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Danger Lurks for These 2 High-Yield Dividend Stocks

Matthew DiLallo, The Motley Fool

Yield-seeking investors need to be careful. While companies might proclaim that their dividends are on solid ground, the numbers can often tell a different story. That's why income investors should take a close look at a dividend payer's financial profile so that they can spot potential dangers ahead of time. That can help them avoid disastrous outcomes, such as a significant dividend reduction.

Two high yielders with concerning numbers are midstream companies Targa Resources (NYSE: TRGP) and DCP Midstream (NYSE: DCP). Here's why danger could be lurking at these high-yield options.

A blue sign reading risk ahead.

Image source: Getty Images.

Razor thin right now

Targa Resources' dividend currently yields an eye-catching 8.7%. But the company isn't generating enough cash to cover that payout. It distributed 100% of its cash flow to investors last year. Meanwhile, it paid out $234.4 million in dividends during the first quarter, which was nearly 20% more than the cash it collected. Because of that, the company's payout is clearly in the danger zone.

That's not the only concern with Targa's dividend. The company also has much more exposure to commodity price volatility than its peers. That's because stable fee-based contracts only cover about 75% of its cash flow while most other midstream companies want that number closer to 90%. On top of that, Targa has junk-rated credit, which makes it costlier to borrow money to fund growth projects. That's an issue considering that the company expects to spend $2.3 billion on expansion projects this year.

Targa, however, has managed to navigate through its situation by using creative means to bridge its funding gap. Not only has the company sold assets, but it has also partnered with private equity funds to help finance expansions. Because of that, Targa has several needle-moving growth projects on track to begin operations this year, which should significantly boost cash flow. That gives it substantial upside potential.

On the other hand, another deep downturn in the oil market could still force Targa Resources to reduce its dividend, given its high payout ratio, outsized exposure to commodity prices, and balance sheet concerns. That higher risk is why investors might be better off keeping Targa on their watchlist until its expansion projects start paying dividends.

Volatility can cut both ways

DCP Midstream currently offers an even higher yield of 9.5%. That payout is on a bit firmer foundation than Targa's since DCP Midstream covered it with cash flow by a comfortable 1.45 times during the first quarter thanks to an uptick in oil prices.

However, the company has many of Targa's other issues. For starters, DCP Midstream also has outsized exposure to commodity price volatility since stable fee-based contracts only supply it with about 65% of its anticipated cash flow. While the company has hedging contracts in place to lock in pricing for another 12% of its expected earnings this year, a big drop in oil and gas prices would impact its profitability. On top of that, DCP Midstream also has junk-rated credit. Though it did recently win a rating upgrade thanks to the improvement in its financial profile over the past few years.

DCP Midstream, like Targa Resources, is investing heavily in building new fee-based growth projects that should come on line over the next year. As they do, those assets will generate some incremental cash flow to provide further support for the dividend while reducing its direct exposure to commodity prices. However, the payout will remain in the danger zone until DCP Midstream improves its financial profile enough to obtain an investment-grade credit rating and boosts its fee-based cash flow to more than 80% of the total.

Intriguing options, but too dangerous for yield-seekers right now

Both Targa Resources and DCP Midstream offer tantalizing payouts. And each has near-term upside potential as they complete their current slate of fee-based expansion projects. However, their outsized exposure to commodity prices and weaker financial profiles make them more dangerous options for investors seeking a steady income stream.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool recommends Targa Resources. The Motley Fool has a disclosure policy.