Cabot Dividend Investor Issue: August 10, 2022

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Profit Despite Inflation and Recession

It’s a recession. The reported second-quarter GDP contraction market the second consecutive quarter of negative GDP growth, the technical definition of a recession.

People can argue whether we are officially in a recession or not. But it’s well worth noting that since the second world war there have never been two consecutive negative quarters without a recession.

Meanwhile, inflation still rages. This week’s July inflation report may show a decrease in the rate from June’s 9.1% spike because of lower gas and commodity prices. But inflation is still a long way from being tamed and will likely stick around for some time.

Stocks will have to navigate an environment of both recession and inflation, at least for the rest of the year. That’s tricky because few companies perform well with both. Commodity-based companies thrive in inflation but struggle in recession. Many defensive companies that shine in recession don’t like inflation.

In this month’s issue, I highlight a stock in one of the rare sectors that can successfully navigate both recession and rising prices at the same time – midstream energy.

These companies are minimally exposed to volatile commodity prices and get paid according to the volume of oil and gas that goes through their systems. Also, unlike most energy companies, prices haven’t skyrocketed over the last year. And they still sell at cheap valuations.

There are several reasons why the midstream sector is still cheap and why it should behave well even in a recession.

While midstream stocks are having a strong year, they haven’t soared nearly as high as most energy stocks, which are commodity price dependent and benefitted from the recent spike in prices. Midstream companies haven’t had the earnings spike because these companies rely on fees and earnings were relatively stable in the pandemic.

This cycle has also been different than most in several ways. For one, despite much higher prices, drilling activity and volumes have not rebounded as they normally have under similar circumstances. Part of the reason is that exploration and production companies learned their lesson after overextending themselves in the last cycle.

Another reason is that the regulators have been particularly hostile to fossil fuel producers. Even when new drilling makes good financial sense and can get approval, energy companies are highly reluctant to embark on new projects for fear of being shut down when the current energy pressures ease.

Although there still isn’t nearly enough infrastructure to process U.S. oil and gas production, regulators have been hostile towards midstream companies as well. It has been difficult, if not impossible, to get new ventures greenlighted. As a result, the midstream companies are focusing less on growth through projects and expansions, and more on using cash to pay down debt, buy back shares, and raise dividends.

It’s made many midstream companies more like utilities with high and stable payouts but little growth. At the same time, oil and gas volumes are likely to remain stable and increase going forward, especially for natural gas. Volumes didn’t get overextended like they usually do in this past recovery, and the current energy supply shortage is likely to persist even through a recession because of continued supply chain bottlenecks and geopolitical issues.

The improved balance sheets, higher dividends and resilient volumes going forward make midstream energy companies much better in a recession than in the past. Also, most midstream companies operate under long-term contracts that have automatic inflation adjustments built in. They operate virtual monopolies in their areas and can easily endure rising prices.

What to Do Now

The market has had a huge rally from the low. As of Monday’s close, the S&P 500 is up 12.9% from the low in mid-June. That’s a lot bigger than just a bounce.

The market is likely sniffing out the end game of the inflation and aggressive Fed conundrum that had plagued it all year. It generally anticipates six to nine months into the future. By then, it sees inflation that is way down and a Fed that is done hiking rates, and maybe even talking about lowering them again.

That’s a good scenario. And the market usually gets these things right. But I remain skeptical. Much can go wrong. Even if inflation pulls back on lower gas and commodity prices, it is far from under control. It’s very possible that this inflation won’t be tamed with a soft landing or just a mild recession. The Fed may have to continue to raise rates deep into next year while the economy gets worse.

This market will be extremely disappointed by news that alters the rosy scenario. It will likely not react well, especially after such a big rally.

But it’s difficult to remain conservative. After all, the market took off and never looked back long before the pandemic woes ended. In fact, they were just beginning. There is an understandable concern about missing this turnaround by not being more aggressive. And that is a possibility.

The portfolio does have more cyclical positions that will benefit from a sustained rally, including Broadcom (AVGO), Qualcomm (QCOM), Intel (INTC) and Visa (V). But the rest of the portfolio is still in relatively defensive, recession-resistant companies.

It is possible that the lows are already in. It is also possible that stocks can hold most of the gains from the recent rally. But it is far less likely that the market continues a sustained move higher from here in the near future considering a still-aggressive Fed, persistent inflation, and a likely recession.

The two midstream energy companies, Enterprise Product Partners (EPD) and ONEOK (OKE) remain BUY rated as this sub-sector should perform and pay a high income under just about any scenario. Although there are already two such companies in the portfolio, another one is being added this week. The strong operational performance, low valuations, and high and safe yields are a great bet in the current situation.

Monthly Recap

July 13
The Home Depot (HD) – Target buy at $200

July 20
SOLD Innovative Industrial Properties (IIPR)

August 3
Intel Corporation (INTC) – Rating change “BUY” to “HOLD”

August 10
Buy Williams Companies Inc. (WMB)

Featured Action

The most resilient and higher-growth midstream companies tend to deal in natural gas and natural gas liquids (NGLs). Natural gas in by far the cleanest burning and fastest growing fossil fuel source in the world, and the U.S. is the world’s largest producer. It is also viewed more favorably by regulators because it is so much cleaner than oil and coal.

Given the current inflation and energy shortages, even some of the more hard-core climate change activists are increasingly seeing natural gas as the bridge to a lower-carbon future. The U.S. and the world currently use fossil fuels for more than 80% of energy needs. It’s unrealistic to expect clean energy sources to replace them any time soon. In the meantime, the U.S. has dramatically lowered its carbon footprint by transitioning to natural gas from coal and oil and will continue to do so.

It’s also a similar situation in the rest of the world. The U.S. still has more natural gas than it can use, and other parts of the world are desperate for the stuff. Massive natural gas export facilities have been built in recent years that liquify gas and ship it overseas. That market should remain red hot, especially with Europe looking for other sources after their fallout with Russia.

Buy Williams Companies Inc. (WMB)

Yield: 5.28%

Williams is an American midstream energy company involved in the transmission, gathering, processing and storage of natural gas. It operates the large Transco and Northwest pipeline systems that transport gas in densely populated areas from the Gulf to the East Coast. Roughly 30% of the natural gas in the U.S. moves through its systems.

The bulk of adjusted EBITDA comes from pipeline transmissions plus a smaller deep-water presence in the Gulf of Mexico (47%) and gathering and processing facilities (38%). The rest is from marketing and NGL (natural gas liquids) services, exploration and production joint ventures, and oil gathering and processing. The company has minimal commodity price exposure, and the vast majority of revenues are fee-based and secured under long-term contracts with inflation adjustments.

It’s also worth noting that Williams has been the most active of the large midstream energy companies in carbon reduction. It issued a report in 2021 committing to a 56% reduction in greenhouse gas emissions from 2005 to 2030. That helps with the regulators. Also, the company acquired the remaining 26% ownership from its limited partner and is now a regular corporation (not a Master limited Partnership).

YTD performance
WMB has returned more than 25% YTD (as of August 9). That is far better than the midstream energy group and only a little below the performance of the overall energy sector. Williams has been able to achieve a higher level of earnings growth than the group because it is reaping the rewards of $8 billion invested in new projects between 2018 and 2021.

Adjusted earnings per share is up 29% in the first half of 2022 versus the same period last year. The recently reported quarter featured a whopping 48% earnings per share spike over last year’s quarter. Williams also increased 2022 earnings guidance.

A huge tailwind is that the there is a rise in natural gas demand in all its sectors. There continues to be a growing need for secure and reliable supplies amid high prices, geopolitical volatility, and climate concerns. In fact, William’s earnings continued to rise right through the heart of the pandemic lockdowns, one of the worst periods for the industry ever.

The Dividend
Williams currently pays out $0.425 per share quarterly, or $1.70 annually, which translates to a current yield of 5.28%. While the company has paid a quarterly dividend since 1974, it hasn’t always raised or maintained the payout. The company slashed the dividend in the aftermath of the 2014 oil price crash. But it has since restructured in a way that makes the current dividend far safer.

Williams restructured to a regular corporation in 2018. It has since reduced its net debt-to-EBITDA by 21% while investing $8 billion in new projects with an 18.8% return on capital between 2018 and 2021. Operating margins have increased from 57% in 2015 to 70% in 2021. And adjusted earnings per share have increased at a CAGR of 18% since 2018.

As a regular corporation, Williams doesn’t have to pay out 90% of earnings that are shared with a general partner. It is retaining cash that goes back into the company with a much lower cost of capital than issuing new shares or increasing debt. The company has a staggering 2.2 times coverage ratio (adjusted funds from operations). That’s the best coverage I’ve seen for any large midstream energy company.

In fact, Williams uses only about 45% of that cashflow to pay the dividend. The rest is enough to cover its growth capital expenditures plan, including a recent acquisition, with room to spare. The cash retention is a huge cost advantage over competitors, and it makes the dividend far more secure. The payout has also grown by an average of over 7% per year for the last five years.

The Future
As I mentioned above, the prospects for natural gas volumes going forward are tremendous. And Williams also has the advantage of having a large and well-established network. Regulators tend to be much more lenient for expansions than new projects, favoring established players. Williams has a well-positioned network that allows it to invest in high-return growth projects with minimal regulatory hurdles.

The company currently has $1.5 billion invested in six projects that will boost the bottom line over the next several years. That should keep the growth pump primed.

Despite the high returns so far this year, the stock still sells and just 8.5 times cash flow, a very reasonable valuation for a company with such solid earnings growth and a high and safe dividend. WMD should be a great addition to the other two existing midstream companies in the portfolio.

The Williams Companies, Inc. (NYSE: WMB)
Security type: Common stock
Industry: Energy, midstream
Price: $32.86
52-week range: $23.53 - $37.97
Yield: 5.28%
Profile: Williams Companies is one of the largest American midstream energy companies that transports, processes and stores about 30% of U.S. natural gas volumes.

Positives

• Natural gas has rising demand in the short and long term.
• The regulatory hurdles are much lower for expansions to established networks.
• Williams uses retained earnings to fund growth and has a lower cost of capital than peers.
• Recent growth projects should power solid growth for years.

Risks

• The regulatory environment remains hostile for any fossil fuel operator.
• A recession could reduce throughput volumes and decrease earnings growth.

Williams Companies, Inc. (WMB)
Next ex-div date: September 8, 2022

Portfolio at a Glance

High Yield Tier

The investments in our High Yield Tier have been chosen for their high current payouts. These investments will often be riskier or have less capital appreciation potential than those in our other two tiers, but they’re appropriate for investors who want to generate maximum income from their portfolios right now.

Enterprise Product Partners (EPD – yield 7.4%) – Enterprise reported an exceptional quarter last week. Adjusted funds from operations soared 23% and distributable cash flow increased 30% over last year’s quarter. The company has a remarkable 1.9 times distribution coverage from cash flow and a payout ratio of just 56%. The midstream energy partnership also has inflation adjustments build into its long-term contracts. EPD should be an excellent holding going forward with a high and safe payout, strong business fundamentals, and a still-cheap valuation. (This security generates a K-1 form at tax time). BUY

Enterprise Product Partners (EPD)
Next ex-div date: October 28, 2022, est.

ONEOK Inc. (OKE – yield 6.4%) – This midstream energy company reported solid earnings earlier this week that surpassed expectations. Earnings per share rose 21% over the same quarter last year and natural gas demand remains very strong, and volumes though its systems continue to increase. Although OKE has leveled off since late last month, it has been trending generally higher since the middle of June. It also sells at a cheap valuation with a rock-solid dividend. It should have the right stuff over the rest of this year. BUY

ONEOK Inc. (OKE)
Next ex-div date: October 28, 2022, est.

Realty Income (O – yield 4.1%) – This legendary monthly income REIT got a boost after reporting stellar earnings last week that beat estimates. Earnings rose 10.2% and the company is navigating inflation and the recession like a champ. The occupancy rate for its consumer staple tenants is the highest in 10 years, and the company increased guidance on the pace of acquisitions, to ensure future growth. This stock is not only a defensive stalwart that has operated successfully in every kind of environment of its many years, but it’s also a great place to be in the current market environment. That’s why O is close to the 52-week high. HOLD

Realty Income (O)
Next ex-div date: August 31, 2022, est.

Dividend Growth Tier

AbbVie (ABBV – yield 4.1%) – The biopharmaceutical company reported mixed earnings last month and the stock sold down. It beat on earnings, up 11%, but missed on revenues. The revenue miss was because of diminished sales from its cosmetic franchise in the worsening economy plus, and more importantly, disappointing results for its cancer drug superstar amid increasing competition. That cancer drug is part of the answer to replacing revenues from Humira, which faces a patent expiration in the U.S. next year.

It’s not good news, but the core story is still intact. AbbVie is still a defensive company in a recession with an excellent longer-term prognosis amid the aging population. Disappointments like this are part of the life of all pharma companies, even very successful ones. It should pay to simply hold the stock and collect the dividend through rough patches en route to better things in the future. HOLD

AbbVie Inc. (ABBV)
Next ex-div date: October 14, 2022

Broadcom Inc. (AVGO – yield 3.0%) – The chip and infrastructure software technology stalwart has moved nicely higher since the middle of July, along with the rest of the sector. AVGO is up more than the sector over that time, up over 13%. It doesn’t report earnings until next month. Broadcom stands to benefit from CHIPs Act subsidies. It’s also very well positioned to benefit in a fundamental way from the 5G rollout and the proliferation of cloud computing and should have continued strong earnings. BUY

Broadcom Inc. (AVGO)
Next ex-div date: September 21, 2022, est.

Brookfield Infrastructure Partners (BIP – yield 3.5%) – This defensive infrastructure partnership reported terrific earnings last week. Funds from Operations, the true measure of earnings for an MLP, was up 30% from last year’s quarter and a new record. That’s powerful growth for a highly defensive, dividend-paying company. Results were higher across the board and Brookfield got the most growth from the midstream energy sector, powered by last year’s large pipeline company acquisition. BIP is still well off the high but has been trending consistently higher over the last month. (This security generates a K-1 form at tax time). HOLD

Brookfield Infrastructure Partners (BIP)
Next ex-div date: August 30, 2022

Eli Lilly and Company (LLY – yield 1.3%) – This superior health care giant that had bucked the trend and performed strongly in a tough market has finally stumbled. It reported earnings that missed expectations by a lot ($1.25 versus $1.70). Lilly also lowered earnings guidance for the full year. Revenues declined from last year’s quarter as well. It also didn’t apply for fast approval of its weight loss drug, which disappointed the Street. The stock only pulled back slightly on the news but is down about 10% from the high.

But things aren’t as bad as the above paragraph indicates. The earnings hit is largely from temporary issues: fewer covid treatments, a strong dollar, and the recent patent loss on one of its cancer drugs. The company left full-year revenue guidance intact. The basic story of the strong pipeline and pending approvals of important drugs remains intact. The stock has actually held up well with such a miss, and the longer-term story remains very positive. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: August 12, 2022

Intel Corporation (INTC – yield 4.1%) – The chipmaker reported earnings last month that were a disaster. Both revenues and earnings were well below expectations where revenue dropped 22% and earnings came in at an $0.11 per share loss versus an expected $0.69 profit. Intel also lowered guidance for 2022. The company blamed supply chains, China and its own execution.

This year was always going to be bad. That’s why the stock was so low. The main attraction was the longer term and the cheap price as the company refocused on the foundry business and technology. Last week, the near term got even worse while the longer-term outlook may have improved. The new CHIPS Act will likely provide generous subsidies for its foundry business expansion. The stock hasn’t even bounced since earnings. Unless INTC can get some sort of traction soon, it will be sold from the portfolio. HOLD

Intel Corporation (INTC)
Next ex-div date: November 5, 2022, est.

Qualcomm Inc. (QCOM – yield 2.0%) – The chipmaker stock fell as much as 6.8% after its earnings report last month and has continued to wallow. The quarter beat expectations on 36% higher revenues and 54% higher earnings than last year’s quarter as smartphone royalties soured 59%. But the company lowered guidance for next quarter and the rest of the year as slowing global growth is expected to reduce handset sales. The market didn’t like that.

The likelihood of slowing phone sales has pressured this stock lower for most of the year. That’s why QCOM is still 25% off the high even after the recent surge. But those slower sales haven’t even materialized yet, and the company still expects 23% year-over-year revenue growth for the rest of the year. It should also benefit as 5G gets applied to many more devices. Slower sales were already priced into the stock. Meanwhile, it sells at just 12 times forward earnings with better than 20% growth ahead, even in a recession. BUY

Qualcomm Inc. (QCOM)
Next ex-div date: August 31, 2022

Visa Inc. (V – yield 0.7%) – Visa’s earnings knocked it out of the park. It beat expectations on both earnings and revenues, which were up 33% and 19% respectively. The company continues to benefit from increased global business from the ending of covid restrictions, despite slower global growth. The stock is normally very quick to recover with the overall market, but it has been more sluggish this time around because of a pending bill in the Senate that will limit credit card fees. We’ll see what the bill looks like and gauge the chances of passage. In the meantime, business is still booming despite inflation and recession. HOLD

Visa Inc. (V)
Next ex-div date: August 12, 2022

Safe Income Tier

The Safe Income tier of our portfolio holds long-term positions in high-quality stocks and other investments that generate steady income with minimal volatility and low risk. These positions are appropriate for all investors, but are meant to be held for the long term, primarily for income—don’t buy these thinking you’ll double your money in a year.

NextEra Energy (NEE – yield 2.0%) – NEE has been on fire and appears poised to retake new highs. It had been a rough year for the alternative energy utility. It underperformed the sector as delays from solar panels in Asia will slow solar projects. But the stock bottomed this spring and is really turning things around. It also got a big boost following the passage of a climate change bill in congress that would be very generous to companies like NEE. The stock is up over 25% since mid-June. This is a great utility and a phenomenal way for conservative investors to play the growth in clean energy. HOLD

NextEra Inc. (NEE)
Next ex-div date: August 29, 2022

Xcel Energy (XEL – yield 2.6%) – Xcel reported earnings last month that matched estimates and beat estimates on revenue. It was a solid report, and the stock has moved higher but not necessarily because of earnings. This smaller alternative energy utility also got a boost from the climate change bill. Plus, it’s in two timely sectors, utilities and clean energy, and should be well positioned for the longer term as well. The stock has trended sharply higher since the middle of last month and appears poised to retest the high. HOLD

Xcel Energy Inc. (XEL)
Next ex-div date: September 14, 2022, est.

Dividend Calendar

Ex-Dividend Dates are in RED and italics. Dividend Payments Dates are in GREEN. Confirmed dates are in bold, all other dates are estimated. See the Guide to Cabot Dividend Investor for an explanation of how dates are estimated.

The next Cabot Dividend Investor issue will be published on September 14, 2022.