Note from Daily Trade Alert: Kinder Morgan is no longer a good dividend growth stock candidate. Dave Van Knapp updated readers of his opinions on KMI in this follow up article.
This month, we add another stock to the growing stable of Dividend Growth Stocks of the Month. This month’s company is a huge pipeline company.
The Kinder family of companies reorganized and converted themselves last year from a Master Limited Partnership (MLP) setup to a “regular” company. The name may not be familiar to you, but Kinder Morgan (KMI) is the largest energy infrastructure company in North America and the 3rd largest energy company overall.
Although their business prospects are not very dependent on the price of oil, KMI’s stock has been caught in the selloff of energy companies this year on the heels of the steep decline in crude oil prices. That presents a great opportunity for dividend growth investors, as will be explained below.
Kinder Morgan’s Dividend Characteristics
Kinder Morgan’s dividend resume is very good, but it does require some interpretation.
KMI’s yield, at 6.1%, speaks for itself. It is excellent, almost double the average yield of all Champions, Contenders, and Challengers.
KMI has increased dividends every year of its existence.
The Kinder Morgan family of energy infrastructure companies all got consolidated into KMI in 2014.
The predecessor companies had been around since 1997, increasing dividends every year.
So for our purposes here, I apply the company family’s 18 years of dividend increases to the younger KMI.
The 18 straight years of increases rate as Good on my scale. (It takes more than 25 years to be called Excellent.)
KMI is unusual in that it commonly increases its dividend more than once per year. So far this year, it has increased its dividend 2% in January, 7% in April, and 2% in July. That is already 11% this year, with a fourth payout scheduled in October. Even if they hold that dividend flat, the total 11% increase for the year is already very good.
The company is on record as targeting a 16% increase in dividends in 2015 and 10% annualized increases until the end of this decade. When the reorganization was announced late last year, Richard Kinder, chairman and CEO, stated that KMI would “have a projected dividend of $2.00 in 2015, a 16 percent increase over the anticipated 2014 dividend of $1.72 [, and] we expect to grow the dividend by approximately 10 percent each year from 2015 through 2020.”
If KMI actually gets to a 16% increase in 2015, I would rate that as Excellent. The increase in 2014 was 9%, which is Good.
Now let’s talk about the payout ratio. In July, Kinder Morgan stated the following in a press release:
KMI expects to declare dividends of $2.00 per share for 2015, an approximately 15 percent increase over the 2014 declared dividend of $1.74 per share. We expect to have substantial cash coverage in excess of our 2015 declared dividends….The overwhelming majority of cash generated by KMI’s assets is fee based and is not sensitive to commodity prices. [However,] KMI does have some commodity price sensitivity, primarily in its CO2 segment….Even adjusting for projected commodity prices, the company expects to increase its dividends by 10 percent each year from 2016 through 2020.
Payout ratios are easy to calculate but hard to interpret for capital-intensive businesses. They tend to appear very high, when in fact the company may have plenty of cash flow to sustain and raise its dividend. That is what KMI is stating is its situation for 2015 and the rest of the decade.
On the following chart, KMI’s cash flow is shown by the orange line and its dividend output by the light gray line. You can see that prior to 2015, KMI had plenty of cash to pay its dividend. The ratio gets higher this year, but dividends do not exceed cash flow, which would be an unsustainable situation.
This is kind of a spotty resume. Let’s break it down.
• KMI’s ROE record is inconsistent. In 1 year of the past 5, it delivered 18% ROE, while it has not broken double-digits in any of the other years. ROE is a measure of a company’s efficiency in converting the money invested in it into profits.
• The company’s earnings growth record is good. The 21% growth rate over the past 5 years is excellent, and the 2016 projection of +17% is good. I took this data from Capital IQ’s most recent report on KMI. Its 16 analysts comprised the most complete data set that I was able to locate.
• KMI’s debt/equity value of 1.3 is around average for all companies. The average for all Dividend Champions, Contenders, and Challengers is 1.6.
• S&P Capital IQ has not given a quality rating to KMI. The lack of a rating is neither a negative or positive indicator.
• S&P’s credit rating, at BBB-, is the lowest “investment grade” credit rating. That means that as an issuer of credit, KMI is considered to have adequate financial resources, but adverse economic conditions or changing circumstances could lead to a weakened capacity to meet financial commitments. This rating is not considered to indicate a speculative financial standing.
• Morningstar awards KMI a Wide Moat rating, its highest grade. That means that Morningstar believes that KMI has strong and sustainable competitive advantages compared to its peers. KMI’s advantages include its extensive pipeline and terminal network, sheer scale, and the toll-road nature of its business. Pipelines are regulated and are near-monopolies, very difficult for competitors to replicate.
How Does Kinder Morgan Make Money?
Kinder Morgan is known as a “midstream” energy company.
KMI is a pipeline and energy transportation company. It is the largest midstream and the 3rd-largest energy company in North America. It owns or operates about 84,000 miles of pipelines and 165 terminals. The pipelines transport natural gas, refined petroleum products, crude oil, carbon dioxide (CO2), and other materials. The company also stores or handles a variety of products and materials at terminals such as gasoline, jet fuel, ethanol, coal, petroleum coke, and steel.
The size and reach of KMI is almost overwhelming. For example, KMI is the:
• Largest natural gas network with 68,000 miles of pipelines. It is connected to every important U.S. natural gas source, and it moves about 1/3 of the natural gas consumed in America. Gas transport supplies over half of KMI’s revenue.
• Largest independent transporter of petroleum products, transporting about 2.3 million barrels of product per day, including gasoline, jet fuel, diesel, crude oil, and natural gas liquid.
• Largest transporter of carbon dioxide (CO2), transporting about 1.3 billion cubic feet per day.
• Largest independent terminal operator, with around 180 terminals. Liquids terminals store refined petroleum products, chemicals, and other liquids. Dry bulk terminals store and handle such materials as coal, petroleum coke and steel. Recently, KMI began moving into shipping, with 7 vessels in service and 5 more to be delivered from 2015-2017.
This map shows KMI’s reach with its pipelines and other facilities. There is hardly a state through which its pipelines do not go.
The business model is toll collector. In 2015, 87% of KMI’s revenue is based on fees collected for moving products. KMI’s customers include major oil companies, energy producers and shippers, local distribution companies, and other businesses across many industries. In most of its operations, KMI operates like a giant toll road.
This model generally avoids commodity price risk, the most pertinent of which is the price of crude oil. Unlike upstream and downstream energy companies, midstream companies get paid to move product. It usually does not matter much what the product actually costs, because the fees stay the same no matter what. The profitability of midstream companies depends more on the volumes of product moved than on the underlying prices of those products.
Growth comes from fee increases as well as increasing the size of the pipeline/terminal network. KMI has an extensive investment program to build new facilities, and it purchases other midstream companies or assets to add to its network and cash flows. Many investments are supported by long-term contracts for the movement of energy products.
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
FASTGraphs 1. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value.
For a closeup look at KMI’s valuation, here are the last two years of the chart displayed earlier, with KMI’s price (black line) plotted. Observe that it is more than two channels beneath the orange “fair value” line. That suggests that KMI is 26% undervalued at the moment.
You will note that I have used cash flow rather than earnings for the orange line. (That is denoted by the “C” marking the data points along the orange line.) Cash is the standard measure to use for capital intensive businesses such as pipeline companies.
FASTGraphs 2. The second valuation step is to compare KMI’s price to its “normal” long-term average price-to-cashflow ratio. Here is the same graph, with KMI’s normal average cashflow valuation shown in blue.
We can see that KMI has historically been assigned a lower valuation by the market than the average of all companies. The blue line is at a price/cashflow ratio of 10.5 rather than the 15.0 that we saw above. By this measure, KMI is fairly valued. Its price is 6% above fair valuation. Anything within 10% (plus or minus) I consider to be fairly valued.
Morningstar. Rather than using valuation ratios, Morningstar uses a comprehensive NPV (net present value) technique for valuation.
Many investors consider this approach to be superior to using P/E ratios. Morningstar makes a comprehensive calculation to project all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of the future earnings is considered to be the fair price for the stock today.
Unfortunately, Morningstar does not currently have a fair value ranking for KMI. So we do not get the benefit of their insight on Kinder Morgan’s valuation.
Current Yield vs. Historical Yield. My final step in valuation is to compare the stock’s current yield to its historical yield. It is better to be near the top of that range instead of the bottom.
As you can see, KMI’s current yield is at the very top of its historical range. That rates as very undervalued. You have never been able to buy KMI at a higher yield than exists right now.
I generally grade valuation on a 5-point scale for each factor. The grading scale looks like this:
Our valuation summary for KMI looks like this:
There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.
Beta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them when their price drops.
KMI’s beta of 0.7 indicates a relatively stable stock price compared to the whole market. That is a plus for this company.
The second miscellaneous factor is analysts’ recommendations. I get this information from S&P Capital IQ. Their most recent report on KMI shows that 18 analysts have rated the company. The average of their ratings is 4.3 on a 5-point scale, which is high (good). A rating of 4.0 is considered a “Buy” rating. Morningstar also polls analysts, and their 4 analysts give KMI a perfect 5.0 rating.
Kinder Morgan is a very attractive dividend growth candidate. Here are its positives:
• High quality company with sound business model.
• Largest energy infrastructure company in North America.
• Strong corporate culture of raising dividends, with a stated target of 10%/year increases through the end of the decade.
• Recent price weakness makes its yield a historically high 6.1%, the highest yield ever available from this company.
• Good valuation.
And here are its negatives:
• Forward profits could be negatively affected by its CO2 business segment.
• Market seems to treat it as an integrated energy company, with more dependence on the price of oil than its business model actually has. Of course, that is what makes it such a good value at the moment.
– Dave Van Knapp
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Disclosure: I hold KMI in my public Dividend Growth Portfolio and my wife’s and my private Perpetual Dividend Portfolio. It was also one of the first companies that I bought when I rolled over my 401(k) into an IRA earlier this year. Obviously, I like KMI as a dividend growth company. Just as obviously, I may be biased in KMI’s favor, but I have made every effort to be objective in this presentation.