Income-hungry investors often focus too much attention on a company's current yield and not enough on its sustainability and growth potential. Because of that, most investors will take one look at Targa Resources' (NYSE: TRGP) 8.3% yield and automatically think it's a better dividend stock than ONEOK (NYSE: OKE) since it only currently yields 4.8%. Here are four reasons why that assumption couldn't be further from the truth.
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No. 1: ONEOK has a well-supported dividend while Targa Resources can't even afford its payout at the moment
After a recent equity offering to shore up its balance sheet and help finance growth capex, Targa Resources only expects its distribution coverage ratio to be between 0.95 times and 1.0 times this year. That's assuming commodity prices don't tank and its growth projects enter service on schedule. Not only is Targa's current coverage unsustainable over the long term, but it's well below the conservative 1.2 times dividend coverage that ONEOK expects this year, even after accounting for a planned 21% increase.
No. 2: ONEOK has minimal direct exposure to commodity prices while Targa has much greater direct exposure
Not only is Targa's coverage ratio razor-thin at the moment but the company's cash flow has outsized exposure to commodity prices. Currently, a third of its operating margin has direct exposure to commodity prices through percent-of-proceeds (POP) contracts, primarily in its gathering and processing segment. Consequently, its earnings fall alongside commodity prices. Contrast that with ONEOK, which spent the last few years converting the bulk of its POP contracts to fee-for-service agreements as well as building additional fee-based assets. These initiatives enabled the company to increase the percentage of its earnings coming from fees to 90% this year, up from just two-thirds in 2014.
No. 3: ONEOK has an investment-grade credit rating, while Targa's has junk-rated debt
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As a result of combining with its master limited partnership earlier this year, ONEOK received an investment-grade credit rating of BBB/Baa3. Contrast that with Targa Resources, which has junk-rated credit thanks to its BB-/Ba2 rating. While it is worth noting that Targa Resources has a lower leverage ratio of 3.3 times versus 4.7 times for ONEOK, that's not enough to push it into investment-grade territory since it has such a tight coverage ratio and greater direct exposure to commodity prices.
ONEOK's higher credit rating gives it a cost-of-capital advantage over Targa. For example, ONEOK earlier this month issued $500 million of 10-year notes at a 4% interest rate and $700 million of 30-year notes at 4.95%, which gave it the cash to repay existing debt and finance capex. Contrast those rates with Targa Resources, which issued $500 million of debt due in 2025 yielding 5.125% and another $500 million due in 2027 that yields 5.375%. To put that into perspective, Targa Resources is paying nearly $7 million more per year in interest compared to ONEOK on the same 10-year debt. The company could have used that money to increase value for investors instead of handing it over to creditors.
No. 4: ONEOK offers visible dividend growth while Targa's planned increases have failed to materialize
Earlier this year, ONEOK agreed to buy out the rest of the units of its MLP that it didn't own in a $9.3 billion deal. In taking full control of the entity, it's in the position to increase its dividend 21% this year, and expects to grow the payout by 9% to 11% annually from 2018 through 2021, all while maintaining a 1.2 times dividend coverage ratio, making it a potential gold mine for income investors. Targa Resources anticipated something similar when it bought out its MLP in 2015, projecting a 15% payout increase for 2016 with 10% compound annual growth through 2018 while maintaining at least a 1.05 times coverage ratio. That said, due to its outsized exposure to commodity prices, weaker balance sheet, and tighter coverage, the company has yet to deliver one dividend increase to investors and can't afford to raise the payout this year given its slim coverage.
While it's possible that ONEOK's growth could also fail to materialize, it does have a stronger financial profile as well as a growing backlog of high-return expansion projects. For example, the company just signed an agreement with EnLink Midstream Partners (NYSE: ENLK) and EnLink Midstream (NYSE: ENLC) to expand its Mid-Continent natural gas liquids gathering system and Sterling III Pipeline. The company will invest $130 million into these projects, which should enter service by the end of next year and provide stable cash flow thanks to the long-term fee-based contracts backing the projects from EnLink Midstream. Overall, ONEOK estimates that it has up to $2.5 billion of quick payback, fee-based projects lined up to drive cash flow growth over the next several years. While Targa Resources also has an extensive backlog of growth projects underway, it's building a mixture of fee-based and commodity price-exposed assets, making its ability to grow cash flow not quite as safe a bet as ONEOK's.
Targa Resources might have a higher yield, but its payout isn't on solid ground due to its outsized exposure to commodity prices and tight coverage ratio. While a payout cut doesn't appear to be on the horizon since it does have several growth projects in the pipeline, those projects will likely only support the payout, not fuel growth. Contrast that with ONEOK, which has a much stronger financial profile. Because of that, it's on pace to deliver robust dividend growth in the years ahead, which should fuel greater total returns for its investors.
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