Shares of Kinder Morgan Inc (KMI) are getting punished on Tuesday, falling nearly 6% as investors digested the company's guidance (available here). KMI is down 6.4% on the year, drastically underperforming the S&P 500's 25% rally. After this underperformance, KMI now yields 5%, making income oriented investors interested in the company, which derives much of its revenue from its general partner interest in Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB). After looking through the guidance of the Kinder Morgan family of companies, I believe that investors would do best by rotating out of KMI.
KMI expects to pay a dividend of $1.72 in 2014, up 8% from 2013's $1.60. While this might seem like a nice bump, analysts had been looking for even more with a consensus 2014 dividend of $1.78. That is a pretty sizable miss, which has likely spooked investors looking for double-digit growth. It is important to consider why KMI is missing expectations so notably and expecting a deceleration of its growth. Kinder Morgan generates much of its revenue from general partner fees tied to the performance of KMP and EPB. KMI also has sizable limited partner stakes in KMP and EPB, receiving their distributions. In many ways, KMI can be seen as a levered play on KMP and EPB, doing exceptionally well when the partnerships perform well but poorly when they disappoint.
KMI owns 9% of KMP units and 13% of Kinder Morgan Management (KMR), which is an LLC that owns KMP units. Together, Kinder Morgan owns about 10% of Kinder Morgan Energy Partners, a stake which is worth roughly $3.5 billion. As detailed here, KMP is poised for a strong 2014 with distribution growth of 5-6%, which will help to power KMI's results higher.
However, KMI also owns 41% of EPB, a stake that is worth about $3.3 billion, and EPB is not faring nearly as well. As detailed here, its distribution will be flat at its current pace of $0.65 in 2014. If not for asset dropdowns (when the General Partner sells assets to the Partnership), results would be even worse due to declining rates at its Wyoming unit. While these dropdowns will keep the distribution stable at EPB, KMI will no longer own the assets, instead owning the 41% of EPB that owns them. While KMI will receive payment for them, its future cash flow generation will be lower, offset partially by the relatively higher EPB distribution.
While results at KMP will be great for KMI, results at EPB will be a drag, which is why the projected dividend is below investors' expectations. It is important to note that while the dividend represents 8% growth from the cumulative 2013 payout KMI has been increasing its dividend during 2013. As a consequence, its most recently declared dividend was $0.41. A $1.72 annual payout implies an average dividend of $0.43 in 2014, which is only 4.9% above the current payout. Again while KMI is increasing its dividend, it is doing so at a decelerating pace, which is worrisome. With issues at El Paso likely to persist at least through 2016, KMI will see a lower rate of dividend growth for some time with 5% potentially the new norm.
It is also worth noting that KMI has been aggressively repurchasing May 2017 warrants (strike price $40) associated with the EPB acquisition. If the stock fails to hit $40 by then, these warrants are worthless, meaning that any dollar KMI spends to buy them back is a dollar fully wasted. Moreover as the stock falls, the warrants are worth less (as the probability of KMI reaching $40 declines). Over the past few months, KMI has been buying these warrants, and I would rather see the company focus its buyback solely on the stock, which will certainly be accretive for investors. For a company that is typically extremely shareholder friendly, I think the focus on the warrants has been a sub-optimal allocation of shareholder resources.
Therefore, the drop in KMI is justified as the company is forecasting pretty disappointing results in 2014 with pretty mediocre dividend growth. Unfortunately, KMI has a lot of exposure to EPB, which is dragging down overall results despite continued strong performance at KMP. Until and unless EPB can regain some pricing power, its distributions will remain lackluster, which hamstrings the potential dividend increase at KMI especially as it drops down more assets to the partnerships. While I appreciate the appeal of a 5% dividend yield, decelerating growth has me concerned, and I expect the stock to be dead money for some time. While KMP does pay hefty general partner fees, I would rather own KMP than KMI because it is unexposed to EPB. EPB is undermining the KMI bull thesis, and KMI investors are likely to remain disappointed over the next 12 months.