit all energy companies equally. Natural gas demand is unlikely to decline much. This is because most of its main uses throughout the world– electricity production, heating of buildings, cooking, fertilizer production, etc. — do not decline in a recession nor as people are shut-in due to COVID-19. As you can see below, during the Great Recession natural gas consumption followed its normal seasonal pattern in the US with barely a hiccup. During the oil price crash of 2015, natural gas volume consumed even went up.
Thus, the underlying cash flows of most natural gas focused production, processing, and transport firms should not be as affected as those of firms more focused on oil. Additionally, midstream companies that have fee-based contracts with investment grade counterparties will be less affected than those that don’t. And finally those energy firms with a lot of oil storage are actually seeing a significant benefit in the current environment as contango creates a profitable storage trade. Excess production combined with declining demand flood the world with oil. That has to be stored somewhere.
In the chart below we focus on natural gas centric firms. Many are trading remarkably cheap right now with EV/Forward EBITDA’s below 8x.
In fact we find this particular grouping of equities ripe hunting grounds because again many of these firms will not be as negatively affected by COVID-19 and oil price war concerns as the market seems to assume. DCP Midstream (DCP) is one such firm.
DCP Midstream Business Model: Natural Gas and NGL Focused
DCP Midstream (DCP) is a K-1 producing natural gas and natural gas liquids ‘NGL’ focused, North American midstream energy limited partnership.
Source: Company Presentation
Its parent DCP Midstream LLC is 50% owned by Phillips 66 (PSX) and 50% owned by Enbridge (ENB). After a simplification transaction that occurred in November 2019 the parent no longer holds any incentive distribution rights ‘IDRs’; however, in combination Phillips 66 and Enbridge now own 56.5% of the common units. This gives them ample interest in the ongoing success of DCP.
DCP fully owns many of its producing assets. However in order to diversify holdings and mitigate risk it also shares interest with other firms in a number of assets including the: Sand Hills Pipeline, Southern Hills Pipeline, Front Range Pipeline, Gulf Coast Express Pipeline, Texas Express Pipeline, Mont Belvieu Enterprise Fractionator, Mont Belvieu 1 Fractionator, and Discovery Producer Services LLC.
Roughly 80% of DCP’s business is either fee-based or fully hedged, with 70% of its counterparties being investment grade. This means we can guesstimate approximately 6% of DCPs current business is both not fee-based or hedged, and placed with non-investment grade counterparties. Given this information, and for want of anything better, I’m going to assume 10% of the $1,275 million in 2020 Adjusted EBITDA management guided to disappears due to the COVID-19 and commodity price challenges outlined above. This is a $127.5 million reduction in 2020 Adjusted EBITDA guidance. Subtracting that $127.5 million from the $780 million worth of distributable cash flow ‘DCF’ DCP guided to for 2020, I get a new reduced 2020 DCF estimate of approximately $650 million dollars.
In a presentation made at Mizuho Energy Summit on March 29th DCP outlined some of the actions it is going to take to meet ongoing challenges. These include approximately $850 million worth of cash flow mitigating measures.
Source: Company Presentation
As a result we can now estimate 2020 distribution coverage to be approximately 2x (= $650 DCF / $325 distributions). Furthermore the firm has committed to utilizing excess cash flow after the new planned outlays to “improve liquidity and leverage, not to fund growth”.
As a result the company should be self funding in 2020.
Source: Author Calculations
In addition the firm has stated it, “currently maintains more than $500 million of liquidity, having recently extended and strengthened its credit facility with decreased fees through 2024… The company’s next bond maturity is not due until September 2021 and there are no foreseeable needs to access the equity or debt markets.” Additionally, it expects to exit 2020 with >$700 million of liquidity and improved leverage. My calculations indicate Debt leverage could even potentially drop as low as 4.5x.
Source: Author Calculations
Thus, what was once a fairly aggressive midstream firm appears to now be seeking to dramatically reduce its risk profile and become a classic dividend growth investment ‘DGI’.
This information is probably not welcomed by common unitholders. Obviously no one wants to endure the kind of price declines they have had to, nor accept a 50% cut in distribution. On the other hand these changes do finally put DCP Midstream on a solid, self-sustaining footing. Furthermore, management has been buying shares in the $4 – $6 range, including a 212,320 phantom units purchase by the CEO on March 25th. These factors should help to reassure investors of the firm’s continuing existence.
They should also set a base for an eventual recovery. After All, even cut by 50% the new $1.56 distribution represents a 38% yield on the common units with 2x coverage.
There are however still a fair amount of unknowns regarding how much EBITDA might drop (my estimate above is admittedly rough), and for now this firm does still carry a lot of debt. Nevertheless, the new self funding cash flows, combined with the realization there is no debt coming due until September 2021 ($500 million in notes), does improve the risk picture. By the time any debt comes due, coronavirus and oil price war induced pain should long be behind us, and the firm should boast a Net Debt / EBITDA ratio <5x. This, plus Phillips 66 and Enbridge’s ongoing support ensures there is no existential threat.
Surprisingly however, there was a relative lack in response from DCP preferred shares. DCP.pC closed today at $7.50 down from $8 when the risk mitigation measures were first announced on the 23rd. If you think about it, the mitigating factors the firm implemented are nothing but good from the point of view of preferred unitholders. DCP has effectively switched itself towards a classic DGI model. There are no IDRs. Less than half of cash flow is being distributed. The firm is not only self sustaining, but it is increasing its focus on debt reduction. These steps all make the preferred less risky. Once debt reduction is accomplished, DCP will look an awful lot like a classic DGI firm with a predictable, self-funding, cash flow stream that covers their growing dividend well. In the meantime, DCP preferred shareholders not only continue to enjoy the same payout they did a month and a half ago when DCP.pC trade at par, but that payout has arguably become more secure than it was back then thanks to a greater focus on retention of cash flow and debt reduction.
Baring a much greater decline in EBITDA than I am forecasting, I think these preferred have become “money good”. As such I think once the firm guides to a new adjusted 2020 EBITDA (Q1 earnings in early May?), we should start to see the preferred return to a price north of $20 per share*.
DCP offers a readily tradable preferred B and C for individual investors. These are both fixed/floating cumulative preferred with terms very similar to each other. Using the preferred C as an example, for now they pay a well covered $1.99 per share at a $7.50 cost and 26.5% simple yield. On 10/15/2023 that payout changes to Libor + 4.882%. At today’s 3 month Libor of 1.23% that equates to $1.53 in payout per share, or a still remarkably attractive 20% yield on cost. A floating rate preferred costing the firm <6% yet yielding the investor 20% on cost seems pretty darn attractive to me; something that has the potential to be kept forever. In fact, given the latest stimulus package is a whopping $2.2 trillion, and they are already talking about another multi-trillion dollar stimulus down the road, I find the adjustable rate nature of these preferred rather comforting.
DCP has seen its unit price slump so far that its new post 50% cut dividend still yields a remarkable 38.3%. Nobody is calling this low risk as to date we have no more than a rough estimate of how COVID-19 and the oil price war might affect EBITDA. Furthermore, DCPs current debt level is admittedly quite high. However our best guess indicates there will be about a 10% hit to 2020 forecasted EBITDA. This is thanks to their focus on less impacted natural gas and NGL, and the fact that they have a fair amount of fixed fee contracts with investment grade counterparties. We also take comfort in the fact that they have no debt due until September 2021, and that the Net Debt / EBITDA should be < 5x, maybe as low as 4.5x, by that time. Thus we believe the current low price of the common units ($3.85) is probably not justified.
We also find DCP preferred quite attractive for the income investor with managements recent risk mitigation moves notably strengthening their appeal. Should our estimate of adjusted EBITDA guidance prove too optimistic, a further cut in the common is still available without having to touch the cumulative preferred. The preferred 2023 fixed to floating feature will be seen as a negative by some, but in our mind it also reduces long-term inflation risk considerably while still offering a very attractive 20% yield on cost.
*This admittedly may be wishful thinking. I am sometimes surprised by how long it takes many individual investors to re-evaluate and get over the ‘feeling’ of being burnt before they once again start to return to the preferred and common shares. Just yesterday my brother-in-law called asking if he should now put the funds he moved to cash during the Great Recession back to work.
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Disclosure: I am/we are long DCP.PC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I do not know your goals, risk tolerance, or particular situation; therefore, I cannot recommend any specific investment to you. Please do your own additional due diligence.