Kinder Morgan's Disaster: Why it Serves as a Lesson to Dividend Investors and Shows the Superiority of These 3 Blue Chip Competitors

Source: Kinder Morgan Inc.

Dividend growth investing has been shown to be the best long-term strategy to grow wealth over time. However, thanks to the worst oil crash in over 50 years many energy dividend stocks, especially MLPs, have proven highly unprofitable over the last five years.

KMI data by YCharts

As you can see, Kinder Morgan Inc. (KMI 0.83%) has badly underperformed the overall market, both in terms of pure share price, and total returns (which include dividend reinvestment). However, superior competitors such as Enterprise Products Partners (EPD 1.19%), Spectra Energy Partners (SEP), and Magellan Midstream Partners (MMP) have done much better. In fact Spectra and Magellan have still managed to beat the market in total returns despite the recent oil crash induced crash.

Find out why Kinder Morgan has proven such a poor investment over the last half decade and how it serves as a cautionary tale about the most important lesson successful dividend investors need to keep in mind to avoid a similar fate. More importantly, find out why Enterprise, Spectra, and Magellan continue to be far superior long-term dividend growth investments; likely to achieve market beating total returns over the next decade.

What went wrong at Kinder Morgan
There's nothing inherently wrong with Kinder Morgan's 84,000 miles of pipelines, 180 storage terminals, and other assets. In fact, America's largest midstream conglomerate generated $4.7 billion in distributable cash flow in 2015 and expects to generate $4.9 billion of DCF this year.

Rather the problem at Kinder was that management was so eager to please dividend hungry investors that it made dividend growth a top priority. This resulted in the company choosing to pay out almost all of its DCF as dividends and relying too much on debt and equity markets to fund its expansion plans.

While this worked fine when oil prices were stable and around $100 per barrel for years on end, as crude crashed and Wall Street abandoned all things oil and gas related en masse, the unit prices of almost all midstream MLPs, and Kinder's share price, plunged as well. This made equity growth capital increasingly expensive and raised capital costs high enough to make an increasing share of Kinder's expansion project backlog unprofitable.

Until the end of 2015 Kinder was able to continue borrowing debt cheaply but eventually its balance sheet became so over leveraged with debt that credit ratings agencies threatened to cut its rating to "junk" status which would hade made future borrowing and refinancing of over $44 billion in debt sky rocket.

Thus Kinder was forced to finally do what Enterprise, Spectra, and Magellan had been doing all along; become more conservative with its approach to debt, and rely more on its DCF to fund growth internally.

For Kinder investors this meant a brutal 80% dividend cut, which the market had already been anticipating for months and had resulted in its share price crashing.

The most important lesson dividend investors need to know

Sources: 10-Ks, Yahoo Finance, Management Guidance, Fastgraphs

Note that this table shows Kinder's yield and 2015 DCR had it not cut its dividend at the end of 2015.

As you can see, Kinder's maximum $.51/share quarterly dividend was simply not sustainable given its low DCR and lack of ongoing access to sufficient cheap growth capital markets. In fact had management chosen to simply maintain this payout in 2016 even this year's projected 4.3% increase in DCF would have resulted in a DCR of 1.08 and Kinder would have had to accept a painful credit downgrade as well as shutting down future cash flow growth in order to accomplish this.

While management made the right choice in terms of maximizing long-term investor value, notice how Enterprise Products Partners', Spectra Energy Partners', and Magellan Midstream Partners' higher coverage ratios gave it superior access to excess cash flow as well as to continue guiding for growing their payouts despite the oil crash.

This was a result of their more conservative managements, which, understanding the inherent cycle nature of energy prices, wisely chose to focus on two other vitally important metrics over the years that make up the cornerstone of long-term distribution sustainability.

Strong balance sheet and project profitability is essential

Sources: Morningstar, Gurufocus

Kinder Morgan's years of excessive reliance on outside growth capital not only resulted in a highly leveraged balance sheet that was the primary reason for the dividend cut, but it also hurt the company's long-term ability to grow shareholder value.

That's because it reduced the company's return on invested capital below its cost of capital meaning that, while new projects coming online will increase cash flow they are still costing existing shareholders money.

In an industry that is continually raising outside capital to grow it can be hard to know whether or not a company is really growing profitably or just using new capital to grow cash flows at any price.

Which is why net ROIC is one metric that you should keep a close eye on. While not a perfect method of judging long-term profitability as it factors in share volatility which doesn't directly affect the profitability of projects, as a rule of thumb it's a good way to check to make sure that each dollar or debt or equity issued is being wisely spent by management.

Bottom line
While yield and dividend growth is often the two things income investors focus on, payout sustainability is actually the most important factor underlying long-term success. Which is why all dividend investors need to make sure that they pay attention to the three pillars of long-term dividend sustainability: coverage ratio, a strong balance sheet, and a positive net ROIC.

While Kinder Morgan may now be on the right track to eventually recover, Enterprise Products Partners, Spectra Energy Partners, and Magellan Midstream Partners still continue to offer investors superior payout sustainability profiles which should result in better long-term total returns.