This year has been a roller-coaster for master limited partnership DCP Midstream (DCP +0.00%). Units of the midstream company plummeted along with oil prices this spring on the fears that the COVID-19 outbreak would torpedo its financial results. The company has since recovered a substantial portion of those losses, though units are still down 30% for the year. Because of that decline, DCP Midstream yields an eye-popping 9.2%. Here's a look at whether income investors should buy this big-time payout.
The bull case for DCP Midstream
DCP Midstream sprung into action as crude prices cratered earlier this year. In late March, the energy company cut its distribution 50%, slashed its capital spending plan by 75%, and set targets to reduce costs and sustaining capital spending. The company expected these aggressive moves would improve its cash flow by $850 million, bolstering its liquidity and giving it the funds to reduce debt. It announced another round of cuts in mid-April, increasing its projected financial flexibility to more than $900 million.
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Those moves paid big dividends for the company. The MLP generated $152 million of excess free cash flow through the third quarter after funding its distribution ($325 million) and growth capital spending ($193 million). That gave it the flexibility to reduce its debt by $175 million this year, pushing its leverage ratio to a more comfortable 3.9 times debt to EBITDA.
Meanwhile, the company's operations and financial results held up much better than expected this year. Its adjusted EBITDA and distributable cash flow have increased in 2020, up 6.5% and 14.5%, respectively, through September, despite the impact of falling oil prices on its volumes and margins. That's due to a combination of recently completed expansion projects and its cost reduction efforts. With market conditions improving and capital spending expected to fall further in 2021, DCP Midstream should continue generating excess cash in the coming quarters, giving it more funds to reduce debt.
The bear case for DCP Midstream
One issue with DCP Midstream is that it has more direct exposure to volatile commodity prices than most MLPs. While it offset some of this impact in 2020 thanks to its cost savings initiatives and hedging program, its cash flow could be under pressure in future years if commodity prices remain weak. For example, it has only hedged 33% of its volumes in 2021 (compared with 43% in 2020) at lower average prices than this year. If pricing declines next year, its cash flow might follow.
Meanwhile, DCP Midstream's balance sheet is still a work in progress. While its leverage has come down, it's above the company's 3.5 target. Given that and its exposure to volatile commodity prices, the company has junk-rated credit. As a result, it's costlier for the MLP to borrow money.
Finally, the company is facing significant long-term headwinds due to the accelerated adoption of renewable energy. While natural gas -- DCP Midstream's primary focus -- will probably remain important for many years, it faces a potential disruption from green hydrogen. So the company might not have many growth opportunities in the coming years, which could keep the pressure on its valuation.
Just not compelling enough to buy
On one hand, DCP Midstream trades at a dirt-cheap valuation these days, since units are still down 30% despite its earnings and cash flow growth. Add that to its big-time yield, and it could produce substantial total returns if the energy market continues recovering.
However, it also faces significant near- and long-term headwinds because of its debt, exposure to commodity prices, and increasing lack of growth prospects. Those factors could hold it back and might even cause another distribution cut. It's just not an ideal option for yield-seeking investors to buy right now.
