Total returns of 27% per year since 1996. 15% annual growth for dividends in the same time. A $100 investment in ’96 would have turned into $2,518 as of 9/3/2010 compared to $185 for the S&P500. It’s no doubt that Kinder Morgan (KMP) has been a stellar investment over the last 14 years. It is still considered by many to be the big Kahuna of the MLP sector. But there seem to be some storm clouds brewing over KMP. Growth is slowing, valuation is frothy, and the MLP sector is changing. So, is it time to sell KMP?
I have a significant position in KMP and over the last 2 quarters I’ve started to ask my self this question. My concerns over KMP lie in a few areas. First, is future dividend growth. As I stated dividend growth has been 15% per year since 1996 but when you look at recent growth it is notably lower as the table below shows.
The rolling 3 year average of dividend growth has gone from 31% to just over 8% in the last 3 years and just a shade under 5% in the last 2 years. KMP is a huge organization with a very large asset base – slowing growth is really no surprise. However, what makes it even harder for growth to the limited partners is the large share of the cash flow that is being taken by the general partner. KMP’s IDRs (incentive distribution rights) are 50% and KMP is into high splits with the general partner taking 45% of cash flows in 2009. This is a big obstacle to future dividend growth. I think best case future dividend growth at KMP will average 5%, and more likely in the 3% range.
My second concern is with valuation. Most valuations that I’ve seen from the likes of Morningstar, Credit Suisse, S&P value KMP somewhere between $66 to $70 a share. As of 10/22/2010 KMP closed at $70.36. Based on these I would say KMP is fairly valued today. Personally, for MLPs, I like to use the current yield vs historical average and the spread to the 10yr note as a gauge of valuation. The chart below shows both these metrics over time.
Based on yield, KMP trades below its average historical yield (6.16% vs 6.94%) signaling a slight over valuation. But based on the spread to the 10yr note KMP is trading below the average historical spread (3.63% vs 2.15%). In the past KMP has traded for higher valuations than it is trading today. Thus on valuation alone I would consider KMP a hold.
Considering both current valuation and future dividend growth is where I start getting a little concerned. At a yield of 6.16% today and 3-5% future dividend growth, an investor is looking at 9-11% annual returns going forward. With my return requirement being a minimum of 10% per year this does not leave a very large margin of safety even with KMP’s incredible record of stability and meeting commitments.
My final and biggest concern with respect to KMP is what seems to be a significant change in the MLP landscape. Companies and investors are beginning to realize the limitation of the general partner and IDR model. One of the first companies to do something about it was EPD. EPD capped GP splits at 25% years ago giving them and their limited partners a built-in advantage. Lower cost of capital and more cash flow going to the limited partners was a good recipe. Recently, partnerships are starting to buy out the general partner all together, MMP and EPD being the biggest examples. No more IDR splits and lower cost of capital. All great for investors but a significant challenge to MLPs that do not have this structure, like KMP. My concern is what impact this has to KMP? How are they going to respond? So far, they have not commented. KMP’s general partner is private and they have been very supportive of the limited partners in the past but it seems to me that the current structure needs to change in order for KMP to remain competitive. If it doesn’t change then growth will be more challenging.
KMP is a great company. Its history of growth and execution is impressive. It still has many opportunities for growth, particularly given its size and asset base. But other MLPs have significant opportunities for growth as well. KMP’s lower potential future growth in dividends plus a less competitive company structure relative to its peers has me considering alternative investments. Weighing all the data I’m inclined to wait and see and NOT sell. But I will be watching closely to see how KMP meets these challenges in the very near future.
Finally, there is an alternative to switching out of KMP if you’re seeking higher returns. There is a different share class of Kinder Morgan stock, KMR, which has exactly the same economic interest in the partnership but trades at a discount to KMP stock. KMR currently trades at a 13% discount to KMP stock. The difference between it and KMP shares is that your dividend in KMR is paid in shares, not cash, and you do not have to worry about filling out K-1 forms at the end of the year. You get the good old standard 1099. With the discount to KMP shares the dividend yield on KMR shares is 7%. In addition, the discount on KMR shares presents a dilution to KMP shareholders, the additional KMR shares issues at a discount are a higher cost of capital to KMP. Kinder Morgan realizes this and has commented on taking action to get rid of the discount. The elimination of this discount over a 1-2 year period, the higher dividend yield, and a modest 3-5% growth rate, make KMR shares quite attractive. The downside to switching from KMP to KMR shares is the taxable event a sale of KMP would generate. But for a long term investor the trade could be worth it.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.