There's no such thing as the perfect energy stock. However, there are five distinct characteristics that make it much easier to create value throughout the commodity price cycle.
With that in mind, I've put Kinder Morgan Inc. (KMI 0.03%) up to my test for measuring those characteristics in a master limited partnership because it is similar in its makeup. Here's how it stacks up.
1. The perfect energy stock should have limited direct exposure to commodity prices
I believe that the perfect energy stock should be loaded with fee-based assets or hedge most of its oil and gas production. Ideally, all its income would be shielded from commodity price volatility for the next year, though 75% is a solid foundation. Further, secured revenue a few years out in to the future would be icing on the cake.
As the slide below notes, Kinder Morgan clearly fits the bill here as 96% of its cash flow this year is either fee-based or hedged.
Data source: Kinder Morgan Inc. investor presentation.
It is also worth noting that Kinder Morgan's cash flow is diversified across a number of segments, including oil production using carbon dioxide for enhanced oil recovery. That production is 81% hedged this year, though its hedges do drop off in the years ahead. However, only 11% of its cash flow is from oil production so it has very limited direct exposure to commodity prices.
2. A solid balance sheet
The perfect energy stock would have an investment grade credit rating and/or a debt-to-EBITDA ratio of 4.0 times or less. This is a metric where there could be some concern for Kinder Morgan. While it does have an investment grade credit rating of BBB-/Baa3, that rating is right on the edge of the investment grade border. Further, its debt-to-EBITDA is rather high as the company expects that ratio to be 5.6 times this year. While this isn't a grave concern, Kinder Morgan does use a lot of debt to fund its growth and that could be a problem as interest rates raise or if a credit crunch hits the energy sector. Suffice it to say, this is something investors should watch.
3. A strong dividend coverage ratio
One of the big draws of an income stock like Kinder Morgan is the fact that it pays out most of its cash flow to investors each quarter, leading to a high current yield. However, if a company pays out too much cash flow, that puts it at greater risk because it means it likely is using more debt to fund growth. That's why we'd like to see a conservative dividend coverage ratio. Ideally, the ratio should be between 1.05 and 1.10, while anything below 1.0 times would be a concern.
Through the first six months of this year, Kinder Morgan's coverage ratio is 1.10 times, so it is in that safe zone. Also, the company expects to end the year generating more than $300 million in excess cash flow. So, no worries here.
4. A history of dividend growth
Investors crave income growth, so a company that has a history of growing its payout suggests it knows how to create value for investors. As the chart below shows, Kinder Morgan fits the bill here as it has a strong history of dividend growth.
5. A visible growth project backlog
In addition to a demonstrated history of dividend growth, a visible outlook for future growth is another very desirable characteristic. This is one area where Kinder Morgan shines. As the slide below shows, the company has an enormous $22 billion backlog of projects that are expected to drive 10% dividend growth through 2020.
Data source: Kinder Morgan Inc. investor presentation.
There are two things worth noting about Kinder Morgan's backlog. First, 90% of the projects are fee-based pipeline or terminal assets, meaning the company will further decrease its direct exposure to commodity prices. In addition to that, a growing portion of its growth is coming from demand pull projects, such as supplying natural gas to LNG export facilities and petrochemical plants, instead of supply push, which is getting oil and gas out of production basins. This suggests that its growth isn't tied to oil and gas production growth but is instead tied to demand growth that's fueled by lower commodity prices.
Investor takeaway
There is a case that could be made that Kinder Morgan is the perfect energy stock as it largely fits all five characteristics. However, it's not a perfect fit as it does have some very direct exposure to oil prices and its leverage ratio is rather high. Having said that, the company also has a huge project backlog of primarily fee-based assets coming into service over the next five years, driven by demand pull projects. That income security is a huge benefit at a time when there's a lot of uncertainty in the energy sector.
