Oil Crash High-Yield: 3 Reasons to Avoid Plains All American Pipeline and Buy Enterprise Products Partners Instead

Source: Plains All American Pipeline

The worst oil crash in nearly 50 years has resulted in a treacherous mine field for dividend investors. On one hand high-quality midstream MLPs such as Enterprise Products Partners (EPD 1.60%), are trading at their lowest levels since the financial crisis.

PAA data by YCharts

However, more dubious pipeline operators such as Plains All American Pipeline (PAA 6.24%) and its general partner, Plains GP Holdings (PAGP 6.12%), have also been mercilessly beaten down by a market that has come to loath all things related to oil and gas.

Let's compare these high-yield MLPs, one a high-quality value stock, the other a classic high-yield trap, to see how you can learn to spot the difference. Find out the three best ways to separate the wheat from the chaff during this crude crash and hopefully fill your diversified dividend portfolio with high-quality yield trading at fire sale prices in order to turbo charge your portfolio once oil prices eventually recover.

Low valuation is just the first step

Sources: Yahoo Finance, Fastgraphs

Valuation, especially forward yield, is usually the first thing that attracts the attention of income investors. As you can see Plains All American is currently trading at a huge discount to its historical valuations, both from a forward yield, and price/operating cash flow basis, and much cheaper than Enterprise Products Partners.

However, anytime you see the market offering a double digit yield, especially in a very low interest rate environment, extra caution is warranted. That's because, though Wall Street often misprices risk and can occasionally misunderstand an MLPs business model, yields over 10% can also be signs of distress.

Thus due diligence is necessary to determine whether Wall Street's opinion that Plains All American's current payout is at risk of a substantial cut is reasonable or not. The best way for long-term income investors to determine this is by looking at the distribution coverage ratio or DCR.

Payout sustainability: the most important thing to consider

Sources: Earnings releases, Earnings presentations.

Note that Plains GP Holdings derives its cash flow from distributions and incentive distribution rights from Plains All American Pipeline and has a policy of paying out all its DCF to investors, thus explaining the DCR of 1.01.

However, this means that the sustainability of its own distribution is dependent on whether or not Plains All American Pipeline can maintain its own payout. With a DCR of 0.88 thus far in 2015 the security of that payout is gravely in doubt given the challenging funding conditions that exist during an oil crash of this magnitude and unknown duration.

On the flip side, Enterprise Products Partners' river if excess of excess distributable cash flow or DCF means that not only is the current payout sustainable, but also capable of supporting moderate growth. In fact, due to market fears over the recent 75% dividend cut by Kinder Morgan, Enterprise management recently issued payout guidance of 5.2% growth for 2016.

Not only is it highly likely that Enterprise will be able to deliver on this 2016 distribution growth, but its vast retained DCF should be able to fund a substantial amount of its $7.8 billion in growth projects its planning on completing through 2017.

Which brings me to the final important factor that shows the difference between Enterprise and Plains All American, their respective access to growth capital, the life blood of the capital intensive midstream MLP industry.

Access to growth funding: the final piece of the puzzle

Source: Morningstar, Gurufocus

Plains All America's more highly leveraged balance sheet puts it in a difficult position. Current market conditions mean that its unlikely to be able to continue borrowing so cheaply and its ultra low unit price means regular equity growth capital is essentially unavailable.

Thus until oil price recover to continue funding growth projects it will need to turn to more expensive funding sources, such as the $1.5 billion in 8% preferred convertible units it just issued.

However, given that its weighted average cost of capital or WACC is likely to rise and is already higher than its return on invested capital, management may be forced to cut the payout in order to free up excess DCF so that Plains' future growth projects remain profitable.

Enterprise on the other hand, can fund much of its growth internally making it far less dependent on debt and equity markets making its upcoming projects more accretive to DCF than its WACC and ROIC would indicate.

Bottom line: Warren Buffett famously said "Only when the tide goes out do you discover who's been swimming naked."

So it is with the oil crash and midstream MLP's. With equity markets panicking and debt growth capital potentially drying up, the strength of a pipeline operator's business model becomes abundantly clear via its distribution coverage ratio, balance sheet strength, and ability to fund future growth via retained excess DCF.

These key metrics are great proxies for not just sustainable long-term distribution growth but also quality, conservative management that has its eyes on the long-term prize. By avoiding such high-yield traps such as Plains All American and instead investing in Enterprise Products Partners, one of the best run midstream MLPs in America, income investors will likely avoid painful distribution cuts and could potentially come out of the oil crash richly rewarded; whenever crude finally recovers.

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