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Kinder Morgan: Working to Deliver More Reliable Dividends

Since 1997, Kinder Morgan (KMI) has spent more than $60 billion building one of North America's largest midstream infrastructures, providing gathering, storage, transport, and processing services to the oil & gas industry.
Source: Kinder Morgan Investor Presentation
Kinder Morgan's immense footprint (84,000 miles of pipelines and over 150 distribution and storage terminals) means the company is vertically integrated into almost all parts of the North American oil & gas industry, including: 

  • Every major gas and oil shale formation
  • The liquified natural gas (LNG) export industry
  • The oil & gas export industry
  • The petrochemical industry 
  • Providing CO2 for enhanced oil recovery

Natural gas pipelines generate 61% of Kinder Morgan's EBITDA, and products pipelines (15% of EBITDA – transports refined products, oil, and natural gas liquids) and terminals (14% of EBITDA – oil and petroleum product storage network) are meaningful drivers as well.

Kinder Morgan's cash flow is also diversified by customer, with 69% of revenue coming from large utilities, refiners, chemical companies, and other energy producers. Counterparty risk is limited since over 60% of Kinder Morgan's revenue is also derived from investment grade customers.

Importantly, the vast majority of cash flow Kinder Morgan generates is supported by multi-year fee-based customer contracts and therefore is not directly exposed to commodity prices. The company's CO2 segment (10% of EBITDA – used in enhanced oil recovery projects) does have commodity price exposure but is hedged for the year ahead.

In total, about 95% of Kinder Morgan's cash flow is either under long-term (average interstate gas pipeline contract has 13.4 years remaining), fixed-rate, and take-or-pay contracts or hedged.

As a result, management estimates that every $1 change in the average crude oil price impacts the firm's distributable cash flow (DCF – similar to free cash flow for pipeline companies) by just $8 million, or about 0.2% of its total DCF. Kinder Morgan's sensitivity to natural gas prices is even lower. For each 10 cents per MMBtu that gas prices fall, the company's cash flow is expected to decline by just $1 million.
Source: investor presentation

Recently the price of oil was above $60 per barrel and natural gas prices were about $2.60. Even if their prices were (temporarily) cut in half from their current levels, Kinder Morgan's DCF would be expected to decline by about $265 million, or 5% of 2019's DCF guidance. The firm's DCF dividend payout ratio for 2019 is expected to be 45%, meaning that even such a drastic energy crash would not likely threaten the dividend's safety.

Kinder Morgan's small amount of commodity sensitivity is largely from its CO2 enhanced oil production and distribution business which generates 10% of the firm's cash flow. However, that business, while more volatile, has historically been the most profitable part of the company, generating substantial free cash flow and nearly 30% annualized returns on investment since 2000.

The company's stable cash flow profile should come as a relief for income investors because Kinder Morgan's dividend record is marred by a 75% cut in late 2015. The payout reduction was made necessary by the firm's dangerous debt levels and crashing share price (prior to the 2014-16 oil crash, Kinder Morgan funded its growth with large amounts of debt and equity). 

Since the oil crash, the company has shifted towards a self-funding business model (zero reliance on equity markets for growth capital), significantly reduced its debt (resulting in a credit rating upgrade to BBB or its equivalent by S&P and Moody's), and is once more growing its dividend in a sustainable manner. 

Business Analysis
Operators in the midstream industry often enjoy meaningful competitive advantages thanks to three main factors. First, the industry is highly regulated at the state, local, and federal levels. In addition, it's extremely costly (often billions of dollars) and time-consuming (an average of several years) to receive approval for and build new pipeline projects. 

Only so many pipelines are needed within a particular geographic area as well, often resulting in a consolidated market. Pipelines also have few substitutes given their safety and cost-efficiency, along with geographical constraints (many oil & gas formations are in hard-to-access areas). 

Add to this the fact that midstream infrastructure runs off a largely tollbooth business model, with many contracts being "take or pay" (over 90% in the case of Kinder). In other words, companies like Kinder Morgan are entitled to be paid a fixed amount by oil & gas producers for access to their pipeline and storage networks, regardless of energy prices and whether or not they actually ship product (assuming the energy producers are financially healthy enough to honor their contracts). 

This creates a relatively commodity price insensitive and stable stream of cash flow from which to pay meaningful dividends. 

Kinder Morgan was founded by Richard Kinder in 1997 and fit this profile for many years. Mr. Kinder, who owns 11% of the shares, launched Kinder Morgan with unwanted assets he bought for cheap from the now-infamous Enron. Over the next 22 years, Kinder used a combination of cheap debt, accretive Kinder equity, and the MLP structure he helped pioneer to build an energy transportation empire.

However, where Kinder Morgan went wrong was in being too aggressive with its growth, both in terms of assets and dividends. Specifically, Kinder became a dividend darling by retaining very little cash flow (it paid out over 90% of DCF as dividends) and taking on a lot of debt to grow its asset base as quickly as possible. 

This included a large amount of borrowing in 2014 to fund its $71 billion acquisition of its MLPs: Kinder Morgan Energy Partners, Kinder Morgan Management, and El Paso Energy Partners. That helped drive Kinder's debt to a high of $46 billion, just in time for one of the worst oil crashes history to decimate the shale oil industry. 

OPEC (an organization of 14 of the world's major oil-exporting nations who work together to "stabilize" the oil market), wary of U.S. low-cost shale producers stealing market share, threw open the production taps and caused U.S. oil prices to fall from a peak of $107 per barrel in mid 2014, to a low of $26 in January 2016. 

Fears of a slew of bankrupt shale producers defaulting on their contracts with Kinder Morgan caused the credit markets to freeze out the company (and many other highly-leveraged midstream players), triggering a liquidity crisis. 

In late 2015, Kinder Morgan faced an ultimatum from Moody's, the credit rating agency. The company would either have to cut its dividend, which management had guided for 10% annual growth through 2020, and use the cash flow to pay down debt or face a credit downgrade to junk status. That would have sent Kinder's future borrowing costs (and its cost of capital) soaring, threatening the economics of its future growth plans. 

So Kinder Morgan made the difficult but necessary decision to cut its dividend by 75% in December 2015, adopt a fully internally-funded business model (which requires no equity growth capital), and focus on deleveraging its bloated balance sheet. 

Since then Kinder Morgan has paid down over $8 billion in debt, part of which was from the sale of numerous non-core assets. With the firm's leverage now about in line with the industry average and expected to remain stable, Kinder Morgan's debt is no longer a dangerous dangerous albatross that threatens its future, nor is it likely to pose a threat to its dividend in the future. 

In 2017 Kinder Morgan announced it would once again start returning more cash to shareholders, via a 60% dividend increase in 2018, with further plans to raise that dividend by additional 25% increases in 2019 and 2020. In other words, 150% dividend growth over three years. The company also authorized $2 billion in share repurchases.

Kinder Morgan's ability to once more be generous with its shareholders is largely due to its internally-funded business model, which relies purely on excess DCF that is retained, and modest amounts of low-cost debt to fund its $6.1 billion growth backlog.

Over the past three years, Kinder Morgan has generated retained operating cash flow (cash flow minus dividends) of about $10 billion and expects to retain about $2.7 billion in cash flow in 2019. The company's scale and reasonably low payout ratio combined to generate a healthy amount of excess cash flow.
Source: Kinder Morgan Investor Presentation

Looking forward, Kinder Morgan expects its growth backlog to increase its cash flow significantly. About $4.3 billion of its $6.1 billion of projects is expected to be online by the end of 2023. Most of the firm's spending is slated towards natural gas projects with a focus on serving the gas takeaway needs of the Permian Basin, whose gas production is expected to about double by 2025, according to research firm WoodMackenzie.

To fund these opportunities, the company has $4.3 billion in borrowing power remaining under its revolving credit facility, in addition to the $2.7 billion in retained cash it expects to generate in 2019.

All of Kinder Morgan's projects are designed to generate returns on investment above its cost of capital, and 70% of the backlog is focused on projects with average projected EBITDA yields of 18% (DCF yields of about 12%). 

In other words, management appears to be focused on only the highest margin opportunities, rather than trying to grow at any cost. CEO Steve Kean explained Kinder Morgan's approach on the firm's first-quarter 2019 earnings call:

"We're very careful with your capital. We don't swing at every pitch. We definitely have our hits and misses....We get there by having elevated return criteria well above our cost of capital. We focused on projects that we understand and primarily focus on expansions off of our existing footprint. All of this helps us invest for returns that are well above our cost of capital and helps overcome the inevitable curveballs that come up during project execution."

Kinder Morgan's execution on its growth projects over the past three years has been successful, and management expects cash flow to rise 10% this year and by a similar amount in 2020.

Essentially, Kinder Morgan's focus on remaining within its circle of competence appears to be working thus far. While the company's growth backlog is much smaller (down about $16 billion since its peak in 2015), that also means the firm has less of a need to spend on growth.

The end result is higher retained cash flow to fund a safer dividend and maintain a reasonable amount of leverage. With that said, the company's lower backlog of projects doesn't mean that Kinder Morgan expects to be unable to grow at all.

As America's largest midstream company, the firm is well situated to benefit from the roughly $800 billion in new midstream infrastructure estimated to be needed by 2035, according to analyst firm ICF.

The U.S. Energy Information Administration also projects that domestic gas production will grow through 2050, driving higher demand for Kinder Morgan's assets. Overall, about 33% growth is expected in U.S. oil and natural gas production from 2017 to 2025.
Source: Kinder Morgan Investor Presentation
Simply put, North American energy production seems likely to continue benefiting from the fracking revolution for years to come, creating many opportunities for midstream firms to connect U.S. supplies to growing demand markets. 

Given Kinder Morgan's greater capital allocation discipline, plus the increased efficiency of many energy producers following the 2014-16 oil crash, the firm appears to have a good chance to capitalize on these favorable secular themes in a sustainable manner.

However, while the Kinder Morgan turnaround has been impressive thus far, there are numerous challenges and risks still facing the industry. 

Key Risks
The same strong regulatory environment that makes the midstream industry lucrative for incumbents can also serve as a risk to Kinder Morgan's growth.

For example, the Trans Mountain expansion, which at one point made up nearly half of Kinder Morgan's growth backlog of projects, was bedeviled by years of court challenges and costly delays.

The outlook got so bad that management decided to not only avoid completing the project, but sold the entire pipeline system to Canada's government. The timing was good since shortly later the project's approval was revoked by a Canadian court in August 2018 (and would have caused its value to plummet). 

This situation highlights one of the largest short-term risks for any midstream company: bringing projects to completion on time and on budget. 

Fortunately, Kinder Morgan's current backlog is focused on smaller, less costly, and less risky energy infrastructure projects. However, the point is that in the future Kinder Morgan investors might not be able to rely on major interstate and transnational pipeline expansion to drive sufficient cash flow growth to keep the dividend growing at historical rates.

After all, Kinder Morgan's massive size means each new growth project has a harder time moving the DCF per share needle. While the U.S. energy industry is likely to provide many opportunities for adding new projects to the firm's backlog, it's unlikely that the company can find enough profitable new opportunities to achieve its historical double-digit growth rates. 

Management plans to continue investing $2 billion to $3 billion per year in growth projects going forward, representing about 2% to 4% annual growth in the company's asset base. 

Combined with the company's payout ratio settling into a steadier state (up from 25% in 2016 to 45% in 2019), dividend growth beyond 2020 seems likely to slow to a low- to mid-single digit pace (3% to 5%). 

However, investors should note that the entire midstream industry has begun transitioning to a self-funding business model that's focused on much smaller but more sustainable dividend growth. 

For example, Enterprise Products Partners (EPD), one of the largest blue-chips in the industry with an asset footprint rivaling Kinder Morgan's, has cut its distribution growth rate to 2% and indicated it may remain at that level for the foreseeable future. 

While Kinder Morgan just delivered its 25% dividend hike for 2019 and says it will deliver another 25% boost in 2020, the company will likely retain its far more conservative capital allocation plan thereafter. Emphasis will likely be placed modest annual growth spending on new projects, and possibly aggressive share buybacks in lieu of fast dividend growth. 

Greater discipline is something that many large midstream companies and MLPs have mentioned in recent years, due to their share prices remaining persistently weak following the oil crash. 

Essentially, the investment thesis for midstream businesses once focused on a combination of high-yield and fast payout growth but has now shifted towards high-yield and slow but safer and more sustainable growth (essentially becoming energy infrastructure utilities). 

Finally, investors should remember that the long-term thesis for Kinder Morgan relies on the U.S. energy renaissance actually happening, which seems likely but is not guaranteed.

Oil & gas prices are commodities set on largely global markets and driven by both supply and demand. Strong long-term energy prices assume rather steady global economic growth driving greater demand for oil & gas.

According to the International Energy Agency, almost 60% of long-term oil & gas demand growth is expected to come from India and China alone. But that kind of growth is based on models that assume sustained high economic and industrial growth rates for many decades. Growth is rarely linear in these emerging economies, and there will certainly be bumps along the way.

Additionally, the world appears to be gradually but steadily moving towards renewable energy, largely a function of concerns over climate change. 

While the Paris Climate Accords may not represent as large a threat to the oil & gas industry as some investors fear (thus far almost no countries are actually making significant efforts to achieve their promises), renewable energy is the fastest growing source of power in the world, and expected to remain so.

In fact, the U.S. Energy Information Administration expects electricity generation from renewables to increase its market share from 18% in 2018 to 31% in 2050. However, most organizations expect oil and gas to remain important energy sources.

For example, the International Energy Agency (IEA) expects oil and gas to remain the primary source of world energy in 2040 with 48% share (down from 54% in 2016), even if the world's countries achieve their Paris Climate Accord targets. 
Source: Chevron Investor Presentation

No one knows what the global energy landscape will look like a decade from now, much less in 2040. However, as with any midstream company, Kinder Morgan's long-term growth runway could end up being somewhat shorter than investors expect if global oil and gas demand comes in below expectations. This isn't something to worry about today, but the evolution of energy should continue to be monitored.

Closing Thoughts on Kinder Morgan
Kinder Morgan was a painful lesson for many income investors that even apparently "safe" dividends as advertised by management are not guaranteed. The company maintained a weak balance sheet and had enough customers' fates tied to volatile commodity prices, ultimately resulting in a liquidity crisis that forced a large dividend cut at the end of 2015. (Kinder Morgan's Dividend Safety Score was firmly in our Unsafe bucket with a score of 8 prior to its dividend cut.)

Fortunately, management appears to have learned its lesson, and Kinder Morgan's days of dangerous debt levels look to be behind it. And while the company's backlog isn't ever likely to allow for a return to the strong growth days of the past, the firm's stable cash flow, diversified operations, and conservative payout ratio mean that the business can still make for a potentially decent higher-yielding dividend growth stock to consider. 

However, before deciding to invest in Kinder Morgan or any midstream stock, investors should understand that these operators face project execution risk and can experience short-term share price volatility (tied to energy prices even if they don't affect cash flow much), even those with self-funding business models.

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