Don't Look At Kinder Morgan's Payout Ratio

Apr.25.13 | About: Kinder Morgan (KMP)

There's a lot to be said at Kinder Morgan (NYSE:KMP), but let's talk about its distribution. We think pipeline firms are excellent examples of the shortcomings of using a payout ratio - almost all of the MLPs (master limited partnerships) have distribution payout ratios above 1. They are simply different business structures compared to corporations, and using the same mousetrap for everything is a recipe for disaster. However, there is usually one constant when it comes to stock analysis, and that is cash flow. Let's see how well Kinder Morgan covers its distribution with cash.

Structure of the Oil And Gas Pipeline Industry

Firms in the oil and gas pipeline industry own or operate thousands of miles of pipelines and terminals - assets that are nearly impossible/uneconomical to replicate. Most companies act as a toll road and receive a fee for transporting natural gas, crude oil and other refined products (and generally avoid commodity price risk). Though there is much to like, most constituents operate as master limited partnerships and pay out hefty distributions that can stretch their balance sheets. Additional unit issuance (dilution) has become common, and capital-market dependence is a key risk.

Investment Considerations

Kinder Morgan is the largest midstream company in North America and owns thousands of miles of pipelines and terminals that would be difficult for new entrants to replicate.

Return on Invested Capital

Kinder Morgan Partners' annual yield is excellent, offering just under a 6% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Kinder Morgan Partners fits the bill.

We think the safety of Kinder Morgan Partners' distribution is good. Please note that we make this statement, despite its payout ratio being significantly above 100% (or 1). We measure the safety of a company's dividend or distribution in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future. Further, it's important to remember that earnings are an accounting measure, and cash is the most important indicator of dividend coverage.

That has led us to develop the forward-looking Valuentum Dividend Cushion. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. We make some adjustments for MLPs, adding back cash related to future equity issuance, but the concept is the same. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend payer has in boosting the distribution in the future. For Kinder Morgan Partners, this score is 1.4, revealing that on its current path the firm can cover its future distributions with net cash on hand and future free cash flow.

Now on to the potential growth of Kinder Morgan Partners' distribution. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the distribution. However, such growth analysis is not complete until after considering management's willingness to increase the distribution. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate and a nice dividend cushion, its future potential dividend growth would be excellent, which is the case for Kinder Morgan Partners.

And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Kinder Morgan Partners' case, we currently think the shares are fairly valued, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, we like the potential growth and safety of Kinder Morgan Partners' dividend. And we're holding strong in the portfolio of our Dividend Growth Newsletter.

Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: KMP is included in the portfolio of our Dividend Growth Newsletter.