Kinder Morgan: Wait For A Pullback

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


Kinder Morgan reported quarterly results that missed consensus, though management did increase the dividend, leaving it on pace for 8% annual growth.

KMI derives the majority of its cash flow as the GP of EPB and KMP, which each have slowing growth rates.

With high leverage and slowing growth, investors should wait until KMP yields at least 5% before buying.

After the bell on Wednesday, Kinder Morgan Inc (NYSE:KMI) reported quarterly earnings that missed expectations, but management did decide to increase the quarterly dividend. With this push and pull from weak results but a higher dividend, some investors decided to take profits with shares trading off by about 0.5% in the after-hours session. Now, KMI is an interesting company because it functions like a holding company, dependent on the fees it generates from two operating companies, which happen to be publicly traded. These companies are Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipeline Partners (NYSE:EPB). As the general partner of each MLP, KMI operates them and is paid handsomely based on their performance. It then returns the majority of the cash flow it receives to its shareholders. In this sense, KMI's performance is dependent on the performance of KMP and EPB.

In the second quarter, KMI earned $0.27 on revenue of $3.93 billion while the street was looking for $0.28 on revenue of $3.78 billion (financial and operating data available here). Revenue was up 16% year over year, and EPS was flat. KMI increased its dividend by $0.01 sequentially to $0.43 and remains on track for 8% annual dividend growth in 2014 to $1.72. Now, net income obviously includes non-cash items, so KMI provides another measure, cash available to pay dividends. This figures was up 13% year over year to $332 million. On a per share basis, this comes to $0.32, which is well below what the company is paying out. This is indicative of KMI's aggressive financial policy that prioritizes paying out as much as possible. KMI's business is also seasonal with the second and third quarters relatively weak. For the full year, KMI should be able to fully cover its dividend.

KMI receives gross cash payments of $719 million, which after expenses and taxes leaves $332 million for dividends. El Paso accounts for $119 million of that sum, half of which comes from distributions on the limited partner units KMI owns. The other half comes as compensation for being the general partner. In particular, the GP gets something called incentive distribution rights ("IDR"), which is essentially a proportion of cash flows, similar to how many hedge funds charge 20% of performance. In theory, the IDR incentivizes a general partner to run the MLP as well as possible. However, KMI now gets 50% of incremental cash flow even though it puts up no incremental capital. This is a great deal for the GP, though there is definitely a case that this structure is too friendly to the GP at the expense of limited partners. Fortunately, limited partners cannot really change the partnership agreement, making a cut in IDRs very unlikely.

Compensation from El Paso is up 10% year over year, but this company has run into some problems with its exposure to the weaker Gulf market and a lower contract rate at its Wyoming pipeline network. As a consequence, I expect payments from EPB to be up 0-5% from the current level during the duration of the year. Relative weakness at EPB will slow the rate of KMI's growth. Rising leverage at EPB could also pose longer term problems beyond 2015 unless EPB is able to reaccelerate its business, which remains to be seen.

KMI's role as GP accounts for 88.6% of the $542 million it receives from KMP. KMP is spending aggressively to accelerate growth, which is slowing towards the mid-single digits. These expansion projects should help to increase the IDR that KMI receives. While this payment was up 11% year over year, it should slow down as KMP's growth slows down. I expect IDR payments to grow by closer to 8% in the second half of the year. With a backlog that faces delays and the law of large numbers making growth harder given KMP's relatively large size, high-single digits is likely to be the growth rate for KMI's IDRs in the next three years. Additionally, KMP's CO2 business requires an outsized amount of cap-ex for limited production growth, which will slow growth while adding debt.

In addition to dividends, KMI has been repurchasing shares and outstanding warrants, which brought its diluted share count down by 1% from a year ago. KMI is dependent on the MLPs it manages for its cash flow, and they are not performing perfectly. EPB is in poor geographies with lower contract rates, which will keep growth at a minimum for at least another year. KMP is a maturing MLP with growth that is moving closer to 5%, and this lower growth rate at the partnership will translate to slowing growth in KMI's payments. As a consequence, dividend growth should be about 8% this year and slightly lower in 2015.

It is also important to note that KMI carries about $9.3 billion in debt. KMI will either need to pay this debt down and refinance it, likely at a higher rate than the current 4.3% average, which will subtract from cash available for dividend payments. I expect KMI to start allocating some cash to bring leverage back towards 4x EBITDA from the current 5+x EBITDA. This is a necessary deleveraging, but it will also further slow distribution growth. With KMI's operating companies offering mediocre performance and a fair amount of debt, I see limited upside from here. Above $35, I would be a seller of KMI. The 4.6% dividend does not compensate for the slowing growth rate at the company.

Investors in equity are only getting paid 0.3% more than KMI bondholders this year. Of course, there is the potential for dividend growth, but investors in equity are lower in the capital structure, thereby making cash flows more volatile and losses greater in a downturn. Bonds also carry a maturity date while equity is perpetual. As such, I would wait for KMI to yield at least 5% before considering its stock. Its IDR payments give it solid cash flow, but the stock is a bit expensive at current levels.

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