National Fuel Gas (NYSE: NFG ) is a utility, gas storage, and pipeline company, as well as an exploration and production company that operates mostly in Pennsylvania and upstate New York. Founded over a century ago, this company has been a gas delivery and utility name until recently. Thanks to major shale gas discoveries in the Marcellus, National Fuel has been able to develop on its 780,000 acre land position in Pennsylvania and upstate New York. National Fuel has poured capital into its exploration and production arm, Seneca Resources, to grow dry gas production.
And in the past three years National Fuel has done just that, with Appalachian gas production rocketing higher. National Fuel has thus far been a great operator, but in fact most investors who bought National Fuel in the past have done so for a consistent dividend provided by its gas delivery business. Unfortunately, its focus on exploration and production make it a less viable dividend play right now.
Two Diverging Businesses
National Fuel's consistent dividend payments and increases have made it a longtime favorite of income investors. With 42 years of consecutive increases, National Fuel is an aristocrat among dividend aristocrats.
Unfortunately its two distinct businesses are at odds with one another: One is a provider of cash while the other has explosive growth but also needs lots of capital, which eats away from dividend growth.
The reality is that National Fuel will be developing the Marcellus for multiple years and is increasingly becoming an exploration and production company. The transportation and utility businesses, from which the entire dividend comes from, has gone from 51% of EBITDA earnings to 43% between 2009 and 2012. E&P companies generally don't pay dividends, especially growth-oriented ones.
And here we can see exactly why. For the last couple years National Fuel has exceeded operating cash flow with capital spending, nearly all of it for E&P operations. And the dividend has only exacerbated the problem: National Fuel has had to borrow to not only fund capex in excess of operating cash flow but to fund its dividend as well.
If management can get a better return in developing the Marcellus, then it should cancel the dividend entirely and use all cash flow to fund the development of its properties. Of course, this kind of radical action would scare the long-term, dividend-minded investors who have been in this name all along, so management will probably not do that. This does, however, show how National Fuel's two businesses have divergent interests.
The market has recognized National Fuel's incredible acreage and successful drilling, and has hence bid the stock price up. In the above chart, the black line represents price with the solid orange line representing earnings. Historically, we can see that National Fuel is well overvalued, at least as a utility. This bid-up has resulted in a low yield of just 2%. At this level National Fuel is no longer suitable for income investors.
For those seeking similar exposure, MarkWest Energy Partners (NYSE: MWE ) might be a better idea. It is a dominant player in transporting, processing, and storing gas in the Marcellus and Utica. As a "pipeline," MarkWest offers the consistency of a utility without those pesky state mandates for renewables, which are driving up capital spending in that sector.
In fact, MarkWest's 4.6% distribution is covered by distributable cash flow, or DCF, 1.12 times, making it a bit safer than most utilities. MarkWest's business will grow right alongside production in the Marcellus. And as a midstream partnership, its growing income from gas processing will result in immediately subsequent gains to its distributable cash flow. For income and exposure to the Marcellus, MarkWest is a much more straightforward choice.
Bottom line? Sometimes cash is the best choice
Unfortunately, like many income plays MarkWest is also pricey right now, with its stock rising by almost 50% on the year. So for now, the best place to hide could just be in cash. When stocks get just too expensive to justify holding, as I believe National Fuel is right now, it might just be best to wait. In a volatile market like this one, the old rebuttal of "but what else can I buy?" is not valid. You don't have to buy anything: With all the steep drops we've seen over the last few years, is it that hard to imagine we could be lower than where we are now?
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