DCP Midstream Stock: Don’t Forget The Preferreds (NYSE:DCP)

The market sell-off has been widespread and aggressive, including within the energy sector. It’s an interesting dynamic, as energy in particular retains many of the strong fundamentals it had just months ago – and in some cases better. Most of the recommendations floating around out there (including from me) are going to be directed towards common equity, but panics like this create opportunities elsewhere in the capital structure.

There is value in DCP Midstream (NYSE:DCP) in its units, bonds, and preferreds in my view, but today I’m going to focus on those two publicly-traded preferred stock issues. Essentially, the partnership is one of the few that still has preferred stock outstanding in energy, and I don’t think that lasts. Even in a more benign commodity price environment, DCP Midstream stands to generate significant free cash flow after paying out the distribution. With most of its debt structure rolled over in recent years and basically all of it now trading well below par after the move in rates, it makes no sense to retire these before maturity even though most are continuously callable. That leaves any free cash flow not being returned to unitholders open to just one thing: retiring these preferreds. As of now, these are currently trading below par, so investors are going to pick up a relatively high yield plus the premium when they are retired.

Preferred Stock Terms

Both the DCP Midstream Series B (NYSE:DCP.PB) and Series C (NYSE:DCP.PC) Preferreds are publicly traded, offering relatively high current coupons for income seekers: 7.875% and 7.95%, respectively. Right off the bat, note that these are fixed to floating issues, meaning they have a date where the rate paid by these preferreds will swap over to an annual floating payout. On June 2023, the Series B Preferred Units will have a floating distribution reset equal to three month SOFR plus a spread of 4.919%. Futures for that currently sit at roughly 300bps, so the rate will reset to approximately 7.9%. The Series C Preferred Units reset just a few months later in October of 2023, with a largely similar outlook (4.882% plus 3M SOFR, so roughly 7.9% payout).

A couple of years ago, management likely had little interest in retiring these Preferreds. Prior to its removal as a benchmark (read more about LIBOR converting to SOFR), 3M LIBOR had plummeted to 0.25%, symptomatic of Federal Reserve money printing and a flight of capital to safer investments. Futures indicated these rates staying low for quite some time, with the view that the outlook for rate hikes was fairly abysmal post-pandemic. While still more expensive than where DCP Midstream was able to issue bonds at once the energy market recovered, management was already looking forward to “saving” money during the reset.

That has changed now. When I spoke to DCP Midstream during the EIC Midstream conference just under two months ago in May, my read on management was that they would be looking to retire these preferreds quite soon, likely within a year to two year time frame. Obviously a lot of things have changed in the time since, both in the energy market or just the overall market as a whole. Even still, I think the game plan there is not likely to change. To me, the decision to retire is going to come down to two factors: the EBITDA outlook and credit spreads.

1. Forecasts for EBITDA has not really changed too much for DCP Midstream. 2022 and 2023 analyst consensus has remained stable over the past two months (roughly $1,650mm). While commodity prices have come down somewhat, 2022 partnership guidance of $1,425mm at the midpoint was based off of $70.00 West Texas Intermediate and $3.50 per mmbtu NYMEX natural gas. We’re still well above that, crude oil prices in 2023 have not moved much even with recession fears, and while there has been some weakness in natural gas, investors that mark to market the business will still find the futures strip implies $1,600mm of EBITDA potential. That implies $650mm per year in excess free cash flow after distributions – a heck of a lot of cash.
2. Offsetting, credit spreads have widened some. When I talked to management, CUSIP 23311VAK3 (Unsecured 2032 Notes) were trading at 5.3% yield to maturity. These represent what I think is pretty representative of where they would try to issue debt at to refinance the Preferreds as far as duration / terms are concerned. In the time since, bond prices have weakened, with the yield widening out to 6.3%. Meanwhile, the Series B and Series C Preferreds have stayed relatively the same. This means there is less financing savings from retiring the preferreds.

The counter to the above is the Credit Facility. Unlike bonds, rates demanded from bank lending groups have not increased much lately. Further, DCP Midstream refinanced this facility recently, pushing out the next negotiation until 2027. With $1,200mm in available capacity and a cost to borrow of less than 3.0%, there is ample capacity to retire all of the Preferreds outstanding (Series A, B, and C total $750mm).

Management has been willing to float debt on the Credit Facility before, doing so during the 2020 pandemic while waiting for better terms. The balance sheet is much improved since then, and the outlook for energy is certainly much better now then back then when oil and natural gas prices had crashed. If management remains as constructive as they have been on the business outlook, I would not be surprised to see them borrow on the Credit Facility short term to pay these down, paying down borrowings out of free cash flow or simply waiting for bond prices to come back down as credit spreads tighten back up.

Takeaways

DCP Midstream is one of a handful of midstream firms that have publicly-traded preferred stock remaining in their capital stack. Close peers like Targa Resources (TRGP) have been retiring these lately, and I expect DCP Midstream to mirror that. In times of market duress like this, low volume preferreds can often have outsized moves, so keep an eye out for whenever these are trading below par. Especially for those that are a bit risk averse and can’t stomach the day to day energy volatility, these are a great value opportunity I think.