Gathering and processing company Summit Midstream Partners (SMLP +0.00%) currently yields an eye-popping 10.9%. Typically, when a payout grows into the double digits, it's because the market believes it's unsustainable and has a higher probability of getting reduced. However, Summit's financial metrics suggest otherwise, which means yield-hungry investors can collect a very appetizing payout.
Digging into the numbers
Summit Midstream Partners is on pace to pay $2.30 per unit out to its investors this year. Given the company's current financial guidance, it expects to generate $2.53 to $2.76 per unit in distributable cash flow, which implies a coverage ratio between 1.1 and 1.2. In fact, it has averaged 1.15 so far this year. That's a healthy coverage ratio for an MLP. For example, midstream behemoth Enterprise Products Partners (EPD 1.28%) expects its coverage ratio to be 1.2 this year, while natural gas pipeline giant Williams Partners (NYSE: WPZ) is planning on 1.17. Providing further support for Summit's guidance and the payout is that fee-based contracts underpin 95% of its expected earnings.
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Meanwhile, Summit also has an adequate financial situation. While it lacks the investment-grade credit rating of Enterprise and Williams, it has similar leverage metrics. Last quarter, for example, leverage was at 4.35. While that's above its 3.5 to 4.0 target range, it compares favorably with Enterprise's 4.3 average leverage ratio of 4.3 this year and Williams Partners' anticipated 4.5 average. Further, Summit has enough liquidity on its credit facility to fully fund all near-term organic growth projects.
So why such a high yield?
Given its solid financial metrics, Summit should trade at a lower yield. Enterprise and Williams, for example, sell for around 6%, while Summit's peer group average is 8.9%. But there are several reasons investors won't pay as much for Summit's units, which is causing it trade at a higher yield.
First of all, its a much smaller company. With an enterprise value of just $2.8 billion, Summit is a fraction of the size of Williams Partners and Enterprise, which are worth $56 billion and $80 billion, respectively. Because of its smaller size, Summit lacks the diversification of its larger rivals, which not only operate gas gathering and processing assets but also long-haul pipelines, storage terminals, and export facilities. This singular focus increases risk, which causes investors to pay a lower valuation for Summit.
Further, that smaller scale is one of the reasons Summit's credit isn't investment-grade even though it has a similar leverage ratio. That increases the company's cost of capital, which cuts into its returns. For example, earlier this year the company issued $500 million of new debt due in 2025 that carried a 5.75% interest rate. Enterprise, meanwhile, issued $1.25 billion of debt last year with maturity dates between 2021 and 2046 that had interest rates between 2.85% and 4.9%, while Williams recently issued $1.45 billion in notes due in 2027 at a 3.75% interest rate. Because it pays a higher cost to borrow money, Summit sends more of its cash flow to creditors, leaving less to allocate on behalf of investors.
Those issues aside, the primary weight on the company's valuation is that Summit has a bit of a hidden liability. In 2016, the company acquired several assets from its parent company in a drop-down deal, paying $360 million up front while also agreeing to a deferred payment due in March 2020 for the balance that could be as much as $800 million. The company has a range of options to finance this payment, including issuing equity directly to its parent, using the availability under its revolving credit facility, or tapping the public debt and equity markets for the cash. While the market's concern is that this payment could significantly affect the company's financial metrics, Summit aims to opportunistically raise a mix of debt and equity over the next few years so that it can make this payment while staying within its financial targets. If the company can achieve that goal, it would lift a huge weight that's currently holding down its market value.
Get paid to wait for the weight to lift
The market seems overly concerned with Summit Midstream Partners' ability to maintain its lucrative payout. However, that worry appears to be unfounded since it has the financial metrics to back up that payout and it has a range of options to deal with the deferred payment to its parent. As a result, investors with a high-risk tolerance can collect a generous income stream while the company slowly raises the cash needed to take care of that payment.
