When a Dividend Cut is Good News

The story I’m about to share with you today is one I’ve shared with my High-Yield Investing premium subscribers before. But I think it bears repeating, because something big and entirely unexpected happened a couple of weeks ago, and few investors noticed.

And to put it simply, the implications could be huge for many income investors.

[ad#Google Adsense 336×280-IA]But more on that in a moment…

The day before Thanksgiving in 1996, Rich Kinder left his post at Enron.

He was disappointed that Kenneth Lay had passed him over for the CEO job.

Soon after, an old college buddy, Bill Morgan, approached Kinder with a business proposition.

Morgan had just bought some assets Enron had no use for: a couple of small pipeline systems and a coal terminal.

He needed someone like Kinder to run the business. Kinder agreed, and the partnership was christened Kinder Morgan Inc. in February 1997.

Kinder doubled the company’s market capitalization to nearly half a billion dollars by watching costs and shipping more volume through the pipelines.

He did all of that in just seven months.

Today, Kinder Morgan Energy Partners (NYSE: KMI) is a $35 billion business, operating more than 80,000 miles of pipeline and roughly 180 terminals throughout the United States.

Master limited partnerships — usually referred to as MLPs — had already been around for decades, but it took someone like Rich Kinder to transform this asset class from a passive holding company into a dynamic investment vehicle.

In the mid-1990s, Kinder Morgan was one of only a handful of master limited partnerships, which together totaled roughly $2 billion in market value. Today, there are dozens of actively traded MLPs with a total market cap of over $100 billion.

These Reliable Income Investments Are Now In Trouble

Lately, as oil prices have slipped below $40 a barrel, the entire MLP class has left investors feeling the pain.

Several weeks ago, Kinder Morgan slashed its dividend to $0.13 per share from the previous $0.51, a 75% reduction. But that’s not the unexpected part. Investors have actually been bracing for this for some time.

What I found fascinating was the market’s reaction. Ordinarily, a dividend reduction elicits a hostile response (especially a cut this deep). You could reasonably expect Kinder Morgan shares to be massacred on the news. Instead, the stock actually opened higher and rebounded 7% the following day — gaining as much as 10.4% at one point.

This could prove to be momentous turning point — not only for Kinder Morgan, but for the entire MLP space.

When is the last time you saw a stock rise 10% on a dividend cut? It would seem MLP investors are finally remembering that share prices don’t just reflect what a company looks like today, but also its earnings potential tomorrow.

Nobody likes a dividend cut. But KMI had already lost two-thirds of its value, plunging from $45 to $15 this year. So the punishment preceded the crime. And the company is still expecting to generate $5 billion of distributable cash flow next year. By lowering dividends temporarily, management can now direct the excess cash toward growth initiatives — much better than issuing new equity at depressed prices or taking on more debt that would have led to a credit downgrade to junk status.

I’ve avoided Kinder Morgan in the past, partially because of the convoluted ownership structure, but also because of its massive $41 billion debt burden. But reducing dividends in this difficult climate will save the company $3.2 billion a year, preserving its investment-grade credit. Furthermore, it won’t have to tap the equity markets until 2018.

I’m an unabashed lover of dividends. But there are times when a company needs to divert some of its cash somewhere else. This is indeed one of those times. Kinder Morgan could either maintain the dividend or invest in new midstream expansion projects to grow future cash flows. But not both.

Clearly, it chose the latter — and that was the smart move. Better to take some medicine today (even if the taste is foul) if it means restoring financial health tomorrow. The fact that investors cheered this move means many agree.

I’m still not buying Kinder Morgan, but I would say that it’s much more worthy of my investment dollars today after this cut than it was in the weeks before (especially now that the bad news is out in the open).

Now here’s why this is important to income investors…

This won’t be the last MLP to reset its distributions to a level more compatible with sub-$40 oil. If you own shares of any MLPs, then hopefully none of your holdings will need to take such measures.

Either way, I’m encouraged that Kinder Morgan’s decision was viewed as a prudent redirection of cash and an opportunity for a fresh start. Instead of a negative kneejerk reaction, investors rewarded the stock with its biggest daily gain in 16 months.

This could suggest a changing mindset for this unique, but out-of-favor group. Master limited partnerships have steadily churned out double-digit gains for years, despite volatile commodity prices. But right now, the management of many of these companies are faced with some tough decisions.

Until the picture gets clearer, I’m remaining largely on the sidelines.

— Nathan Slaughter

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Source: Street Authority