Source: Kinder Morgan.
The worst oil crash in half a century has laid bare the painful truth that high yields come with high risk and income investors who choose yield over quality do so at their peril. Take, for example, the case of two of America's largest pipeline blue chips, Kinder Morgan (KMI +2.77%), and Enterprise Products Partners (EPD +1.91%).
Over the past year, Wall Street has punished both severely. However, Kinder Morgan's collapse, while well earned (its mountain of debt forced management to slash the payout to fund growth projects), Enterprise Products Partners is a classic case of a market overreaction.
Let's examine Enterprise Products Partners' full-year 2015 earnings results to see just why this midstream MLP represents one of America's highest quality high-yield dividend growth stocks. More importantly, here's why Enterprise is so well positioned to protect and grow its payout in a world of lower energy prices.
Business model that's all about stability
The basis of the midstream MLP business model is a tollbooth-like river of cash flow ensured by long-term contracts. Both Enterprise Products Partners' and Kinder Morgan's contract mix takes this basic premise and improve upon it via many of their contracts guaranteeing a minimum operating margin for use of their highly diversified assets.
Specifically I'm referring to Enterprise's focus on several key types of energy pipelines including: natural gas, crude oil, petrochemicals and refined petroleum products, and natural gas liquids (NGLs). Meanwhile Kinder Morgan has its hands in natural gas pipelines, LNG exports, CO2 distribution, oil tankers, and even oil production.
Why is this so valuable to dividend investors? Because while low oil and gas prices may decrease oil and gas production (so-called "supply push" volumes), very low gas and NGL prices can provide volume protection because demand from oil and gas customers ("demand pull" volumes) can offset this.
This provides both Enterprise Products Partners' and Kinder with distributable cash flow (DCF) -- which is what's needed for the sustainable and steady distribution increases -- with incredible stability despite oil prices collapsing 70% since their mid-2014 highs. For instance, in 2015 Enterprise's cash flow (excluding asset sales) increased 2.5%, quite impressive given the carnage of the current energy markets.
BUT if Kinder's DCF is also stable then why is Enterprise in a better position? Because of three other factors that make Enterprise Products Partners far superior to Kinder Morgan.
Payout profile that can withstand almost any storm
Source: Enterprise Products Partners investor presentation.
These images illustrate Enterprise's two largest competitive advantages, and why its such a superior choice to rivals such as Kinder Morgan.
Whereas other pipeline operators, such as Kinder Morgan before its 75% dividend cut, were focused on growing their payout as quickly as possible at the expense of retaining almost no DCF, Enterprise Products has always emphasized slower, but far steadier, payout growth.
This focus on a high ratio of retained DCF, even during the oil boom times, has created a vast excess cash flow cushion that allows Enterprise to continue raising its payout when most of its peers are just maintaining, or, like Kinder, slashing theirs.
In fact, in Q4 2015, the MLP announced its 46th consecutive quarterly payout increase. What's more, management even issued 2016 distribution growth guidance predicting 5.2% growth, resulting in a generous forward yield of 7%.
Large growth opportunities, and most importantly ...
Investors should never simply accept management guidance as gospel. Rather, you should require evidence that 2016 will provide some kind of growth catalyst that will result in DCF growth sufficient to sustainably achieve the MLP's payout growth target.
In this case, Enterprise's growth will probably be courtesy of $4.5 billion in new projects that are coming online.
Source: Enterprise Products Partners investor presentation.
Of course, planned projects need to be funded, and that is where another Enterprise Products Partners' strength lies -- in the form of $4.4 billion in available liquidity as of the end of 2015.
... plenty of access to cheap capital to execute on it
With financial markets in a near panic over the threat of energy defaults, Enterprise Products Partners' annual excess DCF of over $1 billion per year is a godsend that helps it to fund a significant portion of its growth internally. Not only does that result in a much lower leverage ratio than rivals such as Kinder Morgan (which is partially why Enterprise has the highest credit rating in the industry at BBB+), but it also minimizes the need to raise equity funding by diluting current investors with a rising unit count.
That in turn helps keep the long-term coverage ratio high and makes further steady payout growth much more likely to continue even if energy prices remain low for several years.
Bottom line
The sad story of Kinder Morgan's dividend cut should serve as a cautionary tale that shows the importance of long-term investing principles. Specifically, the dangers of focusing primarily for short-term yield and payout increases rather than long-term distribution security and steady growth.
With Enterprise Products Partners, income investors have the opportunity to invest in one of the industry's best-managed midstream MLPs, and at valuations that not only lock in a generous current yield but is also likely to result in market-crushing total returns in the years ahead.
