Targa Resources (NYSE:TRGP) operates one of the largest natural gas gathering and processing businesses in the Permian Basin. That gives the midstream company a strong strategic position in a region that's expected to double its gas output over the next decade. However, before investors buy into Targa's upside, there are a few other factors they should consider first.

The bull case on Targa Resources

Targa Resources generated $1.14 billion of EBITDA last year. However, that number should skyrocket in the coming years as Targa completes its current slate of expansion projects. The company expects to build $2 billion of new assets this year, including natural gas processing plants to support customers in the Permian as well as the Grand Prix pipeline to move natural gas liquids (NGLs) from that region to the Gulf Coast. The company initially thought that its growth projects would boost its EBITDA to more than $1.5 billion next year and as much as $2 billion by 2021.

A natural gas processing plant.

Image source: Getty Images.

However, it has since secured several additional expansions. For example, Targa has partnered with Kinder Morgan (NYSE:KMI) to build the Gulf Coast Express pipeline, which will move natural gas produced in the Permian to the coast. Meanwhile, it locked in several new agreements to grow its gathering and processing business across the Permian, as well as extend its Grand Prix Pipeline into Oklahoma. Further, the company has formed or expanded joint ventures with several midstream companies to expand its footprint in the Bakken, Eagle Ford, and Oklahoma's shale plays. On top of all of that, the company is working with partners to secure another natural gas pipeline out of the Permian. These expansions will grow Targa Resources' earnings and cash flow at an even faster pace, which could finally enable the company to start increasing its 6.6%-yielding dividend.

The bear case on Targa Resources

One reason Targa Resources hasn't been able to increase its dividend is that its current level consumes all its cash flow. Because of that, the company hasn't had any cash left over to help fund its large slate of expansion projects. That has forced it to be creative so that it can finance its growth, including partnering with private equity companies, selling non-core assets, as well as issuing equity to bridge the gap. Also limiting the company's financial flexibility is its sub-investment grade credit rating, which means it's at greater risk of being unable to meet its financial obligations if there is another energy market downturn. Its junk-rated credit also makes it more expensive for the company to raise outside capital to finance expansions.

In addition to its tight financial situation, another knock against Targa Resources is its valuation. The company currently sells for more than 15 times cash flow. That's well above its peer group average of 12 times as well as Kinder Morgan's rock-bottom valuation of nine times cash flow.

Another rub against the company is that it has greater exposure to commodity price volatility than most of its peers because it only gets about two-thirds of its earnings from stable, fee-based contracts. Kinder Morgan, on the other hand, gets 91% of its cash flow from predictable sources like fees. Because of that, another drop in energy prices would hit Targa's cash flow to a much greater extent than its midstream peers. 

The risk/reward skews the wrong way

Targa Resources' prime position in the Permian Basin has it on pace to grow earnings at a fast pace over the next few years. However, investors need to pay a premium price for that growth considering that Targa Resources sells for a much higher value than its peer group average. Add in its tight dividend coverage ratio, junk-rated credit, and outsized exposure to commodity prices, and there's an elevated risk that the company could underperform if turbulence returns to the energy market. That's why investors should put Targa Resources on their watchlists and wait until either its valuation comes down, or its financial metrics improve before they consider buying.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.