Better Buy: Magellan Midstream Partners vs. Kinder Morgan

Magellan Midstream Partners (MMP) and Kinder Morgan (KMI -0.64%) offer dividend investors some monster yields. Kinder Morgan's dividend is up to 7.4%, while Magellan Midstream's payout is 9.8%. Those sky-high yields are due in part to all the turbulence in the oil market, which caused both energy stocks to tumble more than 30% in 2020, driving up their dividend yields.

Here's a look at which of these big-time payouts is the more attractive option for income investors.

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A look at dividend safety

The high yields of Kinder Morgan and Magellan Midstream are only good if they're sustainable. Here's a look at the financial foundations of these companies, which will give investors insight into whether they can maintain their payouts over the long term.

Data source: Kinder Morgan and Magellan Midstream Partners. 

As that table shows, both companies have solid investment-grade balance sheets backed by reasonable leverage metrics. Magellan Midstream's credit rating is a notch higher than Kinder Morgan's because it has a lower leverage ratio. Its leverage is currently below its 4.0 target while Kinder Morgan's is slightly above its 4.5 goal.

Meanwhile, both companies generate reasonably steady cash flow backed primarily by long-term, fee-based contracts or government-regulated rates. Those stable revenue sources have proven their worth during this year's oil market downturn. Despite all the volatility in volumes and commodity prices, Kinder Morgan only anticipates that its cash flow will be about 10% below its initial budget. Meanwhile, Magellan Midstream sees its cash flow coming in roughly 13.5% below its original guidance.

The one major difference between the two is their dividend payout ratios, as Magellan's is well above Kinder Morgan's. That's a concern because it doesn't have as much margin for error if market conditions remain weak. However, given its lower leverage ratio, it could use its balance sheet to bridge a near-term gap.

What does the future hold for these dividends?

Thanks to its steadily improving financial profile, Kinder Morgan initially expected to finish a three-year phased dividend increase this year. The final 25% boost would have pushed the payout to $1.25 per share. However, given all the turmoil in the oil market this year, the company only gave its investors a 5% increase. 

Kinder Morgan did say that it remains committed to delivering the rest of its promised raise, which it could announce at following its next Board meeting in January, assuming market conditions have improved. However, after that, dividend growth isn't quite as clear because the company believes it's entering a phase where there will be fewer expansion opportunities. While there's still some room to increase the dividend since Kinder Morgan has a low payout ratio, it could also use that cash to pay down debt, repurchase stock, or make acquisitions.

Magellan Midstream also fell short of its dividend growth expectations this year. Initially, the company planned to increase it by 3%. Instead, it opted to keep the payout flat because of all the turbulence in the oil market. 

While the company could deliver that planned raise once market conditions improve, it doesn't have much more room to expand the payout. That's because Magellan also believes the energy industry is entering a period of low expansion potential. With its growth engine running on fumes, and an already elevated payout ratio, it might not be able to increase its dividend very much in the coming years.

Kinder Morgan's payout has more upside

Kinder Morgan and Magellan Midstream both generate reasonably stable cash flow, giving them the funds to support their big-time dividends. They also have solid balance sheets, which provides them with the flexibility to maintain their payouts during these challenging times.

What separates the two is their dividend growth potential. Magellan's dividend seems tapped out, given its higher payout ratio and lack of growth prospects. On the other hand, Kinder Morgan has lots of room to increase its payout thanks to its lower payout ratio, including a promise to boost it another 19% in the near term. That dividend upside makes it the better buy between these two.