While This 9.4% Yield Looks Tempting, It Might Be a Bit Too Dangerous for Income-Seekers

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On one hand, DCP Midstream (NYSE: DCP) offers a compelling investment case for income investors. For starters, the MLP currently pays an enticing 9.4%-yielding distribution that it more than covered with cash flow last year. Furthermore, the company's two parents, refining giant Phillips 66 (NYSE: PSX) and Canadian oil pipeline behemoth Enbridge (NYSE: ENB), have agreed to backstop that payout through the end of next year. However, even with those positives, the long-term sustainability of this high-yielding payout is questionable at best, making it one that income-seekers might want to avoid.

Drilling down into the numbers

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Last year, DCP Midstream generated $643 million of distributable cash flow, which was enough money to cover its distribution to partners by 1.04 times. In fact, the company produced enough cash last year that it was able to pay back the $40 million in support its parents provided earlier in the year. That's part of an agreement with Enbridge and Phillips 66 to provide DCP Midstream with up to $100 million in annual support via a reduction in their management fees if needed so that it can maintain a minimum 1.0 distribution coverage level.

Looking ahead, DCP Midstream expects to generate between $600 million and $670 million in cash flow this year, which at the high end would more than cover the $655 million in cash it has agreed to pay investors this year. Though even if results come in at the low end, the backstop Enbridge and Phillips 66 provide would easily cover the gap.

The future is a bit blurry

While the backstop agreement with Enbridge and Phillips 66 helps protect DCP Midstream's high-yielding distribution in the near term, it expires at the end of next year. Because of that, the company needs to build in some cushion before that time to ensure the long-term sustainability of the payout. That's tougher for the company to do, because only 60% of its cash flow comes from stable fee-based contracts, while most MLPs, for comparison, like to see that number above 90%. The reason this number is concerning is that another slump in commodity prices would likely take DCP Midstream's cash flow with it, potentially putting its payout on shaky ground in the future.

That said, the company is working to address its sensitivity to commodity prices by investing in several new assets backed by stable fee-based contracts. For example, the company is spending $300 million to expand its Sand Hills Pipeline further and investing $440 million in a joint venture to build a new natural gas pipeline in Texas. Meanwhile, it's spending nearly $800 million to build two new natural gas processing plants. These projects should begin coming online and generating incremental cash flow in the second half of this year and continue through the end of next year when the gas pipeline joint venture enters service. In addition to those projects, the company is developing another pipeline, as well as exploring several other expansions, which could fuel incremental growth in late 2019 and early 2020. The hope is that these projects, and other initiatives that DCP Midstream has under way, will boost cash flow enough so that it can cover the current distribution rate with plenty of a cushion when Enbridge and Phillips 66 remove their support at the end of next year.

Safe, for now

Thanks in part to its supportive parents, DCP Midstream appears as if it will continue paying its current 9.4%-yielding distribution through at least the end of next year. However, the sustainability beyond that point isn't quite so clear. While the company does have several fee-based growth projects under way to boost cash flow, it also has high exposure to commodity price volatility, which could mute the positive impact of those expansions. That's why income-seeking investors seem better off avoiding the company's currently tempting high yield. Instead, investors might want to consider either of the company's parents since they both offer solid yields of 3% at Phillips 66 and 7% at Enbridge that appear likely to head even higher in the coming years.

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Matthew DiLallo owns shares of Enbridge and Phillips 66. The Motley Fool owns shares of and recommends Enbridge. The Motley Fool has a disclosure policy.