This High-Yield Stock Was Just Too Cheap Not to Buy

Sometimes stocks are cheap for a reason. Maybe their industry is in decline, or the company has financial issues to address. Other times, the market simply has a stock all wrong, tossing it into the bargain bin without good reason.

That's where I think natural gas pipeline giant Kinder Morgan (KMI 2.53%) is these days. In fact, with the stock suffering another double-digit loss since the start of the year, I just couldn't pass up on the opportunity to buy more shares and make it one of my 10 largest holdings.

Quality merchandise at a marked down price

Kinder Morgan's double-digit drop is quite confounding, considering all the good news the company has reported in the past few months. For starters, fourth-quarter results came in just above its guidance range, with $4.48 billion, or $2 per share, in distributable cash flow (DCF) last year. That was enough money to pay its now 3.1%-yielding dividend, fund $3 billion of expansion projects, and surprisingly repurchase $250 million of its dirt cheap stock. In addition, the company completed several actions to shore up its balance sheet and finance future expansion projects.

Image source: Getty Images.

Those expansions have Kinder Morgan on pace to start growing again this year. Overall, the company expects to generate $4.57 billion, or $2.05 per share, in DCF this year, which is about 3% higher than last year. It's enough money to fund $2.2 billion in expansion projects and pay a dividend that's 60% higher than last year's level -- implying about a 5% yield at current prices -- with more than $500 million left over that it could invest in additional expansion projects or buy back more stock. In fact, the company already bought back another $250 million in shares this year.

There's cheap, and then there's this

Kinder Morgan's 2018 guidance implies that shares currently fetch around 8 times DCF. That's an absurdly low value, considering that Kinder Morgan's average peer trades at nearly 12 times DCF. It's hard to justify that value disconnect, given how well Kinder Morgan stacks up against them:

Data source: Enbridge, Kinder Morgan, ONEOK, Targa Resources, TransCanada. Note: Kinder Morgan's current dividend yield assumes a 60% increase in 2018.

Two names on that list, ONEOK and Targa Resources, stand out because they trade at a premium to the peer group average. While they have the lowest leverage ratios among these large pipeline companies, this number alone doesn't tell the whole story. In Targa's case, it might have the least leverage, but it still has junk-rated credit because of its razor-thin dividend coverage and its high earnings volatility, since a third of its revenue comes from commodity-related activities. Meanwhile, ONEOK's leverage ratio was 4.7 at the end of last year, but it recently sold equity to fund expansion projects, which pushed that level down in the near term. 

Another metric worth pointing out is that Targa and ONEOK have the lowest dividend coverage ratios in the group, which could become a concern if the energy sector hits another rough patch. Because of those factors, it's tough to justify their premium valuations relative to Kinder Morgan. While they are on pace to grow earnings at a double-digit pace this year, so are TransCanada and Enbridge, which sell for relatively cheaper values despite solid numbers. Meanwhile, Kinder Morgan's growth rate should shift into a higher gear in 2019, with ample growth further ahead of it, which is just another reason the current valuation gap between Kinder Morgan and its peers just makes no sense.

What can I say? I like cheap dividend stocks.

Kinder Morgan's stock has seemed cheap before only to continue falling, which might be the case again this time. However, I couldn't resist adding more shares after its recent slide, because at around 8 times cash flow, it just seems too cheap not to buy right now -- especially since a massive dividend increase is right around the corner, enabling me to lock in a 5% yield on that purchase.

That dividend, however, is only the beginning of the value I expect to collect from this incremental investment in Kinder Morgan over the next several years, since I think its valuation will eventually revert closer to the peer group average.