ONEOK Inc: Top Notch Energy Stock Yielding 14%

This is a guest contribution by Bob Ciura of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth portfolios for the long run.

Energy stocks have taken a beating over the past year, due to multiple factors that have combined to deal the entire industry a significant blow. First, oil and gas prices have been weak for several years, due to a global supply glut. If that weren’t bad enough, the energy complex has had to deal with the coronavirus pandemic which has suppressed demand for oil and gas.

Not surprisingly, the Energy Select SPDR ETF (XLE) has declined 40% year-to-date, while the broader S&P 500 Index has gained 5% so far this year (not including dividends). Energy stocks are looking attractive for income and value investors, although careful selection is warranted given the many challenges facing the industry.

We continue to rate ONEOK Inc. (OKE) highly among energy stocks, due to its extremely low valuation along with its high dividend yield of 14%. While there are never any guarantees when it comes to high-yield stocks, we believe ONEOK’s dividend payout can survive the pandemic.

Business Overview and Recent Earnings

ONEOK is a large-cap stock in the energy sector with a market cap of more than $12 billion. It is engaged in transportation and storage of energy products. Its assets include a 40,000-mile long network of natural gas and natural gas liquids pipelines, which are connected to many of the strongest oil and gas fields in the U.S. such as the Permian Basin, Eagle Ford and Bakken shale.

Despite the many difficulties facing the energy sector in 2020, ONEOK has continued to report positive net income and distributable cash flow. In the 2020 second quarter, revenue declined by 33% from the same quarter last year. Weak commodity prices and lower volumes were the main reasons for the steep revenue decline, partially offset by cost reductions. This allowed the company to remain profitable. ONEOK generated adjusted EBITDA of $530 million for the quarter, down 16%, while distributable cash flow fell by 40% to $300 million.

Results were particularly weak in the Natural Gas Gathering and Processing Segment, which reported a 52% decline in adjusted EBITDA due to production curtailments in Williston Basin and Mid-Continent region. Fortunately, the Natural Gas Pipelines segment grew adjusted EBITDA by 9.3% due to higher transportation revenue, while the core Natural Gas Liquids segment held up relatively well with a mild 2.7% adjusted EBITDA decline.

Dividend Analysis

Two key factors bode well for the sustainability of the dividend—ONEOK’s distribution coverage, as well as its investment-grade credit rating and substantial liquidity. First, over the first six months the company generated $49 million of distributable cash flow in excess of dividends paid. While ONEOK’s DCF fell below dividends paid by $87 million in the second quarter, the company noted trends had improved in recent weeks due to the reopening of the economy. Ample cash flow coverage of the dividend is key to assessing dividend sustainability when researching stocks.

Therefore, the company believes the shortfall was only temporary. The market certainly does not seem convinced of the bullish case, as ONEOK shares have lost nearly two-thirds of their value year-to-date, pushing the dividend yield up to 14%. But if ONEOK can make it through the pandemic relatively unscathed and return to normal operating conditions, the current share price could be a bargain.

Investors are hoping the company’s balance sheet can hold up long enough to get it to the other side of the pandemic. ONEOK has an investment-grade credit rating of BBB, which helps the company raise capital on more favorable terms. It also has a $2.5 billion undrawn credit facility to help boost its liquidity. And, as of June 30 the company had more than $945 million of cash and cash equivalents on the balance sheet. The company has a high level of overall debt, with a net-debt-to-EBITDA ratio of 4.5x but it is also confident it can service its debt and continue to pay its hefty dividends.

In response to the coronavirus pandemic, ONEOK has taken several steps to reduce costs. The company previously announced it would reduce 2020 capital spending by $900 million by pausing several projects.

Valuation

ONEOK stock trades for a price-to-DCF ratio of just 6.2x, based on our estimate of $4.30 per share in full-year DCF. We believe a better measure of fair value for this company is a price-to-DCF ratio of 10x. While this is still a fairly low valuation multiple in general, it nevertheless leaves plenty of room for shareholders to make strong returns. For example, if the P/DCF multiple expanded from 6.2x to 10x by 2025, it would increase shareholder returns by 10% per year.

Therefore, total shareholder returns could reach 24% per year over the next five years, just from an expanding valuation multiple plus dividends received. If ONEOK manages to generate any distributable cash flow growth over the forecasted time period, shareholder returns would be even higher. Of course, this forecast is reliant on the dividend being maintained, which is no guarantee especially when it comes to beaten-down energy stocks. However, ONEOK has taken aggressive action to reduce costs and shore up its financial position. It also has strong assets that should recover as soon as the oil and gas industry and broader economy return to normal.

Final Thoughts

Investors need to tread carefully in the energy sector. Many high-profile energy stocks including Royal Dutch Shell (RDS.B) and BP plc (BP) have cut their dividends in 2020, with many others announcing deep cuts or outright suspensions. For this reason, investors need to focus on energy stocks with strong assets and healthy balance sheets, which will hopefully allow the highest-quality operators to maintain their dividends.

ONEOK has a strong asset network and the company continues to generate solid cash flow that sufficiently covers the dividend. While there are various unique risks to ONEOK’s future prospects, to this point we still believe the dividend payout is sustainable. If the company can keep the dividend intact, ONEOK’s extremely high yield of 14% is appealing for income. As a result, for income investors willing to accept higher risk in return for higher potential reward, ONEOK could be an attractive high-yield stock.

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