Better Buy: Kinder Morgan, Inc. vs. Plains All American Pipeline, L.P.

For many income investors, Kinder Morgan (KMI -0.11%) doesn't stand a chance when compared to Plains All American Pipeline (PAA -1.31%). That's because Kinder Morgan's current yield of 2.6% just doesn't hold the same appeal as the eye-catching 8.4% payout of Plains All American Pipeline. That said, the reason there's such a vast gulf between the two is that Plains plans to pay out a far greater percentage of its cash flow this year. In fact, its payout ratio is so high that it puts its distribution in a high-risk territory. 

That's one of two major differences between the companies, which, when taken together, make Kinder Morgan the better buy right now, especially for more risk-averse investors.

Image source: Getty Images.

The balance sheet checkup

Before we dig into those two metrics, we'll first take a peek under the hood of the credit profiles of both companies. As the chart below shows, this is one area where Plains All American Pipeline has a slight advantage over Kinder Morgan:

Data sources: Kinder Morgan and Plains All American Pipeline.

Plains' advantage stems from the fact that it has a lower leverage ratio. That said, it's worth noting that both companies are working hard to improve these numbers. Plains, for example, plans to get leverage down to between 3.5-4.0 times debt-to-adjusted EBITDA, while Kinder Morgan is working toward the goal to get debt below 5.0 times Adjusted EBITDA. 

If Plains All American Pipeline hits its target, it could earn an upgrade to mid-to-high BBB/Baa credit ratings, which would not only give it one of the highest credit ratings among MLPs, but should lower its cost of capital, too. Kinder Morgan, on the other hand, just wants to maintain investment-grade credit. As a result, Plains stands to keep its slight credit advantage over Kinder Morgan, which could enable it to borrow money at lower rates in the future. 

Two eye-catching metrics

The scales tilt toward Kinder Morgan when we drill down deeper into the cash flow these companies expect to generate this year and use those numbers to compare the two. Plains All American Pipeline expects to generate $1.54 billion of distributable cash flow this year, up by 9% from last year. On a per unit basis, that's about $2.03. Meanwhile, Kinder Morgan expects to produce $4.46 billion of distributable cash flow, roughly flat with last year at about $1.99 per share.

These cash-flow forecasts provide investors with valuable data to compare the two companies. For example, we can use it to measure the safety of their respective payouts and their relative valuations:

Data sources: Kinder Morgan and Plains All American Pipeline.

The math behind these metrics is simple. Since Kinder Morgan expects to declare $0.50 per share in dividends this year, it will only pay out a quarter of its $1.99 per share in distributable cash flow. That leaves the company with ample cash flow to finance growth projects, which it can do with room to spare this year. Contrast that with Plains, which is on pace to pay out $2.20 per unit in distributions, or 108% of the projected $2.03 per unit in distributable cash flow it expects to produce this year. That number should send a shiver down the spines of income investors because it's not sustainable over the long term. While Plains does expect to grow into its payout ratio over time since it has several growth projects currently under construction that should boost earnings by at least 15% next year, there's always a risk that even the best-laid plans could go awry. 

The other significant difference between the two is the price investors are willing to pay for this projected cash flow. At Kinder Morgan's recent share price, investors are only paying about 9.4 times projected 2017 distributable cash flow for the stock, which is well below the 12.8 times Plains trades at these days. For a stock that had traded at nearly 20 times distributable cash flow before the oil market downturn, and in the low teens for most of the last year, it's quite a value these days.

Usually, when a company trades at such a low valuation, it's because it lacks visible growth prospects. However, that's not the case at Kinder Morgan, which is in the midst of a major expansion phase. The company currently has $13 billion of projects under development that should increase its Adjusted EBITDA from $7.2 billion this year to as much as $8.7 billion -- about a 20% increase -- by 2020 once its recently sanctioned Trans Mountain Pipeline expansion enters service. While Plains All American Pipeline also has a visible growth profile, with expectations that it can increase adjusted EBITDA from $2.26 billion this year up to more than $3 billion -- roughly 30% higher -- over the next several years, investors are paying a hefty premium for that slightly higher growth rate. That's especially true when considering that Kinder Morgan is more than double the size of Plains All American Pipeline. Further, because Plains will pay out all of its cash flow, it needs to secure debt and equity capital to finance growth, which is not only dilutive to investors but might be difficult to pull off if commodity prices take another dive. Because of that, its growth projection is less of a sure bet than Kinder Morgan's fully funded capex program. 

Investor takeaway

While yield-starved investors might prefer Plains All American Pipelines, they're paying a premium for a payout the company can't yet cover with internally generated cash flow. Kinder Morgan, on the other hand, can internally finance its dividend and capex requirements with room to spare. When we combine that fiscal conservatism with its growth prospects and cheap valuation, it's the better buy between the two, in my opinion.