Master limited partnership DCP Midstream (DCP +0.00%) currently yields an eye-popping 10.8% even though it slashed distribution by 50% earlier this year. Given its current sky-high yield despite the recent cut, it's clear that the market doesn't believe the company can maintain its reset rate.
However, the market doesn't always get things right. With that in mind, here's a look at whether it has completely passed over this income stock as a potentially buy-worthy investment.
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Why the market sees red flags
During the oil market meltdown in March, DCP Midstream joined many of its energy sector peers by reducing its distribution. The company also cut its capital expense budget by 75% and reduced other costs. The MLP took these steps to strengthen its balance sheet and mute the impact of cratering crude prices on its cash flow because its business model gives it more exposure to commodity price volatility than other MLPs.
The company needed to shore up its balance sheet because of its junk-rated credit. That low rating makes borrowing money costlier while also limiting financing options and flexibility. On a positive note, the company has improved its balance sheet by getting its leverage ratio down to its 2020 target of 4.0 times debt-to-EBITDA. However, that's above its long-term goal of a sub-3.5 times leverage ratio.
Another issue with DCP Midstream is the variability of its cash flow. While fee-based contracts support 70% of its cash flow, that's much less than other MLPs, which typically like that number above 85%. The concern with this lower percentage is that its cash flow could be under pressure if commodity prices slump. Those worries led the company to pull its full-year guidance earlier this year when oil took a tumble.
What the market might be missing
While the market has concerns with DCP Midstream's balance sheet and cash flow, both are now in a much better position than they were earlier in the year. Instead of cratering with crude prices during the first half, cash flow rose 5% to a record level. Several factors fueled that better-than-expected result, including its cost-saving initiatives, recently completed expansion projects, and its natural gas liquids marketing efforts. During the second quarter, cash flow was so strong that DCP Midstream produced $54 million in excess after covering its dividend and capital expenses, giving it some money to pay down debt.
DCP Midstream's first half was so much better than expected that it recently reinstated its original 2020 financial guidance. That has it on track to produce between $129 million to $269 million in free cash this year after covering its reset dividend and capital spending.
Because it's generating free cash, DCP Midstream has already reached its desired leverage ratio for this year. Meanwhile, since it's on track to achieve its original guidance and generate more free cash because it cut its dividend and capital spending, leverage should continue improving.
With leverage coming down and its business generating free cash after funding its current dividend and capital expenses, this payout seems to be on a sustainable foundation. Further, once DCP achieves its long-term leverage target, it could allocate its free cash toward other things, including returning more of it to investors via a higher distribution or a repurchase program.
Intriguing, but not there yet
DCP Midstream delivered a surprisingly strong performance during the turbulent second quarter. Because of that, it was able to generate more than enough cash to cover its big-time payout and capital expenses, with room to spare for debt reduction. That certainly puts its dividend on a much firmer foundation. While that makes it an interesting option for income investors, it's not a slam-dunk buy because of its weaker credit rating, especially when there are lots of high-quality high-yield options available in the energy sector.
