Midstream energy giant Kinder Morgan (NYSE:KMI) offers investors a huge 7.5% dividend yield. That's pretty enticing, but high yields sometimes hint that investors are worried about the future. So before you jump in here, it pays to consider how risky Kinder Morgan is today.
The core business
Kinder Morgan is one of the largest and most diversified midstream energy companies in North America. It would be virtually impossible for a competitor to replace the assets it owns.
The midstream niche of the broader energy sector helps to move and process oil and natural gas. Kinder Morgan's operations are largely fee-based, meaning it gets paid for the use of its assets. The company does have some exposure to commodity prices, but generally speaking, fees are more important to its top and bottom lines.
Many of the company's peers are set up as master limited partnerships (MLPs), which are a bit more complicated tax wise. Kinder Morgan chose to shift away from that structure several years ago to simplify its business. This is a net benefit for conservative investors because there's little need to worry about tax law changes to the MLP format affecting Kinder Morgan's business or resulting in a decision to change from an MLP to a corporation -- that work has been done already.
The real issue today is that demand for oil, natural gas, and the products into which they are turned has declined thanks to the coronavirus pandemic. That's why investors are generally downbeat on the midstream space. But Kinder Morgan's distributable cash flow payout ratio was a very solid 47% for the first nine months of 2020 so the payout doesn't look to be at risk.And, as a large player, Kinder Morgan is likely to be a consolidator in the industry if the current environment persists and ground-up construction opportunities dry up. In other words, it appears to be doing pretty well and is solidly positioned given the circumstances.
Some issues to consider
That said, no company is perfect, and Kinder Morgan does come with some warts. The first one to look at is leverage. It has historically made greater use of leverage than its peers. Today its financial-debt-to-EBITDA ratio is around 5.7 times. That's lower than it was a few years ago, but still toward the high end of its midstream peer group.
This is relevant because the extra leverage could make it harder for Kinder Morgan to shift toward acquisition-led growth. That's not to say it won't make such a shift if that's where the industry is going, only that debt-fueled purchases would further increase its leverage and thus increase the financial risks here. This brings the story to 2016, when Kinder Morgan's leverage was much higher than it is today.
At that time, the midstream industry was going through a period in which raising capital was difficult. Kinder Morgan's relatively high leverage, meanwhile, made accessing the capital markets even more troublesome. Management had to make a choice between funding its capital spending plans or continuing to pay its dividend. It chose capital spending, cutting the dividend by a huge 75%. That's not great news in and of itself, but the really big problem is that just a couple of months before the cut, it was telling investors to expect a hike of as much as 10%.
It has since shifted back into dividend growth mode, working to regain investor trust. It laid out a multiyear plan that included a 25% dividend hike in 2020. Because of the market conditions this year, it chose to increase the dividend only 5%. That's clearly better than a dividend cut and, like the 2016 decision, it was a good call for the company given the pandemic headwinds.
Still, conservative investors would be forgiven if they had some trust issues here. And that's on top of the company's relatively aggressive use of leverage -- which was a key piece of the 2016 decision to cut the dividend.
Food for thought
To be fair, Kinder Morgan is generally considered a well-run company, and the dividend decision it made in 2020 was to help ensure it didn't have to cut the payout down the line. So this isn't a terrible company filled with all sorts of investment risks.
But conservative dividend investors do need to consider the company's leverage and the two instances in which management made dividend-related statements that it couldn't live up to. Kinder Morgan isn't high risk, but it's also not risk-free.