Numerous studies show that high-yield dividend growth stocks make the best long-term investments over time. For example, a 2004 study by money manager Ned Davis found that between 1972 and 2004, this class of investments beat the market by an average of 24.7% annually.
|Dividend Policy||Annual Return, 1972-2004|
|Dividend cutters and eliminators||5.2%|
|All dividend payers||10.1%|
|Dividend growers and initiators||10.6%|
There is one company in particular I'd like to highlight as one of the strongest income investments you can make today. Thanks to three strong fundamental characteristics, Kinder Morgan (NYSE:KMI) is likely to be a great source of not only income over the coming decades, but also of market-beating total returns.
Lower cost of capital thanks to merger
|Company/MLP||Equity Funding||Cost of Equity||Debt Funding||Cost of Debt||Weighted Average Cost of Capital|
|Kinder Morgan Inc||51%||9.60%||49%||2.80%||6.20%|
|Energy Transfer Partners (NYSE: ETP)||54.50%||8%||45.50%||3.10%||5.70%|
|Enterprise Products Partners (NYSE: EPD)||79.40%||8.5%||29.60%||3%||7.40%|
|Magellan Midstream Partners (NYSE: MMP)||86.40%||8.20%||13.60%||3.40%||7.50%|
Because MLPs pay out the vast majority of cash flows as distributions, to grow they need to raise lots of funding. They do so primarily through issuing debt or selling additional equity. Cost of capital is an important concept to understand in capital-intensive industries such as this. You can think of it as the hurdle rate a partnership uses to determine whether growth projects or acquisitions are worth pursuing. As this table shows, Kinder Morgan has relied on debt more than some of its peers have. The result has been a lower cost of capital than many of its competitors, which is a strong competitive advantage.
Thanks to the $71 billion merger of Kinder Morgan with its three MLPs -- Kinder Morgan Energy Partners (NYSE:KMP), Kinder Morgan Management (NYSE:KMR), and El Paso Pipeline Partners (NYSE:EPB) -- this already low cost of capital is likely to decrease, for two key reasons.
|Company/MLP||Debt Rating||Total Debt ($Billion)||EBITDA/Interest||Debt/Equity||Debt/EBITDA|
|Kinder Morgan Inc||BB||37.95||2.8||1.25||5.6|
|Energy Transfer Partners||BBB-||10.9||3.67||1.54||5.95|
|Enterprise Products Partners||BBB+||19.65||5.49||1.18||4.07|
|Magellan Midstream Partners||BBB+||2.1||8.78||1.65||2.81|
The first reason is that, according to Bloomberg Finance, the elimination of subordinated debt from its MLPs and the cross guarantees of its existing debt between its former subsidiaries should allow Kinder Morgan's credit rating to increase two levels and achieve "investment grade."With this improved credit profile, Kinder Morgan should be able to reduce its debt borrowing costs below its already low levels.
The second reason the merger will help Kinder's cost of capital is with lower cost of equity, which represents the minimum required return investors demand of a stock in order to buy it. Because the merger will eliminate incentive distribution rights and general partner fees to Kinder Morgan, the total cost of equity for the merged company will be much lower. For example, according to Bloomberg, management has calculated that Kinder Morgan Energy Partners' (if it were still a stand-alone MLP) new cost of equity would be 43.1% lower.
The combination of lower cost of equity and probably lower debt costs means Kinder Morgan's new WACC will decline and increase the profitability of Kinder's future growth projects as well as the total pool of projects the company can consider adding to its total backlog, which already stands at an impressive $35 billion.
Superior management means superior profitability
|Company/MLP||Operating Margin||Net Margin||ROA||ROE|
|Kinder Morgan Inc||28.00%||7.70%||1.60%||9.60%|
|Energy Transfer Partners||3.80%||0.10%||0.10%||0.20%|
|Enterprise Products Partners||7.40%||5.60%||6.80%||18.70%|
|Magellan Midstream Partners||40.80%||35.10%||15.80%||46%|
Successful long-term investing requires owning shares or units in businesses with great management teams, and one easy way to determine the quality of a firm's leaders is to look at profitability metrics such as its margins, return on assets, and return on equity.
ROE tells us how good an MLP is at converting cash provided by investors into net profits. However, because a partnership can use debt leverage to inflate this figure, return on assets helps to see how good management is at converting both debt and shareholder equity (cash) into net income. Thus, we want to see both high ROE and high ROA to ensure the financial health of an MLP and the quality of its management.
The preceding table at first seems to indicate that Kinder Morgan might not be very good at using its high debt load to generate shareholder wealth. However, after the merger this metric should greatly improve, because Kinder Morgan Energy Partners and El Paso Pipeline Partners have ROAs of 7.3% and 5%, respectively.
I'd also like to point out that Kinder Morgan's founder and CEO, Richard Kinder, owns a 22.3% stake in the company, with total insider ownership of 35%. That stake should give investors confidence that management is investing alongside them and working to maximize their long-term income and wealth.
Superb dividend growth track record
This chart highlights Kinder Morgan's excellent long-term distribution growth record, a record that helped it crush not only the market's long-term total returns but also those of its peers, as represented by the Alerian MLP index.
Thanks to the merger's lower cost of capital and $20 billion in projected tax savings over the next 14 years, Kinder Morgan is guiding for a 16% dividend increase in 2015 and 10% annual growth through 2020. In addition, management has a track record of meeting or beating its dividend and distribution guidance in 19 of the past 20 years, a 95% success rate.
This projected growth rate is more than double the market's historical dividend growth rate, and combined with Kinder Morgan's high yield, it should maximize the chances of outperforming the market in the long term.
|Company/MLP||Yield||Historic Dividend/Distribution Growth Rate||5 Year Projected Dividend/Distribution Growth Rate|
|Kinder Morgan Inc||4.40%||12.17% over 21 years||10.69%|
|Energy Transfer Partners||5.9%||8.45% over 10 years||17.58%|
|Enterprise Products Partners||3.70%||7.95% over 18 years||6.96%|
|Magellan Midstream Partners||3%||13.42% over 13 years||14.43%|
|S&P 500||1.86%||5.05% over 24 years||5.05%|
Risks to watch out for
While I strongly believe that Kinder Morgan is one of the best long-term income investments you can make, investors need to be aware of a major risk factor to the company's long-term success -- its large outstanding debt.
|Company/MLP||5-Year Debt Issuance (Millions)||5-Year Debt Repayment (Millions)||5-Year Net Debt Issuance (Millions)|
|Kinder Morgan Inc||$76,068||$64,839||$11,229|
|Kinder Morgan Energy Partners||$52,619||$43,479||$9,140|
|El Paso Pipeline Partners||$5,378||$3,380||$1,998|
|Consolidated Kinder Morgan||$134,065||$111,698||$22,367|
Over the past five years, Kinder Morgan has taken on $22.4 billion in net debt, which represents 59% of its total outstanding indebtedness. According to management, after the merger the new Kinder Morgan will have a debt-to-EBITDA ratio --earnings before interest, taxes, depreciation, and amortization -- of 5.6, with a long-term target ratio of 5 to 5.5.
While debt can be very useful for funding growth projects--especially in this near-zero interest rate environment--credit rating agencies typically like to see that ratio at 4.5 or less. Thus, in the future, as interest rates rise, Kinder Morgan is faced with the threat of rising interest costs and a potential credit rating decline if it can't pay off the debt it's using to fund its impressive growth. A lower credit rating would mean higher borrowing costs, which, combined with higher interest rates, would raise its cost of capital and neutralize some of the primary benefits of the merger. That situation, in turn, could threaten the growth rate of the dividend in years to come.
Bottom line: one of the best dividend growth stocks in America
Kinder Morgan is one of the best high-yield dividend growth stocks you can buy today. With the merger now approved, its costs of capital should decline significantly. That fact, along with its other competitive advantages of quality leadership and a great dividend growth track record, means Kinder Morgan is one energy blue chip that I believe should be considered as part of every income investor's diversified income portfolio.
Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.