An 11.1% Current Yield And Upside Potential For Your Income Portfolio

| About: Miller Energy (MILL)


Miller Energy Resources preferred stock is trading at a $1.27 per share discount to par.

Current yield of 11.1% is among the highest in the preferred stock space.

Risks are potentially significant but the rewards largely compensate investors.

Miller Energy Resources (NYSE:MILL) is a small, Nashville-based exploration and production company in the oil and gas space in the Appalachia region of the US and Alaska. The stock is small and speculative, as you'd expect from an independent exploration and development company, so in this article, we're going to take a look at another way to gain exposure to MILL with a much higher margin of safety and a gigantic amount of current income.

The issue in question is the Series D Fixed to Floating Cumulative Redeemable preferred stock (MILL-D, may differ depending on your broker). MILL-D is a traditional preferred stock meaning it has no stated maturity date and no debt issue backing it. It pays regular quarterly dividends to holders making it a nice source of current income. It is that dividend that sets MILL-D apart from other preferreds so we'll jump right into why you should take a look at MILL-D for your income portfolio.

MILL-D pays annual distributions of $2.625 per $25 share (at the issue price), meaning its coupon yield is a massive 10.5%. This is one of the highest coupons I've ever seen on a preferred stock and we'll get into why in just a bit. At the current price of $23.73, however, MILL-D's current yield is even higher at a whopping 11.1%! Given the nature of preferred stocks in general this means MILL-D could provide an enormous amount of income but there are certainly some risks to consider.

Before we get into the risks, MILL-D is also eligible for preferential dividend tax treatment meaning that distributions are taxed at a maximum rate of 15% for most investors. For those investors looking for current income that can result in huge tax savings over a similar issue that isn't eligible for the favorable treatment. That is a very nice perk of investing in traditional preferreds and MILL-D holders enjoy that benefit.

On top of this, MILL-D has a clause in it that states that five years after the issue date of 9/30/2013, dividends cease to be a fixed $2.625 per share and begin being paid at a floating rate of three month LIBOR plus a spread of 9.073%. In essence, MILL-D will likely never pay a dividend under 10.5% but once rates rise, the dividend rate could be significantly higher than that. With three month LIBOR trading well over 500 basis points before the crisis, a "normal" rate environment could see the payout of MILL-D post September 2018 at something north of 15%. That is tremendous upside potential as you can get a substantial dividend increase on a preferred stock.

MILL-D is also cumulative so even if MILL misses dividend payments, it is obligated to make them up. Thus, your dividends are guaranteed barring some kind of bankruptcy event. This is a very nice protection that is not built into common stock dividends as the can be cut or suspended at any time without consequence. Nothing is fully guaranteed but a cumulative preferred is about as close as you can get.

It happens that the same 9/30/2018 date that is used for the conversion to a floating dividend rate is also the date at which MILL-D becomes callable. MILL can redeem MILL-D at any time after that date for the full $25 issue price. With the price of MILL-D trading $1.27 lower than that as of this writing, should that occur, you'd be entitled to a $1.27 per share capital gain as well. So not only do you get to collect enormous dividends, but you get the opportunity for a potential capital gain as well.

I mentioned the risks of owning MILL-D before and they are material so we'll take a look at them now. First, MILL is an exploration and development oil and gas company and by that fact itself, MILL-D is going to be riskier than most other preferreds. MILL is in a boom/bust industry and the reason it issued 10.5% preferred stock is because affordable funding isn't available through traditional means. This is something you must understand and make peace with before owning MILL-D; due diligence is paramount with this issue and you've got to understand MILL's financial position and prospects before you buy its preferred stock.

Volume can also be an issue with MILL-D as average volume is just under 1,000 shares per day right now. While that's not particularly unusual for a smaller preferred stock, if you're looking to buy a huge block of shares you may have to spend a couple of weeks accumulating. For most investors, you shouldn't have a problem building a position but make sure you use limit orders as you don't want massive slippage costs eating into your profits.

MILL-D is a very interesting issue. It has the basic features of a preferred you'd like to see; it's cumulative, it pays a massive dividend, it's eligible for preferential tax treatment and it even has a floating rate conversion feature that will almost assuredly hike the dividend in less than five years. However, owning MILL-D is not for the faint of heart and you must do your own due diligence before owning MILL-D as the issuer is a small company in a very risky industry. If you can make peace with this, however, you could potentially own MILL-D for a decent discount to par, opening the door for years of 11%+ dividends and even some capital gains.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.