Targa Resources (NYSE:TRGP) pays an above-average dividend, even in the energy infrastructure space. At 8%, it's up there with many high-yielding master limited partnerships even though it's a C-corp, which typically yields half that rate. But the reason Targa's payout is so generous is that it pays out almost all its cash flow. As a result, and because of some concerns about its balance sheet and cash flow stability, its payout is a much higher risk than are other payouts in the sector.

The financial checkup

The foundation of any dividend is the stability of the cash flow a company generates. In Targa Resources' case, about 70% of its margin comes from stable fee-based sources, while commodity price-sensitive activities produce the other 30%. That's a much higher exposure to commodity prices than most other energy infrastructure companies. For example, Magellan Midstream Partners (NYSE:MMP) makes most of its money from stable fees, with 85% of its gross margin supported by fee-based assets, while TransCanada (NYSE:TRP) gets 95% of its earnings from fee-based or regulated assets. Both companies thus have more cash flow security than Targa Resources does.

A business man swimming underwater collects money.

Investors need to know the risks before diving in after Targa Resources' high yield. Image source: Getty Images.

Another concern for Targa Resources' investors is its balance sheet. While the company ended last year with a 3.8 leverage ratio, which was well below its 5.5 covenant limit, it's still a concerning number, given the company's greater direct exposure to commodity prices. That's evident by the fact that credit-rating agencies give its debt a "junk" rating, which forces it to pay higher capital costs than its rivals do for debt and equity. 

For example, in March 2016, the company completed a $1 billion preferred-share offering that yields 9.5%. Contrast that with the investment-grade-rated TransCanada, which issued 1 billion Canadian dollars in preferred stock last November at just a 4.9% rate. Similarly, last September Targa issued $500 million in notes due in 2025 that carry a 5.125% interest rate. Meanwhile, in that same month, the investment-grade-rated Magellan Midstream Partners priced $500 million of notes at 4.25% that don't mature until 2046. Given the differences in rates, Targa is paying a larger percentage of cash flow to its creditors than its rivals are, which gives it less money to support distribution and growth projects.

Too close for comfort

Because of Targa Resources' direct exposure to commodity prices and its higher capital costs, the company produces less cash flow during weak market conditions to support dividend payments to shareholders. As a result, its coverage ratio is very tight right now. After averaging a 1.1 ratio last year, the company expects it to be a razor-thin 1.0 this year. Meanwhile, if commodity prices plunge, its coverage could slump below 1.0, which would put more pressure on its finances.

Contrast this with Magellan Midstream Partners, which had a 1.25 coverage ratio last year and expects to deliver a 1.2 ratio this year. As a result, the company continues to generate several hundred million dollars in excess cash flow to help finance growth projects. TransCanada, likewise, covers its dividend with room to spare. In fact, the company has traditionally paid out less than half of its cash flow in dividends each year, reinvesting the rest into growth projects. As a result, investors don't have to worry that it will run into issues financing growth projects. That's not a luxury Targa has, since it barely generates any excess cash, which leaves it with no choice but to secure higher-cost capital from outside sources for growth projects. Those projects therefore don't deliver the same cash flow boost that similar projects from its rivals would.

Investor takeaway

At 8%, Targa Resources pays a mouthwatering dividend. However, that high payout comes with elevated risk, because the company pays out nearly all its cash flow in dividends each year, and that cash flow has greater exposure to commodity price volatility. As a result of those factors, the company might not be able to sustain its payout if oil and gas prices take another deep dive or if its access to outside capital dries up. It's a risk that, in my opinion, doesn't appear to be worth the reward, because there are safer high-yield options out there for investors. 

Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Magellan Midstream Partners. The Motley Fool has a disclosure policy.