Stay Away! 3 Dividend Stocks That Are Yield Traps

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Sometimes investors get overly pessimistic about a dividend payer and push the stock deeply lower over temporary concerns. A high dividend yield in this case is an opportunity. Other times, however, there are long-term issues that are properly reflected in the stock price and abnormally high yield. Today, investors need to be careful with CenturyLink, Inc. (NYSE: CTL), NGL Energy Partners LP (NYSE: NGL), and BP Prudhoe Bay Royalty Trust (NYSE: BPT). The double-digit yields all three offer, reaching as high as 21%, look more like yield traps than good deals.

Bigger, but highly leveraged

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CenturyLink became one of the largest enterprise communications providers in the United States following its merger with Level 3 Communications in late 2017. The combined entity is supposed to be able to compete with giant rivals like AT&T in offering telecom and IT services to businesses. Now that the deal has been consummated, CenturyLink is also looking to cut costs and streamline operations, eventually leading to a more profitable business. Time may prove this move a good one, but right now things look a little stretched.

For example, CenturyLink's debt at the end of 2017 was twice what it was at the start of the year. Clearly, that was related to the Level 3 deal, but the company's debt-to-EBITDA level is now roughly 4.3, compared to AT&T's 3.1 and Verizon's 2.7. And while the notion of financial and business synergies is great, such hyped-up merger benefits don't always materialize. If that turns out to be the case here, CenturyLink's nearly 14% yield may prove tough to support.

In fact, it's already hard for the company to support. CenturyLink has paid out more in dividends than it has earned since it cut its dividend in 2013. And while cash flow, which is used to pay dividends, has been enough to support the dividend in the past, the coverage there isn't particularly robust at the moment. Just take a look at the chart below.

Now reexamine the big acquisition. Not only does CenturyLink have to integrate the new businesses into its own, but it has to pay down debt in a capital-intensive industry and continue to support a dividend that's already on thin ice. I'm not saying that management can't get all of that done, only that buying into that premise is a big risk to take on for investors trying to live off the dividend payments this company is throwing off. Most income investors would be better off elsewhere.

Getting through a rough patch

NGL Energy Partners, a midstream oil and natural gas company, has an over-14% yield and is trying to dig itself out from a huge debt hole. At the start of 2018, the partnership had $2.9 billion in long-term debt and a debt-to-EBITDA ratio of 9.6. The picture doesn't get much better from here, with interest expenses eating up 35% of EBITDA in the nine months through Dec. 31, 2017, and distributable cash flow declining over 40% in that span. Part of the issue here relates to business disruptions from hurricanes, but hurricanes didn't lead to that huge debt load -- aggressive expansion did. In the roughly two years following the partnership's mid-2011 IPO it made 24 acquisitions at a total cost of $1.8 billion. The market has good reason to be concerned, and has pushed the units down to the point where the distribution yield is over 14%.

NGL has already cut its distribution once, in early 2016, to free up cash. And it's taking steps to rectify the debt overhang, including selling assets like a propane distribution business. The partnership's distributable cash flow, meanwhile, should improve as the impact of the recent hurricanes abates. However, this is clearly not a financially strong partnership that is offering a rock-solid distribution.

Management appears confident that it can get its leverage under control and maintain the distribution. However, the high yield isn't worth the risk that the partnership can't make good on that front. Conservative investors should look elsewhere, especially since the midstream space is currently out of favor and even the best-run partnerships appear to be on sale today.

Know what you own

Last up is BP Prudhoe Bay Royalty Trust and its massive 21% yield. Or at least that's what you'll see on most stock-quote services. Make no mistake: It's an illusion. Unlike the two stocks above, this is a case of understanding the investments you make.

Quote services generally take the most recent quarterly dividend and multiply by four to get an annualized dividend number. That usually works well, but not when the dividend is variable, as is the case with BP Prudhoe Bay Royalty Trust. This trust's dividend is driven by two main factors: the often-volatile price of oil and the amount of crude pumped from Alaskan oil lands on which the trust has a roughly 16.4% royalty interest.

As oil prices and production vary, so will the distribution from this pass-through entity. For example, the most recent dividend was $1.23 per unit, but the previous disbursement was just $0.67 per unit. That's a big difference largely driven by a 20% increase in production between the two periods. BP Prudhoe Bay Royalty Trust is probably as close as most investors can get to owning an oil well, but it certainly isn't a way to get a stable income stream.

Look past the yield

Dividend yields can be an important indicator of opportunity, since Wall Street frequently gets irrational and pushes prices down -- and yields up -- over short-term concerns. However, that isn't always the case -- which means yield alone isn't enough. You have to dig in and understand what's going on. BP Prudhoe Bay Royalty Trust is the perfect example of the need to know the story behind the dividend yield. Telecom CenturyLink and midstream player NGL Energy Partners, meanwhile, are more complex situations where you need to balance risk against reward before making a buy decision. In all three cases, it looks like that balance is tilted too far toward risk for most investors.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool has a disclosure policy.