In the past, I've sung the praises of Kinder Morgan, Inc (NYSE:KMI) because I'm confident in its long-term potential to grow its dividend and build wealth for long-term investors, especially retirees. However, recently, I've received some questions from readers about the sustainability of Kinder Morgan's dividend with the company about to go through an extreme makeover. The answer to whether or not Kinder Morgan's dividend is sustainable in the long-term largely has to do with the upcoming merger which is designed to improve the long-term financial health of the company.
How sustainable is Kinder's current structure?
|Company/MLP||Q3 2014 Coverage Ratio||12-Month Coverage Ratio||Long-Term Projected Coverage Ratio|
|Kinder Morgan Inc||0.95||1.12||1.1|
|Kinder Morgan Energy Partners||0.64||0.75||na|
|Kinder Morgan Management||0.64||0.75||na|
|El Paso Pipeline Partners||0.72||0.75||na|
As seen in this table Kinder Morgan Energy Partners (UNKNOWN:KMP.DL), Kinder Morgan Management (UNKNOWN:KMR.DL), and El Paso Pipeline Partners (UNKNOWN:EPB.DL) have recently been struggling to cover their generous distributions. This partially explains why Kinder Morgan, Inc recently announced the $71 billion megamerger of its three MLPs. Management expects the deal to deliver significant cost savings that will not only secure the dividend in the short-medium term, but increase its growth rate. There are four primary ways the merger is so beneficial to the long-term security and growth of Kinder Morgan's dividend.
Elimination of IDR fees and lower payout costs
The merger will simplify Kinder Morgan's capital structure by eliminating the incentive distribution rights, or IDRs, which are fees designed to encourage an MLPs general partner (GP) -- which manages the partnership's assets -- to grow the distribution. This is because at certain pre-determined distribution levels the GP receives a greater proportion of the MLPs marginal cash flows, typically up to 50%. The siphoning off of so much cash flow by IDRs can end up slowing distribution growth as well as raising the cost of capital of the partnership. This can hurt profitability and the growth rate of the MLP.
The merger's elimination of the IDRs, when combined with the conversion of 836 million units of high-yielding MLPs into lower yielding Kinder Morgan, Inc shares, will save the company $1.01 billion annually, as seen in this table.
|Company/MLP||Shares/Units outstanding||TTM Total cash payout (IDRs, distributions, and dividends)|
|Kinder Morgan Inc||1.03 billion||$1.73 billion|
|Kinder Morgan Energy Partners||465.52 million||$3.634 billion|
|Kinder Morgan Management||135.98 million||
|El Paso Pipeline Partners||233.5 million||$801 million|
|KMI pre-merger Total||1.86 billion||$6.165 billion|
|KMI post-merger Total||2.58 billion||$5.16 billion|
|Total 2015 Payout Savings based on Merger||$1.01 billion|
Lower cost of capital
Another important concept to understand when investing in MLPs is the cost of capital. This is the bar a project has to clear to be considered profitable and largely determines whether or not an MLP invests in certain projects.
|Company/MLP||Proportion of Capital (Debt)||Cost of debt||Proportion of Capital (equity)||Cost of equity||Weighted Average Cost of Capital|
|Kinder Morgan Inc||49%||2.80%||51%||9.6%||6.20%|
|Kinder Morgan Energy Partners||33.40%||3.10%||66.60%||8.30%||6.60%|
|Kinder Morgan Management||0||na||100%||8.70%||8.70%|
|El Paso Pipeline Partners||33.40%||3.30%||66.40%||8.40%||6.70%|
As this table shows Kinder Morgan has a lower cost of capital than its MLPs due to its heavier reliance on cheap debt relative to more expensive equity. After the merger, Kinder Morgan's lower WACC will lower the average cost of capital of the consolidated company. Because the new company will be much larger, there is also the chance that it will be able to lower its borrowing costs, further reducing its cost of capital.
Lowering the WACC will not only increase the profitability of future projects, but also allow it to go after projects that wouldn't have been profitable in the past. Thus, it might be able to grow its backlog at a faster rate, which might fuel a faster dividend growth rate over a longer time period.
For example, according to management the new Kinder Morgan, Inc will be able to grow distributions 114% faster per $1000 of new capital expenditure compared to Kinder Morgan Energy Partners.
Massive tax benefits
One of the major reasons to own MLPs is their tax benefits. These benefits are a result of MLPs being "pass through" entities, meaning they don't pay taxes as long as they pass on all taxable items, such as income and depreciation write offs, to unitholders.
Depreciation is simply the ability of a company to account for the cost of replacing existing assets. For example, a $100 million pipeline that last 30 years, depreciates at $3.33 million per year. Companies can deduct depreciation from their taxable income and MLP unitholders can do the same since MLPs "pass through" this item right to them. This is part of the reason why MLP distributions are partially considered "return of capital" and provide deferred tax benefits.
Kinder Morgan's merger creates a corporation that isn't a pass through entity and can both retain earnings (for growth purposes) as well as keep the depreciation benefits to reduce its taxable income, lower its tax bill, and increase profits. Management believes these tax benefits will amount to about $20 billion over the next 14 years.
Less equity sales
Because MLPs pass through almost all of their earnings to unit holders, growth capital usually has to come from either debt or selling additional equity, resulting in dilution of existing investors. As long as the funds are used on investments that increase the distributable cash flow/unit, the investment is said to be accretive (beneficial) and help the distribution grow over time. Each time an MLP issues equity, though, it is raising its total distribution costs, which at some point can force distribution growth to slow. This is because as much as 50% of the marginal cash flow goes to the general partner in the form of IDR fees.
Since Kinder Morgan will now be a corporation, it can retain earnings for growth purposes, making it less dependent on the debt and equity markets for funding future projects. For example, to put the $1.01 billion in annual IDR/payout savings in perspective, Kinder Morgan has spent an average of $2.16 billion annually on capital expenditures over the last five years. In 2014 it expects to spend $3.5 billion due to a large amount of growth projects it's completing. So the consolidation of payouts alone will go a long way in reducing the need for additional debt and equity issuances which provides another long-term potential dividend growth catalyst.
In fact, when all is said and done, management believes the merger will result in a long-term coverage ratio of 1.1, which represents $2 billion in excess cash flow available to secure the dividend over the next five years. This, in turn, has led management to issue guidance of a 16% dividend hike in 2015, and 10% annual growth through 2020.
Bottom line: dividend safe thanks to merger
Despite its recent problems covering its distributions, Kinder Morgan's payout is likely safe and will probably continue to grow for many years fueled by the financial benefits of its merger. Thus, I continue to recommend income investors consider Kinder Morgan for a spot in their diversified income portfolios.