Kinder Morgan After The Merger

Kinder Morgan has been one of the best income investments in the world for people that discovered the company and acted upon it. The original Kinder Morgan—the one with the KMP ticker symbol—benefitted from a great confluence of factors that led to 20% annual returns between its 1997 founding and the November 2014 merger.

The story began with Richard Kinder getting passed up for CEO of Enron. He responded by offering $25 million for Enron Liquid Pipelines L.P. Without a doubt, it is one of the great ironies of American corporate history that the eventually bankrupt Enron sold off the most lucrative, cash-generative assets in its portfolio to avoid executive rivalry and focus on derivative trading in the energy sector instead. Illusory trading was favored over pipeline infrastructure that could build a great company. While Enron was becoming asset light and lying about it, Kinder took the pipes and ran with it.

In hindsight, the conditions were ripe for wild success. America was about to expect a boom in the oil pipeline and storage industry. The CEO was smart and had near total control (owning 17% of the stock to this day), and was set on fire with something to prove after being overlooked.  The valuation was cheap because Kinder Morgan Energy Partners, L.P. had no track record and it takes a couple years of annual reports and general filings for an outsider to get a feel for a company.

The initial dividend payout only took up a measly 5% of annual cash flow, setting the stage for a great 1997-2014. The stock was so lucrative that an initial $100,000 investment led to $20,800 in monthly dividends by 2014. Whatever the investment amount of someone following Richard Kinder, the end result was this—you got 2.5x your initial investment in annual dividend income just by holding and reinvesting for seventeen years.

Richard Kinder, already a darling (for good reason) amongst income investors, burnished that status by declaring that investors would achieve 10% annual dividend growth between 2015 and 2020 if they approved the merger of Kinder Morgan (KMI), Kinder Morgan Energy Partners (KMP), Kinder Morgan Management (KMC), and El Paso Pipelines (EPB). Instead of worrying about which ones pay return of capital distributions that require K-1s, which ones actually issue shares of stock directly instead of dividends, and having to draw diagrams to figure out how El Paso fits into the ownership picture, the current investors have the clarity of knowing that they own a regular C-corp that pays out dividends without requiring any special tax knowledge. Owning Kinder Morgan is now the same as Chevron or Exxon.

While that history is nice, the real question people are interested in: How does Kinder Morgan look now? The answer: Quite good, but there are legitimate risks that should not be glossed over.

At the time of writing, Kinder Morgan trades at $40 per share with a 4.75% dividend yield. If the dividend projections hold true, it is certainly eye-popping: You get your high starting dividend yield coupled with high expected dividend growth. Outside of the tobacco industry, that is an unusual find.

The payout ratio at Kinder Morgan is not attractive right now compared to its illustrative history. Usually, this is a company that pays out about a third of its cash flow. As recently as 2011, Kinder Morgan was paying out $0.74 annual dividends while generating $2.10 in annual cash flow. That provides room for self-funded growth and even increases in the dividend payout ratio during the down years.

That is not the case right now. Kinder Morgan pays out a $1.92 annual dividend, and will generate $1.85 in cash flow this year if current oil prices persist. The business model at Kinder Morgan involves using 180 terminals and 80,000 miles of pipelines to physically transport petroleum, natural gas, and carbon-dioxide products. Portions of the business are reminiscent of a monopoly, as Kinder Morgan owns every pipeline that transports energy goods to the West Coast of Canada.

The appeal of the business model is that the company does not have direct exposure to fluctuations in oil prices—it is the conveyer belt of the energy industry, and earns a fee on its transports whether the price of oil is $60 or $110. The catch, though, is that far-flung transportation plans get shelved when oil gets cheap, and Kinder Morgan is indirectly affected by lower oil prices as the amount of transported petroleum declines.

The exposure, however, is limited. Something like Conoco Phillips goes from $6 billion profits to $500 million losses during an oil bear market. That often leads to dividend freezes as the company has to borrow to pay the dividend and come up with production growth during a period when prevailing prices lead to losses. With Kinder Morgan, the decline is more modest: It went from making $2.10 in 2011 to $1.85 in 2015. The fluctuations in shareholder-owned profits is much more limited.

If current conditions persist, I would expect the projected 10% dividend growth to be more like 4-6% annual dividend growth. In the second quarter of 2015, Kinder Morgan will pay out $0.48 for a 6% dividend increase from the first quarter. This is what I would expect to see continue if oil prices do not improve.

Over the longer term, Kinder Morgan is expected to connect oil produced in the Marcellus Shale Region all the way to the Northeastern States. You may have heard this referred to as “The Palmetto Project.” If these transports happen by 2018, and oil is north of $80 per barrel at that time, you will see the 10% annual dividend growth that Richard Kinder publicly predicted during the initial stages of the merger. There is a clear path to high dividend growth: Experience a moderate uptick in oil prices, and see the current capital investments develop into what is expected of them.

Kinder Morgan is one of the more interesting oil and natural gas options out there right now. The yield is less than what you get with something like BP and Royal Dutch Shell, but there is an important countervailing force at play. Kinder Morgan needs much less of an oil price increase to support dividend, and 10% annual dividend hikes on average are within the realm of possibility. That is not something even remotely close to what Royal Dutch Shell could do—with Shell, you collect your 6.3% dividend yield, and act happy about that payout. The growth comes from what you do with that dividend payout. The Kinder Morgan investors receive a lower starting dividend yield, but will almost certainly earn a higher dividend growth rate that will eventually result in more absolute income once you stretch the holding period out 10+ years. Those are fun tradeoffs to evaluate because even the “wrong” answer will likely prove to be an intelligent allocation of capital 15+ years from now.

Originally posted 2015-06-09 00:00:51.

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