Reduced Dividend Payouts Could Be Coming for These High-Yield Stocks

Companies that operate energy-related infrastructure had been a top choice for income-seeking investors before the oil market downturn. That's because these entities typically generate gobs of cash flow, which allowed them to offer mouth-watering high-yields at a time when most other investments didn't pay very well. However, the oil price collapse exposed a fatal flaw in the business model of many of these companies, which is that they had enough exposure to commodity prices to cause a problem, especially given their reliance on the debt and equity markets to finance growth.

As a result, many have slashed their payouts in recent years to get their finances back on solid ground. More such payout reductions could be on the way, and Energy Transfer Partners (NYSE: ETP), Targa Resources (NYSE: TRGP), and Sunoco LP (NYSE: SUN) are prime candidates for dividend cuts.

Turning the corner but still not on solid ground

Energy Transfer Partners already enacted a back-door distribution cut after it merged with a sibling company that was paying at a lower rate. However, despite that reduction, it currently yields an eye-popping 11.4%, due in part to the fact that its shares have shed more than 35% of their value this year.

On the one hand, Energy Transfer Partners' current payout level appears to be sustainable. Recent project completions have turned around the company's cash flow: It covered its payout by 1.18 times last quarter, though its ability to do so stemmed partially from the support of its parent company Energy Transfer Equity (NYSE: ETE), which has temporarily relinquished some of its incentive distribution rights (IDRs) so that Energy Transfer Partners can generate excess cash to help finance its expansion projects. While the amount that its parent is collecting will start to revert to normal next year, Energy Transfer Partners believes that the upcoming completion of a slew of growth projects will supply it with enough cash flow that it will be able to increase its payout by double-digit annual percentage rates in the near term.

That said, the market doesn't believe in the long-term sustainability of the company's current payout because the IDRs it owes its parent will continue to cut into cash flow. Many industry watcher believe that Energy Transfer Partners will eventually have no choice but to join the rest of its peers and buy out the IDRs from Energy Transfer Equity, and a distribution cut would would likely be required to facilitate such a deal.

Things haven't gone according to plan

Targa Resources completed a similar transaction in late 2015, though it bought out its MLP to eliminate the costly IDRs. At the time, the company believed that the deal would enable it to increase its dividend 15% in 2016 and by a more than 10% compound annual rate through 2018 while maintaining at least 1.05 times dividend coverage. However, the company has yet to increase the payout since announcing the deal due to the adverse impact lower commodity prices have had on its cash flow and balance sheet.

In fact, given Targa Resources' current expectations for commodity prices and volumes, the company expects that dividend coverage will only be 0.95 to 1.0 times this year. That means the company is spending its entire cash flow on its 8.2% yielding dividend. That's not sustainable, especially for a company that needs to lay out $1.4 billion for its growth projects this year. While those projects should boost cash flow in the coming years, the company is paying a high price in the debt and equity markets to finance the expansion, including recently issuing $777.3 million of new stock yielding more than 8%. It would be much cheaper for the company to cut its payout and use some of the cash that would free up to help finance those projects.

This major transformation still doesn't mean the payout is safe

Earlier this year, Sunoco LP announced a deal to sell its gas station business to 7-Eleven for $3.3 billion in cash. That transaction would help Sunoco repair its balance sheet, bringing its leverage ratio from the 6.5 times net debt to adjusted EBITDA it started the year with down to the company's target range of 4.5 to 4.75 times.

That said, Sunoco LP is sending a significant portion of its cash flow to 7-Eleven, which will make it even harder for the company to maintain its current distribution that yields 10.3% since its coverage ratio has averaged just 1.03 times over the past year. While the company will likely use a portion of the cash infusion to repurchase equity, which would reduce the amount of cash needed to support the distribution each quarter, it's unclear if the buyback alone will enable the company to keep its coverage ratio above 1.0 times. Because of that, it's entirely possible that Sunoco LP might reset its distribution to a more sustainable level, which would give it greater flexibility to grow its fuel distribution business, and support higher payouts in the future.

These are high-risk high yields

While all three companies can afford to keep paying their current rates, they'd be better off cutting their payouts and using that cash to shore up their finances. Investors who buy these high-yielders now need to realize that they're taking on more risk for that greater reward. While it could pay off handsomely if these companies can maintain and eventually grow their payouts, investors could also find themselves collecting a lot less income than expected if they opt to go the more conservative route and chose to pay out smaller portions of their cash flow.

10 stocks we like better than Energy Transfer PartnersWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Energy Transfer Partners wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 1, 2017

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