Kinder Morgan Is Fairly Valued

Apr.17.14 | About: Kinder Morgan, (KMI)

Summary

Kinder Morgan increased its quarterly dividend by $0.01 to $0.42.

KMP continues to perform well, but comparably weak EPB results are dragging down KMI's growth.

With slowing dividend growth, investors should wait for a pullback before buying KMI.

Kinder Morgan (NYSE:KMI) reported quarterly earnings that were a bit disappointing after the bell on Wednesday, and shares pulled back by about 1.5% as a result (financial and operating details available here). Net income actually fell by about 1.7% year-over-year to $287 million, and EPS of $0.28 missed expectations of $0.33. However, KMI is a stock owned primarily for the dividend and potential dividend growth, which is why investors tend to focus primarily on cash flow rather than net income.

Cash flow did show a somewhat better picture. Cash available to pay dividends rose to $573 million in the quarter, up from $513 million a year ago. As a consequence, KMI hiked its quarterly payout to $0.42. This payout is up 11% year-over-year, but only up $0.01 from the fourth quarter of 2013. For all of 2014, management continues to guide to a payout of $1.72. Importantly, KMI is paying out less than it could. Cash available for dividends per share came in at $0.55 in the first quarter, and KMI has been using excess cash to opportunistically repurchase shares. During the first quarter, KMI repurchased about 2.8 million shares.

While KMI grew its dividend substantially year-over-year, the pace of dividend growth is beginning to slow, which has put downward pressure on shares. This quarter is unlikely to alleviate that concern. Given KMI's 2014 dividend guidance, investors should look for two $0.01 quarterly hikes over the next three quarters. KMI yields a solid 5%, but that dividend growth is not nearly as robust as once hoped. This slower dividend growth is driven by the performance of KMI's businesses.

Kinder Morgan generates the vast majority of its cash flow in its role as the general partner ("GP") of two master limited partnerships ("MLP"), Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipelines (NYSE:EPB). As GP, KMI manages and operates these MLPs. In return, it is paid incentive distribution rights ("IDR"). IDRs are essentially a proportion of cash flow, analogous to how a hedge fund charges a fee based upon its performance. This system attempts to align the interest of general and limited partners as the GP is paid more the better the MLP performs.

Now, KMI is paid very well for its role as GP, and it now receives 50% of all additional cash flow generated by KMP and EPB. As a consequence, if you are extremely bullish on these MLPs, KMI is a wise investment, as it is paid increasingly more. Conversely, if cash flow were to decline at its MLPs, KMI would be disproportionately hurt. KMI is reliant upon the performance of KMP and EPB to grow its quarterly payout. While KMP continues to drive higher results for KMI, EPB has been a weaker performer, which is a reason why KMI's growth rate is slowing down.

In its role as GP, KMI received $467 million from KMP, up 13.3% year-over-year. In addition to its role as GP, KMI owns a limited interest in KMP. As a consequence, KMI received $527 million in total from KMP, which was up 12.6%. El Paso is struggling from a lower contract renewal rate in its Wyoming system, and this will drag on results for the duration of 2014. Total compensation from EPB was $115 million in the quarter, up 9.5% year-over-year. EPB will be holding its quarterly distribution flat at $0.65 over the next three quarters, so KMI's cash flow from EPB will be somewhat stagnant going forward.

Moreover, KMI is dropping down (selling) its stake in the Ruby Pipeline and gas storage to EPB this year. KMI will receive cash for these drop downs, but it no longer will directly receive the cash flow these assets generate. Instead EPB will, though some of the cash will flow back to KMI through the IDRs. These drop downs will make EPB look healthier than it is and will be a mild headwind on KMI's cash flow. KMP should continue to increase its payout this year, which means KMI will receive more, but EPB will likely hover around current levels for the next 9-18 months. Until and unless EPB can resume meaningful growth, KMI's dividend growth will be less than 10% in each of the next two years.

Investors should also note that KMI carries about $10 billion in debt. With its current market capitalization of roughly $34 billion, KMI is certainly not an overly-indebted company, but rising rates during refinancing could put downward pressure on cash flow for dividends. There has been some speculation as well that KMI should consider merging with KMP, though this debt load could make a deal more complicated. At this point, I do not foresee a merger over the next 12 months.

Overall, KMI continues to be a solid dividend growth stock, but that growth rate is certainly decelerating. Nonetheless, a 5% yield is nothing to sneeze at. KMP continues to perform well, and KMI's IDRs are increasingly valuable. However, problems in Wyoming could weigh on EPB's results over the next few quarters. KMI is paid handsomely to manage EPB, but significant growth in this payment is unlikely until 2016 at the earliest. Given the problems at EPB and the deceleration at KMI, I think a 5% dividend is not too far from fair value. I would wait for shares to trade back below $32 before buying KMI and would rather own KMP thanks to its 7% yield.

Disclosure: I am long KMP. 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.