Targa Resources (NYSE:TRGP) is one of the few oil-and-gas midstream companies that hasn’t slashed its high-yielding dividend in recent years. While most rivals reduced their payouts so that they could route those profits toward expansion projects, Targa has gotten creative so that it could maintain its payout, which currently yields 9.2%. That dividend is looking increasingly sustainable given that the company’s cash flow is set to rise significantly over the coming years as its expansion projects come online.
Because of that, the company has the potential to deliver big-time returns for investors. However, several risks remain, which is why investors should think carefully before buying this midstream stock.
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The bull case for Targa Resources
Targa Resources has spent the past few years focused on two main goals. First, it has worked hard to secure high-return expansion projects to improve the flow of natural gas and natural gas liquids (NGLs) out of the country’s fastest-growing shale plays. In conjunction with that, the company has also tirelessly toiled to lock up funding for these projects so that it can protect its financial profile.
Targa has been wildly successful on both counts. It currently has $2.5 billion of expansion projects that are expected to come online by the second half of this year. These projects, and others it has under development, have the company on track to grow its earnings from $1.4 billion in 2018 to around $2 billion by next year. Further, the company managed this without reducing its dividend because it secured financing through a variety of joint ventures. In early 2018, for example, the company entered into development joint ventures with a private-equity fund that is providing $960 million in financing for three of its expansion projects. Earlier this year, meanwhile, the company sold a 45% stake in its Bakken Shale gathering and processing business to another private-equity fund for $1.6 billion, which will finance a significant portion of its capital budget for 2019.
As a result of these efforts, Targa has managed to secure healthy, fee-based earnings growth while maintaining a solid balance sheet, even as it has avoided significantly diluting existing shareholders through large-scale stock sales, and kept its high-yielding dividend intact. All of this puts the company on track to deliver a compelling blend of growth and income that could fuel high-octane returns for investors over the next few years.
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The bear case for Targa Resources
While Targa Resources has accomplished a lot recently, there are still a few areas of concern. For starters, it’s currently paying out roughly 100% of its distributable cash flow in dividends. While cash flow should rise in the second half of this year as its expansion projects come online, the dividend coverage remains razor thin.
What makes that tight coverage all the more concerning is that Targa has greater exposure to commodity price volatility than most midstream companies. The company currently expects fees and other stable sources to provide about 75% of its earnings this year, and while that’s an improvement from 67% last year, it’s still below the 85%-plus comfort level of most of its peers. Because of that, another big slump in commodity prices could have a noticeable impact on Targa’s financial results.
Finally, Targa’s balance sheet isn’t quite as healthy as those of its rivals. While it ended 2018 with a relatively low leverage ratio of 4.1, the company’s credit rating remains below investment grade. Because of that, the company must pay higher rates to borrow money.
These sub-par metrics will likely make Targa’s stock very volatile if oil prices plunge again, since they increase the risk that the company might need to reduce its payout.
Verdict: Targa Resources isn’t a buy just yet
With a high yield and a high growth rate, Targa certainly looks like a compelling opportunity. However, it’s still too risky for most income-seeking investors, given the company’s razor-thin coverage ratio, higher-than-average exposure to commodity prices, and junk-rated credit. While those three conditions should improve over the next year as the company completes its current slate of expansion projects, investors might be better off watching Targa from the sidelines until that happens so that they can avoid what could be another volatile year.