Could This 8.4%-Yielding Partnership Be the Next Income Machine?

The shale energy revolution has spawned many opportunities for income investors during the last few years, but these opportunities were not created equal. This article looks at a high-yielding midstream gas partnership with infrastructure in an excellent location.

Jun 12, 2014 at 11:52AM

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A natural gas pipeline under construction. Source: Wikipedia

The energy revolution in North America has created a number of steady yet high-yielding income opportunities for those willing to do the homework. But some of these opportunities are better than others. How can one quickly discern the safe businesses from the unsafe?

There's no easy answer to that question, but the best place to start is distributable cash flow, or DCF. In short, DCF best represents the ability of a master limited partnership to pay its distribution. This metric can usually be found by subtracting interest expense and maintenance capital expenditure from EBITDA earnings. 

With that in mind, let's look at Southcross Energy Partners (NYSE:SXE), a midstream processor and fractionator of natural gas. Southcross is uniquely exposed to the petrochemical renaissance going on all along the Gulf Coast. The partnership is mostly involved in processing natural gas liquids, or NGLs, and transporting those NGLs to either export terminals or petrochemical factories.

Unlike gas producers, Southcross has actually benefited from low gas prices. Thanks to massive shale gas discoveries, the price of natural gas in the U.S. is now much lower than in Asia or Europe. This has resulted in a boom in the petrochemical industry, which consumes natural gas liquids in the production of necessary chemicals. In the secular growth story of growing gas usage in the U.S., I believe the best returns will not be found in gas producers, but in the processors and transporters of that gas. Midstream gas companies will benefit from growing natural gas activity without being too affected by low gas prices.

Instead of focusing on the crowded, competitive Houston petrochemical market, Southcross has wisely chosen to move down the road a ways to Corpus Christi, Texas, a city of about 300,000 people south of Houston, but still on the Gulf Coast. Corpus Christi is an ideal place for the petrochemical renaissance: It's much closer to the Eagle Ford shale than Houston is. It's still the sixth-largest port in the country. It has a functioning LNG export facility, and quite a few factories that need natural gas liquids. The city is also fairly close to Mexico, which is a growing export market for U.S. natural gas. Southcross couldn't have picked a better place for growth. 

But here's the catch
Among midstream gas MLPs, Southcross' 8.4% yield really stands out. But, in this case, the distribution seems too good to be true. During the last 12 months, distributable cash flow was only $26 million, but distributions were $43.7 million. In fact, distributions were above even EBITDA earnings, which were only $42.4 million. This makes Southcross a fairly risky bet in an industry where investors tend to be income-oriented and risk averse.

However, when we look at the bigger picture, there seems to be at least some method to Southcross' madness. The partnership recently completed a pipeline from the gas window of the Eagle Ford into Corpus Christi. In addition, management decided to expand a pipeline westward by 94 miles into a newer portion of the Eagle Ford. There will likely be great demand for this pipeline space as NGL production in the Eagle Ford steadily increases.

The end result should be a continuation of the steady EBITDA growth trend. For example, adjusted EBITDA in the first quarter of 2014 shot up to $14 million versus just $5 million in the same quarter last year. It's very possible that Southcross will simply grow into its distributable cash flow.

Bottom line
To meet its generous distribution, Southcross will have to grow its way out of its cash flow coverage ratio of 0.6. Given the company's growth trajectory, I believe that is very possible. However, those who are risk averse have no reason to roll the dice on this one. Look, instead, to more steady operators such as Spectra Energy Partners (NYSE:SEP), which provides a much more modest 4.2% yield, but also comes with a fantastic coverage ratio of 1.38 times.

With Spectra, you'll get similar natural gas midstream exposure, but with a surefire distribution, and plenty of room for sustainable distribution growth.

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Casey Hoerth has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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