Kinder Morgan, Inc. (KMI -0.32%) is on a path to increase its dividend by 25% a year between 2018 and 2020. The most recent hike, announced in April, was an incredible 60%! But there's a backstory here, and it includes a 75% dividend cut.
Kinder appears to be on a better path now, but that path has unfortunately come with a sizable setback to its growth plans. With shareholders expecting big dividend hikes, will the pipeline company just end up disappointing investors again?
Those dividend hikes aren't so big after all
No company wants to cut its dividend. It's a move that management takes if there really aren't any other good options -- which is why it's so important to take a deeper look at Kinder Morgan's 2016 decision to cut its dividend by a massive 75%.
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Oil prices started to fall in mid-2014, and by 2015 things were looking really bad in the energy industry. Investors began to shun oil-related companies like Kinder, even though its midstream business was largely supported by fee-based assets.
This wouldn't have been a big deal by itself, but Kinder also has a history of using more leverage than its peers. Kinder's debt-to-EBITDA ratio is currently around 6.7 times, compared to giant industry bellwether Enterprise Product Partners' 4.4.
These two factors left Kinder in a bind. It had billions of dollars' worth of growth projects lined up that it still wanted to build. Normally it would have funded that spending with a mixture of equity sales and debt. The difficult market environment, however, meant that business as usual wasn't going to happen. Management had to make a tough choice: In an attempt to maintain its credit ratings, Kinder Morgan slashed the dividend to free up cash for its capital budget.
Even after all of the planned dividend hikes between 2018 and 2020, the dividend will still be nearly 40% below where it was before the 2016 cut.
What's going on today?
The current round of dividend hikes, which were announced in mid-2017, is clear evidence that Kinder's prospects have improved materially. Despite the dividend cut, it is a well managed company and has a long history of successfully executing on big growth projects.
Except for one: Faced with material pushback from local residents and the local government, Kinder Morgan agreed to sell the Trans Mountain Pipeline system, a key expansion project, to the Canadian government in early 2018. Fellow Fool contributor Matthew DiLallo laid out the numbers on that project not too long ago, with the $5.7 billion Trans Mountain investment expected to provide Kinder with around $860 million in annual earnings upon its projected completion. Now that won't happen, which means Kinder is going to have to find other avenues for growth, which will likely include more capital spending in the U.S. market and, perhaps, acquisitions.
KMI Dividend Per Share (Quarterly) data by YCharts
However, after announcing the agreement to sell the Trans Mountain Pipeline system, Kinder Morgan specifically said the move wouldn't impact its dividend growth plans. That's nice, but only a couple of months before the 2016 dividend cut, management said it was going to keep increasing the dividend. It's just hard to trust Kinder Morgan when it comes to the dividend.
Not as bad as it looks
This time, however, looks different. First off, Kinder Morgan has around $4.3 billion in spending planned through 2022, a number that doesn't include the Canadian pipeline asset it is selling. So growth spending hasn't stopping because of this setback. The problem is that it will have to replace the nearly $6 billion project with new spending if it wants to maintain its dividend growth plans.
But in the first quarter alone it added nearly $1 billion in growth projects to its backlog. There really is material opportunity to make up for the shortfall left from the asset sale, especially given the $39 billion-market-cap company's massive footprint.
KMI Total Long Term Debt (Annual) data by YCharts.
Moreover, with the company's dividend still well below the levels it was at prior to its 2016 cut, Kinder is generating ample free cash flow internally to support the current payout. In fact, the company is in the middle of a $2 billion stock buyback plan, with around $1 billion or so left. In a worst-case scenario, that spending could be halted, with the cash instead being used to support the dividend. And debt levels, while still relatively high, are also lower than they were when the company cut the dividend -- it has reduced debt by 16%, or nearly $7 billion, over the last two and a half years. The fiscal situation is simply better today than it was a couple of years ago, and energy markets are notably better as well.
In other words, Kinder Morgan's dividend growth looks like it could be supported by the business even with the loss of the giant Canadian pipeline project. That said, a lot will depend on its ability to find replacement projects. That's the key to watch in the coming quarters. If you own Kinder, I wouldn't run for the hills -- but I would keep a close eye on the backlog.
If you don't own the pipeline company, however, you'd be wise to stay on the sidelines until it has identified substitutes for the $5.7 billion project. That's particularly true if you are a conservative investor who remembers the last time management made a dividend growth promise (I personally wouldn't buy the stock for this reason alone). The risk-reward trade-off -- the possibility of a 4.5% yield that's supposed to grow in the future versus the risk that management will fall short of its goals again -- simply isn't good enough to justify new money when you can buy pipeline peers with higher current yields and better-defined investment plans.
