In the summer of 2017, Kinder Morgan Inc. (NYSE: KMI) announced huge dividend increases, representing a 60% increase for 2018 and 25% after that. That sounds very generous! But, for long-term shareholders, those who have stuck with KMI, it is welcome news as it shows the company is trying to make up for its 75% payout cut in 2016. The plan is to raise the dividend to $0.80 in 2018, $1.00 in 2019, and $1.20 in 2020.
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So the question is, are these dividends safe? And is this growth possible?
The picture has been ugly
First, let's recap some of the factors that led to the dividend drop in the first place.
Henry Hub spot prices fell from an average of $4.39 in 2014 to averages of $2.63 and $2.51 in 2015 and 2016, respectively. The effect of gas prices on KMI is huge because even though the company doesn't primarily produce or sell gas, customers have canceled contracts or renegotiated at lower prices or lower volumes.
Total revenue fell from about $16.2 billion in 2014 to $13 billion in 2016 (a 19.75% decrease). Natural gas is the primary activity of KMI, with its pipelines representing 63% of its assets, and 50% of segment earnings before depreciation and amortization (EBDA). Its revenue fell from $10.1 billion in 2014 to $8 billion in 2016. The visual on top-line revenue over these last years is ugly.
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Not surprisingly, its share price has fallen from a high of about $44 per share in April of 2015 to $13 in Jan 2016. These factors, combined with the dividend cut, have generated a lot of negative sentiment about the company.
Pulling the rabbit out of the hat
When revenue dropped, management stopped the operational bleeding by cutting cost of sales and operations accordingly; you can see from the chart above that EBDA hasn't fallen as much as revenue. This has preserved distributable cash flow (DCF) relatively well.
Kinder Morgan estimates that for every $0.10 per MMBtu drop in natural gas prices, it loses $1 million in DCF. This is also good news because it suggests there is only a small effect on cash flow from a further drop in gas prices.
The dividend cut had more to do with how to spend free cash flow than the effect of falling revenue. The company is constantly facing a balancing act between investing in new projects, reducing debt levels, and dividend payouts.
Clearly, KMI needs to spend some cash on investing in growth projects. It has already written off many assets. Between 2015 and 2016, the amount of physical assets on the books shrunk. It needs to find new ones that can generate an adequate return. KMI has always allocated a significant amount of cash flow into capital expenditures and purchases of assets. Planned expenditures for 2017 are $3.1 billion, with a backlog of $12.2 billion.
The 2017 second-quarter earnings report indicates no new external debt is planned and debt repayment will be internally financed.
There's another rabbit in there somewhere
In the company's most recent earnings release, management gave a hint where all this growth will come from. It "expects future natural gas infrastructure opportunities will be driven by greater demand for gas-fired power generation across the country, LNG exports, exports to Mexico, and continued industrial development, particularly in the petrochemical industry." It expects 30% growth in demand for natural gas over the next 10 years.
KMI states that comparing first half of 2016 to first half of 2017, natural gas transport volumes were up 3% and exports to Mexico were up 8%. We don't get to see the future budget assumptions, but as KMI claims to move 40% of the natural gas in the US, it is likely these optimistic industry trends have made their way into the company's budgets and planning. Average contract lengths for gas are six years, which gives some predictability to their revenue streams. And there's the usual trick of selling off less desirable assets to raise cash.
Could be a squeeze
In short, Kinder Morgan generates enough distributable cash to pay its current dividend and support a higher payout going forward. But it will be a juggling act between keeping their dividend promises, maintaining adequate capital investment levels, and kicking the debt can down the road. This isn't anything new for the company's management, though, and shouldn't drastically alter anyone's investment plans.
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