How Kinder Morgan Is Covering Dividend Increases

About: Kinder Morgan, Inc. (KMI)
by: Callum Turcan

Kinder Morgan recently released guidance for 2019.

The company plans to allocate more capital towards growing its asset base and boosting its dividend payments, all while still living within its means (more or less).

Rising cash flow generation makes this possible.

Divestment proceeds are going towards debt reduction instead of share buybacks.

The planned dividend increase in 2019 will push the yield on Kinder Morgan's shares up to 6%.

Kinder Morgan, Inc. (NYSE:KMI) was one of the first giants of the oil & gas industry to release financial guidance for 2019. The company remains committed to raising its per share dividend by 25% to $1 in the first quarter of 2019, and management has a strategy to make that fiscally possible. Readers should note that will boost the yield on shares of Kinder Morgan up to 6% from 4.8% as of this writing. Let's dig in.

Evaluating Kinder Morgan's expected cash flow position

Management estimates that Kinder Morgan will generate $5.0 billion in distributable cash flow next year, up almost 10% from the $4.6 billion in DCF the company is forecasting for 2018. The midstream giant's growth-related capital expenditure budget is set to rise by 24% to $3.1 billion next year, up materially from its 2018 budget of $2.5 billion. Note Kinder Morgan increased its 2018 capex budget by $0.3 billion from its original forecast in light of the ongoing boom in American energy production.

Before taking share buybacks and after taking the expected payout increase into account, Kinder Morgan will spend roughly $1.9 billion next year on its dividends. The company also spends $0.2 billion per year covering its preferred dividends.

Distributable cash flow shouldn't be confused with free cash flow. DCF is a non-GAAP figure that is derived by taking Kinder Morgan's net income, adding back non-cash charges and adjusting for various other effects (DD&A is the biggest factor here, followed by differences in book taxes versus cash taxes), and then subtracting sustaining capital expenditures from that figure.

Sustaining capex is not considered a part of Kinder Morgan's growth capex budget. Based on its performance during the first three quarters of 2018, it appears Kinder Morgan is projected to spend around $0.6 billion this year on sustaining capex.

Management is more or less targeting free cash flow neutrality in 2019, but there isn't a buffer that will allow the firm to build up its cash pile. Distributable cash flow of $5.0 billion would come close to covering $2.1 billion in dividend payments (common and preferred) and $3.1 billion in growth-related capital expenditures.

Growth runway

Being able to simultaneously boost its growth capex and dividend payments, while remaining free cash flow neutral (more or less), is a product of Kinder Morgan's cash flow growth.

Kinder Morgan expects to turn the Elba LNG export terminal online during the first quarter of 2019, which will be steadily ramped up to its peak production capacity by the end of the year. Two Permian gas pipeline projects - the Gulf Coast Express (due to be operational in October 2019) and the Permian Highway Pipeline (due to be operational by late-2020) - will keep the momentum going. These projects, among many others, are part of the firm's $6.5 billion project backlog. New developments are added every quarter due to favorable macro conditions in the natural gas industry.

Kinder Morgan Inc Project Backlog

Source: Kinder Morgan

Bringing cash back home to retire debt

Back in the middle of last year, Kinder Morgan approved a $2.0 billion share buyback program that began in December 2017. Through the end of the third quarter of 2018, the company spent $0.5 billion repurchasing 27 million of its common outstanding shares. This leaves plenty of room left for additional buybacks, and during Kinder Morgan's Q3 2018 conference call, management noted:

"I'll say again that we continue to believe that our current share price is an attractive value for share repurchases."

However, even though management indicated share repurchases are attractive at current prices, it is clear the company would prefer to allocate capital towards improving its debt metrics. This is a much better strategy than share repurchases in my opinion.

After Kinder Morgan Canada (which Kinder Morgan owns 70% of) sold off the Trans Mountain crude oil pipeline and the related expansion project to the Government of Canada for 4.5 billion CAD (3.4 billion USD as of this writing), Kinder Morgan decided to redistribute that cash back to the parent company. The firm expects to receive about 2 billion USD as part of this maneuver, all of which will be used for debt reduction. Management commented:

"We revised our debt to EBITDA target down from 5.0 to approximately 4.5 times with the KML announcement regarding use of proceeds and KMI's announcement that we will apply KMI share approximately $2 billion U.S. to debt reduction. We are achieving our leverage target."

At the end of the third quarter of 2018, Kinder Morgan had a net debt-to-EBITDA ratio of 4.6x (not including cash held by Kinder Morgan Canada that will be distributed back to public investors), a nice improvement from the 5.1x net debt-to-EBITDA ratio the company sported at the end of 2017. Kinder Morgan won't receive the proceeds from Kinder Morgan Canada until January, so this particular catalyst won't come into play until next year.

Readers should keep in mind Kinder Morgan was targeting a net debt-to-EBITDA ratio of 5.1x by the end of 2018 as of December 2017. A net debt-to-EBITDA ratio below 4.5x is considered healthy in the midstream stream, so this is a very welcome development.

Management was happy to tout that "all three ratings agencies have provided formal notification that our credit ratings are on positive outlook for an upgrade, and S&P announced they expect to raise our rating in January." There is a lot to this, as a better credit rating combined with a smaller debt load and improving coverage metrics makes refinancing a lot less painful.

In a rising interest rate environment, Kinder Morgan will be forced to refinance its debt burden at higher rates. The only way to really put downward pressure on rising interest expenses is to pay down debt, but, having a better credit rating (generally) reduces the risk premium creditors demand (which offers marginal to modest upside in this situation).

At the end of Q3 2018, Kinder Morgan had $37.1 billion in total debt. $2.3 billion of that is due within a year, and that includes the $0.7 million KMI has drawn against its $5 billion revolving credit line. The revolving credit line matures in November 2019, which Kinder Morgan will likely extend in some fashion or another.

Considering the revolving credit line carries a relatively low rate of interest (around 3-3.6%) compared to Kinder Morgan's senior notes, the company may prefer to direct its $2.0 billion cash infusion towards paying off higher interest-bearing securities while its revolving credit line is refinanced through borrowings on a new facility. As an aside, it is important for Kinder Morgan to retain access to large amounts of liquidity as part of its normal business operations (unexpected midstream opportunities aren't cheap).

Final thoughts

Kinder Morgan's 2019 strategy leans on five things: allocate larger amounts of capital to growth projects, steadily grow cash flow generation, follow through with promised dividend increases, focus on improving debt coverage metrics, and free cash flow neutrality. That is a solid strategy, and one that will make Kinder Morgan a fundamentally stronger company in the years ahead.

Increasing its dividend yield up to 6% will make KMI a much more attractive income investment, but the company needs to keep chipping away at its debt load. Thanks for reading.

Disclosure: I/we 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.