Wall Street has a notoriously short memory, which is good in some ways but often leads to investors repeating the same errors over and over again. When it comes to income investing, making a mistake can mean a painful decline in the dividend income you generate from your portfolio. That's not the type of blunder you want to repeat, which is why I will never buy Kinder Morgan (KMI 0.82%), Energy Transfer (ET 0.87%), or Plains All American Pipeline (PAA 2.23%). Here's why these three income stocks will never make it into my portfolio and why I think you should avoid them, too.
1. Actions speak louder than words
In 2016, Kinder Morgan cut its dividend by a massive 75%. It was a painful blow for investors who had come to rely on that income. The main reason for the cut was that a high level of leverage coupled with the midstream sector being out of favor had made it hard for management to raise growth capital. It had to make a choice between growth spending and the dividend, and chose growth spending. That was the best choice for Kinder Morgan, but it wasn't a great outcome for income investors.
Image source: Getty Images.
The decision itself, however, isn't the big problem here. What worries me about this episode is that just a couple of months prior to the dividend cut, Kinder Morgan was telling investors to expect a dividend increase of as much as 10% in 2016. Essentially, the company said one thing and then ended up doing the exact opposite. I have a hard time trusting the management team at this point.
Today, Kinder Morgan is back to upping its dividend and income investors are again excited about the stock. But with essentially the same leadership team in place and the fact that the midstream company's leverage is still relatively high for the industry, I'm not willing to touch the stock. There are too many other options in the space that don't come with trust issues for me to bother.
2. Putting investors last
Kinder Morgan made the conscious decision to put its business ahead of investors' interests. I can actually respect that choice broadly speaking, since running a company into bankruptcy court is clearly a horrible outcome for investors. There's an obvious balance that needs to be struck. What I'll never able to forgive is a management team that appears to put itself above investors, which is why I will not buy Energy Transfer.
In late 2015, Energy Transfer agreed to buy competitor Williams Companies in a $33 billion deal. However, the midstream industry was under pressure at the time, and raising capital to fund the agreement quickly became a sticking point. Energy Transfer realized it had made a bad call and wanted out of the deal to which it had agreed.
The big problem was that consummating the deal would have required a large stock sale or a material increase in debt. Both of these moves would have put the distribution at risk. To give credit where credit is due, management clearly realized the problem and tried to solve the issue before it took out the distribution. And, in the end, Energy Transfer was able to scuttle the deal. On the surface that seems like a win, but the method used to kill the Williams acquisition is very troubling.
Energy Transfer sold convertible debt that caused technical issues for the deal and, after some time in court fighting over the issue, Williams basically gave up and let Energy Transfer walk away. A big chunk of that convertible debt, however, was sold to Energy Transfer's CEO. If the deal had gone through, it appears that his purchase of that convert would have shielded him from a distribution cut. While that may have simply been an aggressive tactic, the fact that the CEO appeared to be protecting himself from a worst-case scenario at the expense of investors doesn't sit well with me.
Investors are again hot on Energy Transfer, but the CEO is still there and I just can't stomach the idea of putting trust in a leadership team that I'm not sure has my best interests at heart. That's especially true when there are so many other choices in the industry that don't have as concerning a past.
3. Fool me twice, shame on me
Last up on my do-not-invest list is Plains All American. Like the two names above, this partnership is back in investor favor after a difficult multiyear spell. To sum it up, Plains had taken on a material amount of leverage to fund its growth plans. When the midstream industry hit a rough patch, that leverage quickly became an issue. That set the stage for the problem that I think should keep investors on the sidelines here.
In 2016, Plains All American agreed to acquire the incentive distribution rights of its general partner. The move was made to simplify its capital structure and improve the partnership's credit profile. This would, according to management, give it the ability to better capitalize on growth opportunities in the future. The downside was that the move also included a distribution cut.
PAA Financial Debt to EBITDA (TTM) data by YCharts.
Plains was open about that cut. And, perhaps, the idea of enduring a little near-term pain for long-term gain would be worth it. However, within a year or so, the partnership had to reduce the distribution again. Essentially, the first attempt at getting things moving in the right direction didn't work out as planned. With difficult industry conditions persisting, management had to go back to the drawing board in an effort to get the company's leverage under control.
The double hit to the distribution added up to a roughly 57% cut. Going back for the second reduction, while likely the right call for the partnership, suggests that management may not have as good a handle on the business as investors would like. That's doubly true when you consider that a large number of peers didn't have to lower their distribution even once. In this case, I'm not convinced it's worth the risk that management misjudges the business's prospects again, leaving investors to hold the bag.
Investing is about trust
When you buy a stock, you are giving your hard-earned savings to a company expecting that it will do its best to use that money wisely. Trust is vital. I'm not confident enough in the management teams at Kinder Morgan, Energy Transfer, or Plains All American to give them my savings. While the opportunities here may look compelling today, the way they've managed shareholder capital in the past is troubling. There are just too many other options out there without this type of baggage for most investors to bother with potential trust issues like these.
