Heading into the fourth quarter, the high-yield payout of Summit Midstream Partners (NYSE:SMLP) looked like it was on a firm foundation. The metrics at the pipeline and processing master limited partnership (MPL) seemed solid, since 98% of its earnings came from fee-based sources, it covered its lucrative distribution with cash flow by 1.17 times, and it had a conservative leverage ratio of just 4.1. However, those numbers went from solid to seemingly suspect when the company unveiled its fourth-quarter results and outlook for 2018. As a result, its 13% yield seems like it might be on shaky ground.

Drilling down into the numbers

Summit Midstream Partners' fourth-quarter results were a bit weaker than in the previous year:

Metric

Q4 2017

Q4 2016

Year-Over-Year Change

Adjusted EBITDA

$72.9 million

$72.7 million

0.3%

Distributable cash flow (DCF)

$49.2 million

$52.8 million

-6.9%

Distributions paid

$45.1 million

$44.5 million

1.4%

Distribution coverage ratio

1.09 times

1.19 times

-8.4%

Data source: Summit Midstream Partners.

Scissors about to cut a $100 bill.

Summit's guidance makes it seem like its high-yield payout is at risk of getting cut. Image source: Getty Images.

While earnings crept up thanks to higher natural gas volumes flowing across its various systems, DCF dipped. That's mainly because Summit issued $300 million of preferred shares last year to finance expansion projects, which diverted some of its cash flow toward paying distributions to those investors. On top of that, Summit issued more common units to fund expansion, which increased the amount of cash it needed to distribute to those investors. These two factors combined to drive the coverage ratio below the company's 1.1 target.

Worse yet, Summit expects that key metric to fall further in 2018. While the company does anticipate another slight bump in earnings, given guidance that adjusted EBITDA will increase about 0.7% at the midpoint, it only expects to produce enough DCF to cover its payout by a tight 0.95 to 1.05 times this year. That's a concerning number, suggesting that the company can just barely afford its current distribution level, which isn't sustainable over the long term. That coverage ratio is also well below the level of top-tier MLPs such as Magellan Midstream Partners (NYSE:MMP), which expects to keep that number above 1.2 this year. 

A calculator and pen on top of $100 bills.

Summit has crunched the numbers and doesn't think there's any reason to worry. Image source: Getty Images.

Waiting for the reacceleration

However, the decline in Summit's coverage ratio was by design. CEO Steve Newby noted on the fourth-quarter call that the company's commitment to having a strong balance sheet led it to issue $300 million of preferred equity in the quarter, which allowed it to repay debt and "significantly reduce leverage," with the ratio falling to a conservative 3.22. The CEO further stated that "while this preferred offering will impact DCF by approximately $29 million per year and cause our distribution coverage ratio to average approximately [1] for 2018," the company is comfortable with this level because of its strong leverage metrics and the growth it has coming down the pipeline. 

The other reason Summit wanted to raise that cash is that it has two large system buildouts under way. The first is a $110 million project to support ExxonMobil's (NYSE:XOM) growth in the Delaware Basin. Summit is currently building gas-gathering pipelines and a processing plant underpinned by a long-term, fee-based contract with ExxonMobil. In addition, Summit is building a $60 million processing plant in the DJ Basin to support a large producer in the region. While Summit expects to finish both projects this year, they'll provide minimal earnings in 2018 because of timing. However, the CEO noted on that call that "we are forecasting significant volume and adjusted EBITDA growth resuming in 2019 driven by our Delaware and DJ expansion projects," as well as incremental growth from its assets in the Utica Shale as producers ramp up their drilling activities this year. 

In addition to those projects, Summit is developing others in the Delaware Basin, including the Double E pipeline, which would move natural gas from companies like Exxon out of the region and toward market centers. While it would be a large project, probably costing several hundred million dollars, CEO Steve Newby made it clear on the call that "we anticipate given our current longer-term projections, we would be able to stay with our leverage metrics and be able to fund that project internally." In other words, the company doesn't believe it would need to cut its distribution to investors to finance growth. But with a much tighter coverage ratio than peers like Magallan Midstream, as well as a lower credit rating, Summit has much higher capital costs, which is why there's a risk that the company still might need to adjust the payout to finance expansion. 

Heightened risk for the time being

Summit Midstream Partners choose to raise capital late last year to improve its balance sheet and fund growth. However, that money came at a cost, including significantly tightening the company's distribution coverage this year. While Summit believes this is just a temporary tightening, it's something income seekers should watch closely, because the weaker coverage number increases the risk that the company might need to cut its high-yield payout if everything doesn't go according to plan. That's why risk-averse investors might want to consider a safer option like Magellan instead

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