The income-focused investors of Eagle Rock Energy Partners (NASDAQ:EROC) received some bad news this week. The master limited partnership announced that it was slashing its distribution to shareholders from $0.22 per unit to $0.15 per unit. Quite honestly, it was easy to see this distribution cut coming.
Two early warnings signs
Eagle Rock Energy Partners had two red flags that when combined made it likely the company would be forced to cut its payout to investors. First, it hasn't been earning enough to cover its cash outflow to stock owners. Furthermore, its debt had been piling up making it tougher for the company to grow its way out of the cash flow crunch.
Revenue streams weren't rock-solid
Eagle Rock's biggest issue is its exposure to commodity prices at its midstream business. This year the company projects just 41% of its contracted volumes would be fee-based. While that's up from 27% last year, it leaves a larger portion of revenue exposed to commodity prices.
For an MLP, having revenue that's locked in is critical to maintaining and growing a distribution. Enterprise Products Partners (NYSE:EPD), for example, boasts a fee-based gross operating margin projected to be around 81% this year. Those secure cash flows are one reason why Enterprise Products Partners has been able to raise its payout for 37 straight quarters. On top of that, the company has retained a significant chunk of cash flow each quarter by maintaining a distribution coverage ratio of 1.4 times or better. Enterprise Products Partners has reinvested that cash to grow its business instead of sending it back to investors.
Debt was weighing Eagle Rock down
Eagle Rock Energy Partners really has been between a rock and a hard place. Because the company's earnings are down, its ability to borrow has also been affected. One reason for cutting its distribution is to redirect some of that cash toward debt repayment. The closer it can get its leverage ratio to investment grade, the better it will be for the future. For example, because Enterprise Products Partners' leverage ratio is less than four times it's able to basically borrow at will to fund growth.
Fellow Fool Amiee Duffy has done a great job of explaining the virtues of an MLP having an investment-grade credit rating. It's a designation that is becoming more important to the management teams of MLPs. For example, Amiee points out that one of the reasons why Crestwood Midstream Partners (NYSE:CMLP) has been strategically active in its acquisitions is because the company is seeking to boost business to the point where it can attain an investment-grade credit rating. For Crestwood Midstream Partners this has meant acquiring assets that both diversified and strengthened its position in key asset basins like the Bakken. Until Eagle Rock can get its debt down to more acceptable levels its growth opportunities will be limited.
Eagle Rock Energy Partners has been moving to strengthen its operations, but it still has a long way to go. Cutting the distribution really is a prudent move at this point. It will enable the company to get its debt under better control so that Eagle Rock can reach the place where it can focus on growth rather than on how it's going to pay a distribution that doesn't represent its current operating environment.
Fool contributor Matt DiLallo owns shares of Enterprise Products Partners L.P.. The Motley Fool recommends Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.