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Better Buy: Kinder Morgan vs. Plains All American Pipeline

By Reuben Gregg Brewer - Jan 26, 2020 at 10:47AM

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Between two high-yield midstream players, is one better or are they both about in the same position? A word of caution -- don't just look at the yield.

Kinder Morgan (KMI -0.95%), one of the largest midstream companies in North America, offers investors a yield of nearly 4.8%. Smaller Plains All American Pipeline (PAA -1.21%) offers investors a yield of 7.75%. The easy answer here is pick the higher yield, but there's so much more to know about this pair before you make a final call. Here's a quick primer of how these midstream players are similar and different that will help you decide if either is right for your portfolio.

Dividend cuts

In 2016 Plains All American cut its distribution by 21%. The master limited partnership followed that up with another cut in 2017, this time trimming by 45%. The total of the two distribution cuts was nearly 60%. One of the big reasons for the cut was that management had allowed leverage to get too high, so when the midstream space started to feel some pain, Plains had to retrench... twice. One distribution decrease would be bad enough, but the second one shows that management woefully misjudged the markets it serves. 

A man turning valves on an energy pipeline

Image source: Getty Images

Kinder Morgan cut its dividend in 2016 as well. The cut was a huge 75%, basically ripping off the bandaid with one quick pull. The main reason was, again, leverage. In a difficult energy market, Kinder ended up having to decide between growth spending or the dividend, because debt and equity markets weren't a good option for funding its capital investment plans. The dividend lost, which was probably the right move for the company. However, the bigger problem here is that just a couple of months before announcing the dividend cut, Kinder's management team was saying it planned to increase the dividend by as much as 10% in 2016. Talk about being whipsawed! 

Wall Street is forward looking, which is appropriate most of the time. However, in this case conservative dividend investors shouldn't forget the past. Kinder Morgan and Plains All American both made mistakes that led to painful hits for income investors. There were plenty of midstream peers that managed through the same time period without enacting such drastic measures, a list including industry bellwether Enterprise Product Partners, smaller but similarly conservative Magellan Midstream Partners, ONEOK -- which, like Kinder, rolled up its own controlled partnership -- and TC Energy, a Canadian player that's long made relatively aggressive use of leverage, among others. 

There are reasons to be more positive about Kinder Morgan and Plains All American today. However, dividend investors shouldn't go in blind -- both companies are working to regain investor trust. If you are living off of dividends from your portfolio, there are likely better options in the midstream space.

Turning things around

That said, both Kinder and Plains All American have started to increase their disbursements again at this point. Kinder announced an aggressive hike schedule in 2017 that would last until 2020, and would more than double the payment. It has, so far, followed through on that plan, while also reducing leverage (more on this below). It has done a very good job of living up to its word since backtracking on the dividend in 2016. Investors have recognized this, and the yield difference between Kinder and Plains All American shows this.

That said, even after all the planned increases are in place, the dividend will still be nearly 40% lower than it was before the cut. So investors still aren't whole. 

Plains All American isn't quite as far along the path distribution-wise. It increased its disbursement by 20% in 2019, marking the first hike since the second cut. There's no particular plan from here with the distribution, though management has done a very competent job of repositioning the partnership and reducing debt. Like Kinder, however, the distribution remains well below the levels seen before the cutting started. The higher yield is partly a reflection of investor concerns about where Plains All American goes from here. 

Fixing the foundation

The base from which all companies operate is the balance sheet. A strong balance sheet provides a cushion when times are tough and the strength to expand when times are good. Kinder Morgan and Plains All American allowed leverage to increase too much in the good times, weakening their ability to deal with adversity. To their credit, they have each realized the error and have set about fixing it.

Kinder Morgan has reduced its financial debt to EBITDA ratio from around 9 times to roughly 5 times (note the chart below doesn't include Kinder Morgan's fourth-quarter 2019 financial results). That's a drastic improvement, but Plains All American has gone from a peak of around 6 times to roughly 2.3 times. Plains All American's leverage now sits toward the low end of the industry, with fiscally conservative peers like Magellan and Enterprise. Kinder Morgan, on the other hand, remains notably higher. It has a long history of using debt more aggressively than its peers, but that obviously hasn't always worked out so well. 

KMI Financial Debt to EBITDA (TTM) Chart

KMI Financial Debt to EBITDA (TTM) data by YCharts

Although Kinder has done more to prove it is on the right track dividend-wise, Plains All American has taken much bolder steps at shoring up its financial foundation. Plains gets the kudos here.

Next steps

Plains All American has been spending on growth projects over the last couple of years, but plans to notably reduce that spending in 2020. It has a few projects on tap that will play out through 2021, so there's no reason to expect growth to stall. It's targeting 1.3 times distribution coverage as well, which provides ample safety for the distribution and room for increases. That said, investors probably shouldn't go in anticipating 20% distribution hikes every single year. It's more appropriate to expect increases that follow along with the partnership's EBITDA growth, which is expected to be in the mid single digits in 2020. 

Kinder Morgan should announce another 25% dividend increase at some point in 2020, fulfilling its multi-year dividend promise. Its dividend in 2019 was covered by distributable cash flow by roughly 2.4 times, which is a huge margin of safety. Still, during the fourth-quarter 2019 earnings conference call, management made a point to highlight both the investments it made and those it didn't make, summing up by explaining: 

The point of all this is that we make the right decisions on behalf of our shareholders. We act as principles, not agents. We act like owners and we protect our owners resources. 

Clearly, Kinder Morgan, despite a robust backlog of future projects (roughly $3.6 billion), is well aware of the trust that it has lost. And while it has stated its dividend intention in 2020, there's no express numbers given for 2021 and beyond. Investors should conservatively expect future hikes to track along with the growth of distributable cash flow over the longer term. On that score, distributable cash flow is projected to rise in the low-single digits in 2020. The massive dividend hike set for this year is going to end up reducing the dividend coverage. At 2.4 times there's ample room for reduction without putting the dividend at risk, but large hikes like investors have seen in recent years are going to end sooner rather than later. 

Who wins?

For conservative income investors, the choice between Kinder and Plains All American is probably a solid "neither". With the history of disbursement cuts at Plains All American, one hike isn't enough to make a trend. Kinder Morgan has gone much further in proving it is on the right track, but the dividend remains well below its historical high-water mark, and there's no guide for what growth will look like once the splashy, news-grabbing increases end in 2020. Investors that like a little more certainty should probably wait until the future is more clear, noting that debt is still a bit higher here than at many of the company's peers.

For more aggressive investors, Kinder Morgan is probably the better option. As one of the largest midstream players in North America, it has the diversification and scale to take on projects that relatively small Plains All American (which is roughly a quarter the size of Kinder) can't. And it has done a lot more to prove that it has turned a corner, despite still having a higher level of leverage.

That being said, most investors would probably still be better off looking at midstream peers that managed through the same rough period as Kinder Morgan and Plains All American and were able to continue increasing their dividends, a list that includes all of the other names noted above.

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Stocks Mentioned

Plains All American Pipeline, L.P. Stock Quote
Plains All American Pipeline, L.P.
$9.82 (-1.21%) $0.12
Kinder Morgan, Inc. Stock Quote
Kinder Morgan, Inc.
$16.76 (-0.95%) $0.16

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