DCP Midstream (DCP) lives in the shadows of two industry giants. Canadian pipeline behemoth Enbridge and refining giant Phillips 66 each own half of the energy midstream company's general partner. Because of that and its smaller size compared to other master limited partnerships (MLPs), most investors haven't come across the company.
That's causing them to overlook its increasingly attractive 4.4%-yielding dividend. Here's why those seeking to collect passive income might want to consider taking a closer look at DCP Midstream.
Putting the payout on a more sustainable footing
DCP Midstream hasn't always been an attractive option for income-focused investors. The MLP slashed its payout by 50% in early 2020 because of the initial impact of the pandemic on the energy sector.
However, that move enabled DCP Midstream to retain more cash, which it used to shore up its financial profile. The company has reduced its leverage ratio from 4.2 times debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) in the second quarter of last year to 3.3 times at the end of 2022's first quarter. Meanwhile, it's on track to get its leverage ratio below 3.0 times by the end of this year, comfortably below its 3.5 times target. That progress in reducing leverage enabled the company to receive a credit rating upgrade to investment grade. That rating should increase its ability to access lower cost capital in the future.
DCP Midstream has generated excess free cash flow after covering its distribution and growth capital expenses for eight straight quarters. It tallied $247 million of free cash flow during the first quarter, 102% higher than the prior quarter.
Meanwhile, the company has enhanced the durability of its cash flow by investing in projects to grow its fee-based earnings. Stable fee-based contracts now provide about 70% of its earnings, putting a solid floor under the distribution.
Setting the stage for future growth
With leverage continuing to fall, DCP Midstream is in an excellent position to start growing its distribution again. It anticipates giving investors a raise in the second half of this year.
Meanwhile, the MLP recently added more fuel to support a higher distribution by agreeing to acquire The James Lake System for $160 million. The James Lake System includes 230 miles of gathering pipeline and a 120 million cubic feet per day natural gas processing facility in the Permian Basin. The transaction is immediately accretive to its cash flow and highly complementary to its existing assets in the region.
That's likely the first of many deals as the MLP takes advantage of its improved financial profile and investment-grade credit rating to execute its growth strategy. One aspect of its plan is opportunistic consolidation by acquiring assets that are a good strategic fit for its existing portfolio. If it can continue finding highly accretive acquisitions, it'll help grow the company's cash flow, giving it more fuel to increase the distribution in the future.
In addition to making acquisitions, DCP Midstream can use its financial strength and surging free cash flow to invest in expansion projects and repurchase equity. The MLP only invested $9 million into expansion projects during the first quarter because it still has adequate capacity across its system to handle customer needs. However, producers are starting to drill more wells with oil and gas prices surging. That could eventually provide DCP Midstream with opportunities to expand its system and grow its cash flow. Meanwhile, equity repurchases will reduce its outstanding unit count, enhancing its ability to increase the per-unit payment in the future.
All signs pointed to a bigger income stream in the future
DCP Midstream is about to become an even more attractive opportunity for those seeking passive income. The MLP's current high-yielding payout is on an increasingly solid foundation thanks to its improving financial profile and growing cash flow. With its cash flow about to get another boost from an acquisition, the MLP will have more fuel to increase its distribution later this year. It could continue to grow that payout as it makes future deals and other growth-related investments. That's income upside investors won't want to miss.