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High MLP/Midstream Yields But Ample Coverage, Payout Ratios

09/01/20 | Bryce Bingham

Summary

  • Distribution coverage for MLPs remains elevated relative to history after 1Q20 distribution cuts, implying that MLPs are better able to afford their distributions today than in the past, yet yields remain elevated compared to history.
  • Payout ratios for 1H20 and 2Q20 are in line with 2018 and 2019 data, despite headwinds in 2Q20, highlighting midstream’s ability to afford dividend payments.
  • A few MLPs have begun to emphasize free cash flow after dividends in place of MLP-centric metrics like distribution coverage and distributable cash flow.

Despite the lingering uncertainty in energy markets, 2Q20 dividend payments were steady, with the vast majority of energy infrastructure names holding payouts flat and a few names even increasing dividends sequentially (read more). As of August 28, yields for the Alerian MLP Infrastructure Index (AMZI) and Alerian Midstream Energy Select Index (AMEI) sat at a lofty 12.5% and 8.0% respectively, well above their five-year averages of 8.5% and 6.1%. With such elevated yields, distribution coverage and payout ratios are helpful for understanding midstream’s ability to afford current payouts. Today’s note examines how MLP distribution coverage and midstream dividend payout ratios have fared amid macro volatility and discusses the rising importance of free cash flow after dividends.

MLP distribution coverage remains elevated by historical standards.
After COVID-19 began to disrupt oil markets in March, many energy infrastructure companies cut their payouts in order to preserve financial flexibility (read more). As a result, 1Q20 distribution coverage ratios, which are a measure of distributable cash flow (DCF) over distributions declared, for constituents of the AMZI were well above historical norms, with the index average reaching 2.6x for 1Q20. While the 1Q20 data reflected the impact of energy headwinds on distributions, it did not reflect an impact on DCF given that oil prices did not collapse until mid-March. Production shut-ins and lower energy demand began to show up in midstream results in 2Q20. However, MLPs continued to show resilience in distribution coverage last quarter in an extremely challenging environment, as shown in the table below. Note that 2Q20 coverage reflects cash generated in 2Q20 and the distribution to be paid in 3Q20 as a result of 2Q performance. The index average of 1.8x, while down from 1Q20, still compares favorably to historical data. Average coverage for the AMZI for 4Q16 and 4Q17 was just 1.2x. In short, MLPs are better able to afford their distributions today than in the past buoyed by cuts for some names and an emphasis on sustainable distributions from others, yet yields remain elevated compared to history despite arguably less downside risk in payouts.

Digging deeper into the data, the large cap names that did not cut their distributions earlier this year continued to provide solid coverage, demonstrating the benefits of a focus on sustainable distribution growth and capital discipline that the space has been moving towards for years. Among this group, Magellan Midstream Partners (MMP) stands out for coverage below 1.0x during the quarter. However, management believes that the partnership will have sufficient DCF to continue paying distributions at the current level for the remainder of 2020. CNX Midstream Partners (CNXM) cut its 1Q20 distribution by 80%, but its more recent distribution increase to $0.50 per unit alongside the announcement of its acquisition by its parent, CNX Resources (CNX), is above pre-COVID levels. This will likely be CNXM’s last distribution payment as the transaction is set to close in 4Q20. NGL Energy Partners (NGL) also stands out for low coverage following a cut, but this results from seasonality in its natural gas liquids, refined products, and biodiesel operations. More recently, NGL has been focused on mitigating the impact of seasonality on its cash flows by expanding its water business.

Free cash flow gaining traction.
While helpful for comparing among MLPs, the use of distribution coverage has its shortcomings – namely the lack of comparability with other sectors. MLPs have begun to move away from distribution coverage and DCF in favor of metrics that are more widely used and better reflect their business models. On its 1Q20 earnings call in May, Western Midstream Partners (WES) noted that it will shift to focus on free cash flow given that it is more relevant for its total return-oriented business (see quote below). The company has joined Cheniere Energy Partners (CQP) as the only AMZI constituents that do not provide DCF. While it still reports DCF, DCP Midstream Partners (DCP) is emphasizing free cash flow. Going forward, the partnership will report free cash flow in place of distribution coverage, describing free cash flow as “a more comprehensive measure of cash flow and indicative of [its] ability to delever.” In 2Q20, DCP generated $54 million of free cash flow after distributions, benefiting from reductions to its capital program and its 50% 1Q20 distribution cut. With free cash flow becoming the priority across energy as the sector seeks to attract generalist investors, it is likely that MLPs will further incorporate free cash flow metrics into their reporting to complement or potentially replace traditional DCF-based metrics.

Payout ratios further emphasize midstream’s ability to afford dividends.
Looking at the broader energy infrastructure space, dividend payout ratios also highlight financial flexibility among midstream companies. The table below compares historical and current payout ratios for the dividend-paying constituents of the AMEI, with the ratio calculated using distributions paid in the period and operating cash flow for the denominator. For example, the 2Q payout ratio is comparing the distribution paid in 2Q from 1Q results and operating cash flow for 2Q. For names that cut their 1Q20 payouts (those paid in 2Q), the 1H20 payout ratio will reflect the larger 4Q19 dividends paid in 1Q20. Keep in mind that MLP payout ratios are generally higher than those of their C-Corps peers because MLPs are not burdened with income tax payments, and operating cash flow can be impacted by swings in working capital, which can be more common during periods of commodity price volatility.

As shown in the table, there is a wide dispersion among payout ratios reflecting a variety of idiosyncratic factors, including dividend policy, customer base, and the company’s operational footprint. Notably, the ratios for 2Q20 reflect the brunt of COVID-19 impacts on energy production and demand with multiple names seeing payout ratios above 100% for the quarter. In some ways, 2Q payout ratios can be considered a real-life stress test, providing an indication of a company’s ability to afford its dividend in what was likely one of the most challenging quarters in these companies’ histories. Despite 2Q headwinds, the average payout ratio for the dividend-paying constituents of the AMEI in 1H20 and 2Q20 is in line with that of the full years 2018 and 2019. For 2Q20, eight out of 32 names had a payout ratio below 50%. Names that cut dividends earlier in the year generally saw a reduction in their payout ratios and represent the lower end of the data set, with the notable exception of Plains All American (PAA), which had a notable shift in working capital from 1Q to 2Q. After cutting its April dividend by 72%, Inter Pipeline (IPL) had the lowest 2Q20 payout ratio of all AMEI constituents at 8%.

Bottom line: What does this mean for investors?
For investors frustrated by abnormally high midstream yields or wary of additional cuts to payouts, distribution coverage and payout ratio data is helpful for gauging how well companies can afford their dividends. All things considered, the coverage and payout data are encouraging for investors looking to midstream and MLPs as a source of income in their portfolios. Some companies fared better than others in the real-life stress test that was 2Q20, reinforcing the resilience and strength of these businesses in an extremely tough environment. Importantly, however, all these companies maintained or grew their payouts sequentially for 2Q20 as management teams looked past the temporary headwinds in the quarter to an ongoing recovery. In short, companies stayed the course despite stretched payout ratios for 2Q in some cases. With free cash flow in focus across energy, commentary around free cash flow generation after dividends and reporting those values each quarter would provide greater clarity on a company’s financial flexibility while allowing for comparability with other sectors. While MLP-centric measures using DCF are likely to stay, they should be complemented with more widely used metrics.