Well, it happened — Kinder Morgan (KMI) bowed to the inevitable and slashed its dividend by 75% after hours on Tuesday.
Interestingly, KMI stock popped on Wednesday, as investors seemed genuinely relieved that the uncertainty surrounding the stock is finally over.
Normally, I would run away screaming from a stock that had just slashed its dividend by 75% because that is a sure sign of financial distress.
But what we have in Kinder Morgan is less a matter of a company in peril and more a case of a company restructuring how it is financed.
Kinder Morgan is not a master limited partnership, but it essentially operates and finances itself like one. And in the standard MLP formula, the vast majority of free cash flow gets paid out as dividends (or “distributions” in MLP parlance).
Growth projects are funded by issuing new shares or new debt. This is because of the quirks in the tax code that force MLPs to distribute the vast majority of their earnings to shareholders, but a side effect is that it effectively gives the market a “vote” on each major new growth initiative.
It was a fine system that served the midstream MLP space well for the better part of two decades … right until it didn’t. With market sentiment souring on all things related to energy — and with Kinder Morgan already highly leveraged — the market voted a resounding “no.”
I should be clear on something here. I’m not a believer in market efficiency, nor do I believe that the all-knowing, god-like market “predicted” a dividend cut at KMI. I believe it is far more accurate to say that markets create self-fulfilling prophecies; the market had already pushed the stock down, all but forcing Kinder Morgan to cut its dividend.
In the case of Kinder Morgan, we do not have a company in distress. We have a healthy company with an impressive cross-continental network of essential pipelines that is now in the process of reorganizing the way it is financed.
The market has decided that it no longer likes the traditional MLP funding model, so Kinder Morgan is transitioning into more of a typical corporate model in which new growth projects are financed with retained earnings.
Last week, in response to its share-implosion and the threat of credit downgrade, KMI made the following statement:
“KMI has now completed its 2016 budget process and expects to generate 2016 distributable cash flow of slightly over $5 billion, which would be sufficient to support dividend growth in the range discussed in the third quarter call. Alternatively, this cash flow can be used to fund some or all of KMI’s equity needs for 2016.” [Emphasis mine]
Well, that’s what it did. Kinder Morgan opted that it is in the best interests of its shareholders to use its cash flow to fund growth, as this will ultimately lower the cost of capital and make KMI more profitable.
And as a result, according to a late Tuesday release, Kinder Morgan will have no need to access the capital markets for “the foreseeable future.”
Founder and Chairman Richard Kinder is taking some heat from shareholders used to collecting KMI’s fat and growing dividend. But Kinder shouldn’t be attacked here — he should be applauded.
A chairman less concerned about the wellbeing of his shareholders might have simply issued new stock at today’s gutter prices, massively diluting the shareholders in the process. Given the situation, Kinder made the right move.
So what does this say about the prospects for KMI stock?
Investors were accustomed pricing KMI stock based on dividend yield alone, and by that metric, KMI is looking a little skimpy. The new dividend works out to a yield of about 3% at current prices. But looking beyond yield, there is a lot to like here.
KMI has wide moats around its businesses: Its natural gas pipelines are essential to the functioning of the American economy, come what may with energy prices. The company budgets an increase in distributable cash flow (a profit metric common to MLPs) of 8%. And it’s worth noting that it grew DCF modestly this year, despite the brutal selloff in energy.
At today’s prices, KMI stock trades at book value and is about as unloved as a stock can be. I’m long the stock and expect it to do well from here.
And here’s one more point to consider: The dividend is not likely to stay low forever. Richard Kinder earns just $1 per year in salary. The rest of his compensation comes from the dividends generated off of his massive hoard of KMI stock.
Kinder probably didn’t like taking a 75% haircut, so you can bet that he’ll be looking to raise the dividend over time. It might be a while before it’s over $2 per share again. But it will get there.
As of this writing, Charles Sizemore was long KMI.