2015 was a very tough year for high yield. Income investors were hit by the sell-off in several sectors including energy, shipping, REITs, limited partnerships and BDCs. It may have felt as if your high-yield portfolio was taking superlaser fire from the Death Star. NGLS-PA is a cumulative preferred issue for Targa Resources Partners (NYSE:NGLS). This article will show that NGLS-PA is a safe issue despite the lofty yield.
NGLS-PA is a par $25 cumulative preferred unit with a 9% coupon. Distributions are paid monthly, and NGLS-PA now yields 12.6% at a recent price of $17. The company has the option to call NGLS-PA at par starting on 11/1/2020. If NGLS-PA is not called by 11/1/2020, the coupon will change from a fixed rate of 9% to a floating rate of 7.71% plus one-month LIBOR. One-month LIBOR is currently only 0.42%, but most investors expect interest rates to rise substantially by 2020. Even a Jedi Knight should be afraid of what a sharp spike in interest rates can do to perpetual preferred stocks. Fortunately, the fixed to floating rate feature of NGLS-PA offers a protective shield against this interest rate risk. See prospectus for additional details.
The acquisition of NGLS by Targa Resources Corp. (NYSE:TRGP) is expected to be completed on 2/17/2016 (See page 5 of the company's January 2016 Investor Presentation). NGLS-PA will remain outstanding as an obligation of TRGP. The merger will be beneficial to NGLS-PA holders by reducing leverage (See page 26 of the Investor Presentation) and the company's cost of capital. Onerous incentive distribution rights will be eliminated. See page 6 of the company's January Investor presentation for details.
The NGLS-PA distribution is far more secure than the TRGP common stock dividend. This is illustrated by the Pro Forma Public Structure chart on page 7 of the January Investor Presentation. Targa Resources Partners LP will be 100% owned by TRGP following the acquisition. NGLS-PA will remain an obligation of Targa Resources Partners LP. Therefore, the NGLS-PA preferred will remain senior to the partnership equity owned by TRGP. Funds cannot be up-streamed from the partnership to TRGP unless the preferred dividend is paid in full. TRGP needs funds from the partnership to pay its common stock dividends and interest on its Revolving Credit Facility Term Loan B.
The small size of NGLS-PA makes a deferral even more unlikely. Upon completion of the acquisition, there will be 161 million shares of TRGP outstanding with a market capitalization of approximately $1.7 billion. NGLS-PA has a par value of just $110 million with an annual distribution obligation of only $9.9 million. A deferral of the tiny NGLS-PA distribution would save very little cash and cause huge cash flow problems for TRGP. See Harry Chernoff's excellent recent article for more on the corporate structure and implications for NGLS-PA.
How dependent is TRGP on commodity prices? 72% of Q3 2015 margin was fee based (See page 35 of the January Investor Presentation). Weak commodity prices could potentially result in a reduction of the TRGP dividend, but would not be enough to affect the NGLS-PA distribution. In fact, retaining more capital by reducing the TRGP dividend would actually help to reduce credit risk.
Commodity price sensitivity for the 2016 Adjusted EBITDA guidance is broken out in more detail in the company's 10/5/2015 press release:
+/- $0.05/gal NGLs = +/- $20 million Adj. EBITDA
+/- $0.25/MMBtu nat gas = +/- $10 million Adj. EBITDA
+/- $5.00/bbl crude oil = +/- $5 million Adj. EBIT
Note that NGLS is significantly less sensitive to changes in the price of oil than to price changes for natural gas liquids and natural gas. For example, a $20 drop in the price of oil from prior estimates would be expected to reduce 2016 adjusted EBITDA by only $20 million (less than 2%).
How strong is the preferred distribution coverage for NGLS-PA? NGLS had Q3 2015 adjusted EBITDA of $305.8 million. Q3 2015 interest expense was $61.1 million and the preferred distribution requirement was $2.5 million. Therefore, Q3 coverage of interest and the preferred distribution was a healthy 4.8X. The NGLS acquisition by TRGP will slightly improve coverage. Lower commodity prices may hurt coverage, but only modestly given that over 2/3 of NGLS margin is fee based and independent of commodity prices.
How does the 12.6% yield of NGLS-PA compare to the Targa debt issues? The Targa Resources Partners LP's 6.875% unsecured notes maturing on 2/1/2021 (CUSIP 87612BAH5) are now trading at $91.50 with a 9% yield to maturity. NGLS-PA is slightly riskier than the notes, but offers a significantly higher yield and some potential tax advantages.
My newsletter (see additional disclosure below this article) is focused on high-yield preferred stock issues. Many income investors would rather dine with Darth Vader than risk another Kinder Morgan (NYSE:KMI) style dividend cut. Some analysts are predicting the TRGP dividend will be cut. Fortunately, the NGLS-PA dividend is far more secure. Owing preferred issues like NGLS-PA is a great way to avoid getting Kinder Morganed in 2016.
Disclosure: I am/we are long NGLS-PA.
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.
Additional disclosure: Panick Value Research Report subscribers received an advance look at this article. The Panick Report is now #1 in the "Dividends" section of the Seeking Alpha Marketplace.