Hi Robert,

First, it’s important to note that Targa Resources Partners LP was acquired by the owner of its general partner, Targa Resources Corp. (TRGP), near the bottom of the energy downturn back in early 2016. Nevertheless, its preferred shares, which were issued just a few weeks before the roll-up was first announced, remain outstanding.

Targa’s consolidation presaged a wave of similar deals among troubled midstream operators following the energy crash. The intent of these transactions was to shore up balance sheets by reducing leverage, mainly by eliminating various drains on cash flows.

To this end, TRGP’s cash flows are expected to grow at a double-digit pace through 2020. In the meantime, however, Targa’s midstream business, which focuses on more commodity-sensitive areas such as gathering and processing and logistics and marketing, remains challenged.

Indeed, Targa’s cash flows still are not fully covering its dividend. For the first nine months of 2017, distributable cash flow covered its payout by 0.92 times. That’s why the dividend on the common has been flat, at $0.91 per share, since late 2015.

The good news is that TRGP’s dividend coverage on its common is mostly academic for preferred shareholders. Even if the company has to cut its payout on the common, it still has to make good on its obligation to preferred shareholders. That’s one of the main reasons Igor’s play on Targa’s eventual recovery favored the preferred, not the common.

By the way, the preferred is cumulative, so even in the unlikely event that Targa were to defer any payouts on this security, it would eventually have to make them up.

The preferred also has a built-in kicker for a rising-rate environment. As of 11/1/2020, the preferred’s payout shifts from a fixed rate of 9.0% to 7.71% plus one-month LIBOR, which was recently around 1.56%. Assuming rates continue to head higher, then the floating rate is attractive.

The one catch here is that LIBOR is set to be replaced by U.K. regulators with another system by the end of 2021. That’s due to the uproar over a rate-rigging scandal where banks attempted to game the system since it was based on a poll of their estimated borrowing rates.

But will the preferred even be around that long for this to be an issue? Since Targa’s two preferreds were issued as the energy crash was approaching bottom, investors demanded a sizable risk premium, as evidenced by the 9.0% rate on this issue and the 9.5% on the companion issue (a private placement by TRGP that was not directly available to retail investors). The average yield on Targa’s regular debt is about 4 percentage points less.

In a low interest rate environment, preferreds were out of favor until the energy sector’s crisis made them a necessity–the hybrid securities count as equity on the balance sheet, which was very helpful back when credit metrics were so stretched. Presumably, if energy prices continue to recover, Targa’s performance will further improve, and it may one day be in a position to lower what it’s paying out to debt and hybrid security holders.

Targa can’t call away the 9.0% preferred until 11/01/2020, at the earliest. Buying at current levels would mean risking a capital loss of 4.6% if the security were to be called away at that point. Factoring in that possibility, the yield to call is currently around 6.6%.

Best regards,
Ari