Better Buy: Kinder Morgan, Inc. vs. ONEOK, Inc.

Pipeline companies can be excellent options for income-seeking investors. These entities typically generate steady cash flow, the bulk of which they send back to investors via generous dividends. That's certainly the case with natural gas pipeline giants Kinder Morgan (NYSE: KMI) and ONEOK (NYSE: OKE): Their current dividend yields -- 2.6% and 5.3%, respectively -- are well above the 1.9% average yield of the S&P 500.

While income-seeking investors might be drawn to ONEOK's higher current yield -- and for a good reason, because the stock could be a gold mine for dividend lovers -- they shouldn't dismiss Kinder Morgan just because it has a lower payout at the moment. That's because its dividend is set to skyrocket in the coming years, which, when combined with its more visible growth prospects and much cheaper valuation, gives it an edge over ONEOK as the better buy right now.

Drilling down into the numbers

Aside from both being large pipeline companies, Kinder Morgan and ONEOK are similar in several other ways. That's evident from the following chart, which details a few important factors about each company's debt and dividends:

As that chart notes, both have investment-grade credit ratings backed by similar leverage ratios. They also generate a comparable percentage of cash flow from stable sources. The biggest difference, at the moment, is that Kinder Morgan pays out a much smaller portion of its cash flow in dividends. That's the primary reason why its yield is half ONEOK's.

That said, Kinder Morgan recently announced plans for a massive dividend increase next year, followed by two more substantial boosts. Meanwhile, ONEOK expects to deliver more moderate raises over the next few years. To put these plans into perspective, if each company hit its respective targets, investors who buy today would have an effective yield of 6.4% at Kinder Morgan and 7.2% at ONEOK by 2020. However, it's worth noting that Kinder Morgan's coverage ratio in 2020 would be above 2.0, while ONEOK's would remain around 1.2.

Two differentiating factors

Aside from paying a smaller portion of its cash flow to support its dividend growth plan, Kinder Morgan doesn't need to grow cash flow to support its dividend forecast; it can currently cover its projected 2020 payout with plenty of room to spare. Still, Kinder Morgan has ample growth ahead of it since the company has $12 billion worth of expansion projects coming down the pipeline that it expects will increase earnings more than 20% by 2020.

ONEOK, on the other hand, needs to boost cash flow to support dividend growth given its much tighter coverage ratio. While the company currently has $355 million of expansion projects underway through 2018 and believes it can complete between $1.5 billion and $2.5 billion of projects over the next few years, it must secure and complete those additional expansions to deliver high-end dividend growth.

The second important distinction between the two has to do with their relative valuations:

As that table shows, Kinder Morgan is currently much cheaper than ONEOK. There are several reasons why that's the case, including Kinder Morgan's lower current yield, its previous balance sheet issues, and concerns about its ability to build the controversial Trans Mountain Pipeline expansion project in Canada. That said, the company has significantly improved its financial situation over the past two years thanks to a slew of strategic initiatives. Notably, it doesn't even need to complete the Canadian pipeline expansion to deliver its planned dividend growth. And I think that, as those worries fade away, the market will reward Kinder Morgan with a higher valuation.

The odds are with Kinder Morgan

While I believe ONEOK is an exceptional option for dividend-focused investors, Kinder Morgan just has more going for it right now. Most importantly, its stock is significantly cheaper and it doesn't need to complete any growth projects to achieve its dividend growth targets. Hence, it has the potential to deliver higher total returns over the next few years.

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Matthew DiLallo owns shares of Kinder Morgan and has the following options: short January 2018 $30 puts on Kinder Morgan, long January 2018 $30 calls on Kinder Morgan, and short December 2017 $19 puts on Kinder Morgan. The Motley Fool owns shares of and recommends Kinder Morgan and ONEOK. The Motley Fool has a disclosure policy.