One of the big risks when you invest in a high-yielding stock is a dividend cut. But once a distribution cut has been made, that danger is reduced, which is exactly what's happened at Ferrellgas Partners (NYSE:FGP) and Alliance Holdings GP, L.P. (NASDAQ:AHGP), and why now is the right time to look at buying each of them.
That was a mistake...
Ferrellgas Partners made a decision a few years ago to expand beyond its core propane distribution business. That core wasn't exciting, but it had supported a $2.00-per-unit, per-year distribution basically since the limited partnership went public in mid-1994.
The company went through its ups and downs, just like any other. Propane, which is largely used for heating, tends to see demand wax and wane with the weather (more on that in a second) and it is slowly being replaced by other fuel options, like electric heat. Which is why Ferrellgas has long used acquisitions to expand its business in this highly fragmented industry.
That said, the last few winters have been particularly warm, leading to reduced need for propane delivery. That backdrop helps explain the decision to juice growth by moving into the midstream oil and gas space. Only that didn't work out as well as hoped, leading to the write of around 70% of what was spent on midstream acquisitions.
But, here's the thing...the damage has been done. Ferrellgas expects the distribution cut to free up around $160 million a year to pay down debt, but it also gives it some breathing room should this winter prove to be another warm one. The partnership's distribution yield after the cut is around 6%, well below that of competitor Suburban Propane Partners (NYSE:SPH), where the warm winters have resulted in a huge drain on cash. Cash at Suburban fell 75% year over year in fiscal 2016 --something that should make you ask yourself if the distribution can be maintained. That's led investors to push the unit price lower and leave Suburban's distribution yield at around 12%.
The loss of a key midstream customer at Ferrellgas resulted in the ouster of the CEO who orchestrated the midstream move, the decision to write down the value of that investment, and, now, the announcement of a huge 80% or so distribution cut. The cut was made to free up operational cash flow and help pay down the debt taken on to acquire the midstream business. Clearly, this is all bad news.
At Ferrellgas, however, the distribution has been cut already. And if the winter is warm, the impact will likely be less debt getting paid down, not another cut. There's still the struggling midstream business to worry about, but the company's estimates of freed-up cash should take much of that into account. With so many of the risks already addressed or priced into the partnership's unit price, Ferrellgas could be a great option for contrarian investors looking at the propane space.
Alliance Holdings is a similar story. This partnership is the general partner of coal-focused Alliance Resource Partners, L.P. (NASDAQ:ARLP). Coal has been a rough business lately, with weak demand and pricing pushing several of Alliance's competitors into bankruptcy. Alliance Resource Partners, however, is nowhere near that point. For example, long-term debt makes up less than 15% of the capital structure and, despite the tough coal market, Alliance has remained profitable and able to generate decent cash flows throughout the downturn.
Part of the reason for this is that the partnership is focused on the Illinois Basin coal region. That's an area that has been taking market share from the other major U.S. coal regions for years. In fact, the U.S. Energy Information Administration expects the Illinois Basin to see demand increase between now and 2040 even in its worst-case outlook. So, Alliance is financially strong and operates in the "right" coal region.
But times are tough right now, and that led Alliance Resource Partners and its general partner to trim their distributions earlier in the year. That said, Alliance Resource Partners' distribution coverage in the third quarter was 2.4 times -- a huge margin of safety. In fact, it leaves plenty of room for distribution hikes when the supply demand imbalance in coal starts to work itself out (and plenty of room if it doesn't).
So you could buy Alliance Resource Partners and its 7% or so distribution yield or its general partner Alliance Holdings GP and its 7.25% distribution yield. Not only is the GP's yield a little more enticing but it also has more upside potential. This is because Alliance Holdings basically runs Alliance Resource Partners. It gets paid a fee to do that and it collects distributions from the partnership units it owns. But it also gets incentive payments for increasing Alliance Resource Partners' distribution.
Coal is on the outs right now, but it isn't going away overnight. And if the EIA's projections are close to the mark, Alliance has a brighter future than most other coal companies. Add in the already notable distribution coverage, and distribution hikes at Alliance Resource Partners look like a worthwhile bet, which would, in turn, lead to even larger hikes at GP Alliance Holdings. In fact, GPs normally have lower yields than the LPs they control because of their leverage to distribution growth.
Thus, now could be a good time to invest in Alliance Holdings for investors willing to take on a contrarian investment.
Less risky than they seem
The point here isn't to suggest that Alliance Holdings and Ferrellgas are risk-free investments -- far from it. But because of distribution cuts at both, the biggest risks appear to have been addressed. For contrarian investors, the hard decision to cut the distribution at each of these partnerships is the signal that now is the time to do a deep dive and possibly add these high yielding stocks to your portfolio.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Alliance Resource Partners. 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.