DCP Midstream (NYSE:DCP) recently reported its full-year results for 2019 as well as its outlook for 2020. At first glance, those numbers seem to suggest the master limited parnership's 15.5%-yielding distribution is on a sustainable footing.

However, a deeper dive shows that the payout remains a risky bet. Here's why dividend investors should steer clear of this payout for the time being.

Drilling down into the numbers

Metric

2019

2020 Forecast

Distributable cash flow

$762 million

$730 million to $830 million

Distribution Coverage ratio

1.23 times

1.2 to 1.4 times

Debt-to-EBITDA ratio

3.96 times

around 4.0 times

Data source: DCP Midstream. 

As that table shows, DCP Midstream generated more than enough cash to cover its high-yielding payout last year, thanks to an 11% year over year increase in DCF. That enabled the company to end the year with a coverage ratio slightly above its roughly 1.2 guidance, allowing it to retain $136 million in cash.

Leverage, meanwhile, was right around expectations and less than 4.0 times debt-to-EBITDA, thanks in part to $209 million of asset sales it completed during the year. The combination of retained cash and asset sale proceeds gave it the financial flexibility to invest $887 million into expansion projects, -- which was slightly ahead of its $600 million to $800 million target range -- while maintaining its targeted leverage level.

For 2020, the company expects to pull several levers so that it can maintain its high-yielding payout while continued to expand its portfolio even as it keeps leverage in check. Assuming it maintains its current distribution level, DCP Midstream expects to retain between $100 million to $200 million of cash this year. That gives it some of the funds needed to finance its projected $550 million to $650 million capital spending plan, which is the final stage of a multiyear $3 billion expansion program. The MLP plans to bridge the gap between retained cash and investment spending by selling assets so that it can maintain a leverage ratio around at its 4.0 times target.

Scissors cutting a hundred dollar bill in half

Image source: Getty Images.

Two risks to watch closely

DCP Midstream believes it can navigate through this year's challenges while maintaining its big-time payout. However, the company needs to overcome two major hurdles so that it can finance expansion and keep distributing cash at its current level.

The first one is the outsize impact commodity price volatility has on its cash flow. DCP Midstream expects to get about 70% of its cash flow from stable fee-based contracts this year. While that's an improvement from 65% last year, it's well below the 80%-plus level of most MLPs. The company has hedging contracts in place to mute some of this impact, bringing the total percentage of its cash flow locked in by contracts to about 79% this year, which is a bit short of its 80%-plus goal. What makes this shortfall a concern is that the company budgeted for oil to average $60 a barrel this year. Instead, crude tumbled to around $50, which could cause cash flow to be at or below the low end of its guidance range.

The other worry with DCP Midstream is that it needs to sell assets to bridge the gap between cash flow and capital expenditures so that its leverage ratio doesn't spike. Given all the volatility in the energy market, it might not get good values for the $100 million to $300 million in assets it aims to sell. Because of that, it might fall short of its goal or accept a lower value for its assets to bridge the gap.  

Too risky right now

DCP Midstream needs to execute flawlessly this year to thread the needle of continuing to pay a high-yielding distribution while funding what remains of its expansion program amid challenging energy market conditions. If it can't find buyers willing to pay a good value for the assets it aims to sell, and commodity prices keep falling, then it might need to reduce its payout so that its financial metrics don't deteriorate.

However, if it achieves its asset sales target and commodity prices cooperate, then it won't need to worry about reducing its distribution. That's because it will be much easier to maintain the current payout level next year when capital spending will decline to a range that it can easily self-finance with retained cash and new debt while maintaining its leverage target. 

Even though sustainability is only one year away, the payout seems a bit too risky for dividend investors in the near term.