It can be tempting to focus on a stock's current dividend yield, since the higher it is, the more money theoretically be flowing into your bank account. However, more often than not, higher yields carry greater risk. That's certainly the case with Targa Resources' (NYSE: TRGP) 7.8% payout, which is barely hanging on by a thread.
TransCanada's (NYSE: TRP) lower payout of 3.9%, on the other hand, is as rock-solid as they come. In fact, the Canadian energy infrastructure giant's dividend appears poised to grow at a healthy rate over the next few years while the payout of its U.S. peer has a high probability of getting reduced even though it now has several expansion projects in the pipeline. That safer payout is just one of the reasons why TransCanada has my vote as the better buy.
A quick look under the hood
When it comes to dividend stability, three factors are crucial. First, a company needs to generate enough cash flow to support the payout. Second, that cash flow needs to be relatively predictable. Finally, it needs a strong enough balance sheet to weather whatever lies ahead. As this table shows, TransCanada meets those criteria:
Those numbers speak volumes regarding the quality of TransCanada's dividend. Because it generates very stable cash flow and covers its payout with plenty of cushion to spare, there's minimal risk that the company would need to reduce the dividend. Targa, on the other hand, has two significant marks against its payout: Its cash flow has outsized exposure to volatile commodity prices, and it currently pays out everything it earns. Given that razor-thin coverage, tumbling commodity prices could ultimately force the company to slash its payout.
That said, Targa Resources does at least have one thing in its favor, which is a much lower leverage ratio. However, that's partially because TransCanada has nearly 10 billion Canadian dollars' ($8.4 billion) worth of growth projects to finance this year, which has temporarily elevated its leverage ratio. Meanwhile, Targa's lower leverage still hasn't won it any favor with the credit rating agencies, which rate its debt as non-investment grade because of its greater exposure to commodity prices and its ultra-tight dividend coverage.
A look at what the future holds
One of the reasons TransCanada retains a significant portion of its cash flow is so it has the capital to finance growth projects. Currently, it has a whopping CA$24 billion ($19.5 billion) worth of near-term growth projects underway and another CA$40 billion ($32.5 billion) of medium- and longer-term expansions coming down the pipe. Given the fee-based nature of these projects, TransCanada has high confidence that it can increase its cash flow by a double-digit annual rate, which should fuel dividend growth close to 10% annually through 2020. That healthy growth rate is worth noting given the company's history. Since 2000 TransCanada has increased its payout by a 7% compound annual rate, which has enabled the company to generate a 14% average annual return over that time frame. With the dividend growth rate accelerating over the next few years, it could deliver even higher total returns.
Targa Resources, meanwhile, hasn't increased its payout since late 2015 despite promising double-digit annual growth through 2018. As a result, its stock has plummeted by two-thirds over the past three years. That said, the company secured several expansion projects this year and now has $2.6 billion of growth-focused investments underway, which it expects to complete through 2019. However, it's worth noting that, unlike TransCanada, not all these projects are fee-based, so there's more uncertainty about the impact they'll have on future cash flow. However, the company estimates that they have the potential to increase its adjusted EBITDA from a projected $1.13 billion this year to as much as $2 billion by 2021. Those earnings would go a long way in supporting Targa Resources' payout.
That said, one potential stumbling block is that Targa needs to raise outside capital to finance those projects. Given its junk-rated credit and higher-yielding stock, the company would pay a higher price for that money than TransCanada, even more so when considering its head start from generating excess cash to reinvest in growth projects. That higher cost of capital could significantly eat into Targa's returns, which is why it might consider cutting its payout so it can generate excess cash to help finance those projects.
A pretty safe bet
While Targa Resources offers a much higher current dividend yield, it's a high-risk gamble that could implode given how tight coverage is at the moment. TransCanada, on the other hand, has a much more secure payout that it has a high probability of growing at a healthy rate over the next few years. That growth should drive higher total returns for investors, still making it the better buy between the two.
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