Calumet Specialty Products Partners: 2 Reasons to Avoid This High-Yield MLP

Source: Calumet Specialty Products Partners

The most severe oil crash in 50 years has devastated numerous energy stocks, however most refiners have been spared the worst of the carnage because low oil prices usually boost their margins. This hasn't been the case with specialty refiner Calumet Specialty Products Partners (NASDAQ: CLMT), which has been bludgeoned by the market to its lowest levels since the financial crisis.

CLMT data by YCharts

This unit price crash has resulted in a sky-high yield that may tempt many income investors. However, such a high-yield also represents the market's opinion that the current payout is likely facing an imminent cut. So does Calumet Specialty Products Partners represent an amazing long-term income opportunity or a value trap that should be avoided? Read on to find out.

Valuation at multi-year lows

Sources: Yahoo Finance, Fastgraphs

As you can see Calumet has never exactly been a high prices MLP. However, at today's six year lows its trading especially cheap. However, as history's greatest investor Warren Buffett famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

So is Calumet Specialty Products Partners a wonderful company? From the perspective of what matters most to investors perhaps not.

Payout profile: the most important thing to consider

Source: Calumet Specialty Products Partners investor presentation.

MLPs like Calumet are all about income. However successful long-term income investing requires looking at more than just yield. Payout sustainability and long-term realistic growth prospects are equally, if not more important.

From that perspective Calumet's payout profile leaves a lot to be desired. It's struggled to maintain a minimal sustainable distribution coverage ratio -- the best metric for measuring long-term distribution sustainability -- of 1.0 over the past three years. In fact only the recent margin boosting effects of super low oil prices have allowed it to secure the current payout.

Oil prices are certain to recover eventually and when they do margin compression is likely to severely hurt distributable cash flow. This makes analyst five year distribution growth projections of 6.5% CAGR not just unlikely but, from a long-term perspective, a very bad idea.

This is because Calumet needs to emphasize growing its coverage ratio over time. This would serve two vital purposes. First it would create a cushion to decrease the risk to the current payout when refining margins do eventually decline.

As importantly it would create a stream of excess DCF which the MLP could use to pay down its debt and fund more growth projects and acquisitions internally rather than rely entirely on the debt and equity markets. Which brings me to the likely reason that Wall Street has crushed Calumet's unit price so badly.

Risks explain market's pessimism

Sources: Gurufocus, Morningstar

Calumet has an incredibly leveraged balance sheet, and since it pays out almost all its DCF to investors its entirely reliant on external funding sources for growth capital. As you can see historically the MLP has funded growth pretty evenly, which is where its main problem now lies.

With its unit price so low it can't sell more units to fund more growth which means it must rely purely on debt. However, because of its already large debt burden it has a B+ credit rating from S&P. That is the lowest investment grade level and this limits the amount of additional borrowing the MLP can do lest its credit be downgraded to junk and its borrowing costs greatly increase.

Long-term interest rates have no where to go but up which but up meaning that Calumet's weighted average cost of capital will likely rise over time. Given that its return on invested capital is incredibly low this makes further profitable growth difficult. That in turn could make growing the DCR high enough to sustain the current payout before the next refining industry downturn impossible.

In the meantime Calumet's complete reliance on its creditors means that they may pressure the MLP to slash or even eliminate the payout in order to use this DCF to pay down its debt.

Bottom line:
Despite the recent completion of Calumet's multi-year organic growth initiative -- which may very well preserve the distribution in the short-term -- I believe that Wall Street's high-yield is warranted.

Calumet's highly leveraged balance sheet, high cost of debt, and lack of access to equity capital markets means that future profitable growth could be limited. With its historic difficulty in maintaining a sustainable level of DCF relative to its enormous payout income investors must understand that this is a highly speculative investment.

With so many midstream MLPs -- with far more stable business models and more sustainable distributions -- yielding 15+% I think there are far better high income choices available I today's market.