Image source: Plains All American Pipeline.
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Any stock that has a high yield can be a very tempting thing. The thought of locking in a strong percentage return that makes share price growth less important is something that will help many investors sleep well at night. The problem with high-yield stocks, though, is that the company paying that dividend may not be able to grow -- or even maintain -- that payment over the long term if things head south. One of those high-yield payments that look pretty questionable right now is Plains All American Pipeline
So we asked three of our contributors to highlight why they would be apprehensive of buying Plains' stock. Here's what they had to say.
As much as I like a management team that is committed to paying a stable, growing dividend, it's also concerning when a management team continues to pay out a dividend as the fundamentals of the business are screaming for a cut. Plains is in that latter category, and the fact that management is holding to its guns on its payout should make investors a little nervous.
Over the past year or so, Plains All American Pipeline has seen its distributable cash flow deteriorate slightly, but more shares and a distribution raise have pushed its distribution to unsustainable levels. It seems that the first issue here is that management probably should have kept its payout flat and focused on using some retained cash to grow. Instead, it is now resorting to more creative ways to raise capital, such as its $1.6 billion issuance of preferred equity units. These units get 8% interest until converted, and once they do, it will also increase total units outstanding, making it that much harder to raise the per-unit distribution in coming years.
If the company was really prudent, it wouldn't have put itself in that position in the first place. Now, the company is making moves that will compromise its ability to grow today to prop up a payout instead of cutting it now and focusing on the longer term. With management making those kinds of decisions, it's hard to get excited about shares of Plains All American.
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As Tyler mentioned, Plains All American Pipeline really pushes its distribution to the limits. Instead of retaining cash flow to fund growth, it pays out everything it makes, and then some. The primary reason it does so is that it has a general partner, Plains GP Holdings , which has incentive to grow distributions at Plains All American Pipeline. Plains GP Holdings owns not only the 2% general partner interest, but also the incentive distribution rights of Plains All American Pipeline.
Incentive distribution rights, or IDRs, allow the general partner to enjoy an increasing share of the distributable cash flow the MLP generates. In Plains GP Holdings' case, because Plains All American Pipeline's quarterly distribution is above the $0.3375-per-unit threshold, Plains GP Holdings is entitled to 50% of all cash distributed in the quarter above that level, in addition to its 2% general partner interest.
These IDRs really add up. Last quarter, for example, Plains All American Pipeline's distribution was $0.70 per unit. However, it paid what amounted to an additional $0.3885 per unit in distributions to its general partner because of the IDRs and general partner interest. That's cash Plains All American Pipeline could have paid its own investors, or better yet retained to fund growth. Instead, the company is hamstrung by this huge cash outlay each quarter, which is why investors are better off avoiding this stock.
I think the best reason to avoid Plains All-American is quite simple: There are better, safer midstream investments out there.
Magellan Midstream Partners, L.P. is one. Its distribution yield is currently around 4% versus the astronomical 13% at Plains All American, but that's because Magellan follows a much more conservative capital allocation strategy, retaining more cash for capital growth than most midstream MLPs.
Many MLPs pay out essentially all their cash flows and use equity offerings to raise capital. This makes it much more expensive (the dividend yield essentially becomes the interest rate on the cash raised) to raise cash in a downturn. So by retaining more cash, Magellan is much better positioned to ride out downturns, invest in growth right through them, and steadily increase the dividend without being forced to slash payouts in downturns.
ONEOK also deserves a hard look. ONEOK is the general partner of ONEOK Partners LP, receiving all of its income from its general partner interest and 41% ownership of common units. It is yielding nearly double digits but expects to generate a significant amount of free cash above its dividend in 2016, giving it a nice margin of safety.
Furthermore, its operations are concentrated in natural gas and NGLs, where there is likely to be significant long-term support for growth, versus Plains' oil-heavy business that could be in for a rough 2016 as more and more oil producers announce oil production will fall this year.
Plains could turn things around and ride through this without cutting its payout. But with the risks it is facing, and better investments out there, it's best to avoid it for now.
The article 3 Reasons Investors Should Avoid This High-Yield Dividend Stock originally appeared on Fool.com.
Jason Hall owns shares of Oneok. Matt DiLallo has no position in any stocks mentioned. Tyler Crowe owns shares of Magellan Midstream Partners. The Motley Fool owns shares of and recommends Oneok. The Motley Fool recommends Magellan Midstream Partners and Oneok Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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