Better Buy: TransCanada Corporation vs. Targa Resources Corp.

By Matthew DiLallo Markets Fool.com

Yield-hungry investors might take one look at Targa Resources' (NYSE: TRGP) 6.5% yield and declare it the hands-down winner over TransCanada (NYSE: TRP) and its 3.7% current payout. However, that would be a mistake. That's because as we dig into these companies a bit deeper, it becomes crystal clear that TransCanada is the better buy as it can deliver a much higher total return over the long term, with much less risk.

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The financial checkup

One thing investors have learned the hard way during the recent oil market downturn is that a high yield is only as good as the company's ability to sustain that payout. That's why it's important to take a close look at its financial metrics. Here's a snapshot of the financial situation of these companies:

Company

Credit Rating

Debt-to-Adjusted EBITDA

Current Distribution Coverage Ratio

% of Cash Flow Fee-Based or Regulated

TransCanada

A

5.8 times

2.1 times

95%

Targa Resources

BB-/Ba2

3.8 times

1.05 times

70%

Data sources: TransCanada and Targa Resources.

As that chart shows, TransCanada's financial strength blows Targa Resources out of the water. While the Canadian pipeline giant does have a much higher leverage ratio, it has a greater ability to support that debt because of the stability of its cash flow due to its focus on owning fee-based andregulated assets. TransCanada also only pays out about half of its cash flow via dividends, retaining the rest to reinvest in growth projects.

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Targa Resources, on the other hand, paid out virtually everything it made last year, which left it to rely on the capital markets to fund growth projects. The problem with that approach is that Targa Resources has junk-rated credit, which makes its cost of capital much higher than TransCanada's. For example, last March Targa issued $1 billion of preferred stock that carried a 9.5% dividend rate while TransCanada was able to sell 1 billion Canadian dollars in preferred shares last fall at a much lower 4.9% dividend rate. That cost-of-capital advantage makes it much cheaper for TransCanada to finance growth.

Image source: Getty Images.

What's coming down the pipeline

Speaking of growth, Targa Resources currently has $885 million of growth projects in development across its shale-focused portfolio, all of which should enter service by the first quarter of next year. For perspective, that capital represents about a 5.5% increase in its asset base compared to its enterprise value. While Targa does have some other attractive projects in development, it doesn't yet have clear visibility on those projects to add them to its backlog. Because of that, it's hard to predict when the company might be in the position to resume dividend growth.

Contrast this with TransCanada, which is currently working its way through CA$23 billion of growth projects that should enter service through 2020. That represents a 22% increase in its asset base against its current enterprise value. Furthermore, because it generates tremendous excess cash flow and has a top-notch balance sheet, the company shouldn't have any issues financing these projects at an attractive rate. Consequently, it has clear visibility to grow its dividend by an 8% to 10% annual rate through 2020. Meanwhile, TransCanada has another CA$48 billion of commercially secured long-term projects that have the potential to extend its dividend growth well into the next decade.

Investor takeaway

TransCanada's current yield might not be as high as Targa Resources' but what it does offer is a much safer payout that should grow handsomely over the next few years. Meanwhile, there's a real risk that Targa Resources might need to cut the payout if it can't access capital at attractive rates to finance its growth projects. That risk isn't worth stretching for its yield, especially since TransCanada has the potential to deliver double-digit total annual returns when combining its yield and its expected growth rate. Needless to say, it's far and away the better stock to buy.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.