3 Expensive Lessons To Learn From Kinder Morgan’s 75% Dividend Cut by Ben Reynolds, Sure Dividend
Kinder Morgan (KMI) recently announced that will cut its dividend payments 75% – from $0.51 a quarter down to $0.125 a quarter.
Sadly, much of Kinder Morgan’s stock was owned by retail investors; specifically dividend investors and retirees.
Note: Kinder Morgan was not in the Sure Dividend universe as it didn’t have 25+ years of steady or increasing dividends.
At the end of last week, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. The chat spanned many different topics, Read More
The company had a ‘shareholder friendly’ reputation, with slogans like:
“Promises Made, Promises Kept.”
“Run By Shareholders, For Shareholders.”
With slogans like that, you’d expect Kinder Morgan management to be up-front about problems it may be having.
Most investors understand that businesses run into temporary trouble from time to time. An open, honest management could communicate this and warn about the possibility of a future dividend cut or dividend freeze.
Unfortunately, that’s not what Kinder Morgan did. The following quote is from CEO Richard Kinder from the company’s 3rd quarter earnings release on October 21st (about 50 days ago):
“As a company, we remain focused on our goals to continue to return cash to our shareholders in increasing amounts, to maintain our investment grade ratings and leverage targets while funding our business in the most efficient and economical way possible…
We currently expect to increase our declared dividend for 2016 by 6 to 10 percent over the 2015 declared dividend of $2.00 per share. We expect this range will provide the flexibility for us to meet our dividend and have excess cash coverage (emphasis added).”
There is little doubt that Kinder Morgan management was at least discussing the possibility of a dividend cut ~50 days ago.
Instead of being upfront with shareholders, management continued to claim dividends would increase – leaving investors with a false sense of security. This is not shareholder friendly behavior.
What A Shareholder Friendly Company Would Have Done
Philip Fisher used the analogy of different restaurants to explain different capital allocation policies. Patrons to a Chinese restaurant expect Chinese food. Patrons to an Italian Restaurant expect Italian food. Similarly, investors in a company that is committed to paying steady or rising dividends expect dividends. Investors in a growth stock expect the company to reinvest earnings into further growth.
There’s nothing wrong with either approach (although dividend stocks have historically outperformed).
Kinder Morgan’s shareholders were expecting dividends. The excerpt below is from a Seeking Alpha comment on a recent Kinder Morgan article:
“My retirement dream is shattered; from comfortable I will go to near pauper category.”
That’s someone who was expecting dividends to continue. I believe that the vast majority of Kinder Morgan shareholders were invested in the stock primarily because of its dividend yield and dividend growth potential.
Could management have continued to pay dividends?
The answer is yes. Here’s a quote from a Kinder Morgan press release from December 4th:
“KMI has now completed its 2016 budget process and expects to generate 2016 distributable cash flow of slightly over $5 billion, which would be sufficient to support dividend growth in the range discussed in the third quarter call (of 6% to 10%). Alternatively, this cash flow can be used to fund some or all of KMI’s equity needs for 2016 (emphasis and note added).”
Kinder Morgan could have continued to increase its dividend, or hold it flat, or even done a small dividend cut. The company has the cash flows to do so. A shareholder friendly company would’ve realized what its shareholder base (the real owners) would want, and act accordingly.
Instead, management chose to continue focusing on empire building rather than reward its shareholder base. The company made a mid-dinner switch from Chinese to Italian… Diners are now losing their stomachs.
There are lessons to be learned in analyzing the Kinder Morgan debacle. These lessons are easier to stomach for investors who didn’t invest in the stock. For those who did invest in Kinder Morgan, these lessons will likely not be forgotten.
Lesson #1: Pay Attention to Financing
Kinder Morgan requires continuous capital injections to fund its ambitions growth prospects. In good times, the company could easily tap both equity and debt markets to fund its growth.
Most shareholder friendly businesses repurchase shares (here’s what you need to know about share repurchases). Kinder Morgan regularly issues shares – diluting shareholder ownership in order to fund growth. The company’s share count has more than doubled since 2012.
In addition, Kinder Morgan relies on low-cost debt (due to the current low interest rate environment) to fund growth. In 2011, Kinder Morgan had $14 billion in long-term debt. The company currently has around $40 billion in long-term debt.
Kinder Morgan’s high debt load and sinking share price made both debt and equity financing unattractive. The low share price meant the company would be destroying shareholder value in a big way by issuing shares. The high debt load (and resulting greater risk of default) mean the company would have to pay unfavorable interest rates on new debt.
To get around this issue, Kinder Morgan issued convertible preferred shares with a 9.75% coupon in October of 2015. Obviously, 9.75% is a very high price to pay for capital in today’s low interest rate environment.
This was a clear sign the company was desperate for capital to continue its growth when it should’ve been trying to clean up its balance sheet.
Lesson #2: Avoid Overly Aggressive Growth
Kinder Morgan has long tapped financial markets to fund its growth. This is only sustainable when credit markets are functioning properly. If history is any indication, credit markets don’t always function properly.
A good question to ask about any business is: ‘if this company couldn’t get financing, would it survive?’
A truly high quality business will be able to generate enough cash flows to fund growth organically. They may borrow, but not to excess, and not at any cost.
Kinder Morgan (and many other MLPs and REITs) generate almost all of their growth from investments generated by either issuing new shares or debt. This is a dangerous process that can result in overleverage when management gets too ambitions, or ‘miscalculates’ demand.
Lesson #3: Look At Management’s Actions, Not Their Words
When Kinder Morgan consolidated its MLP businesses in 2014 it hurt many long time investors in Kinder Morgan MLPs due to tax consequences.
Unit holders of the MLPs were only required to pay taxes on distributions when they died or sold the securities.
The only caveat is that if the MLP were to be purchased, taxes would come due for all distributions the unit holder had received in the past. Keep in mind, these are mostly retirees and individual investors who were long time investors in Richard Morgan’s MLPs.
One of the draws of these MLP investments for retirees was their tax deferred status. By consolidating his MLPs into one entity (which is not an MLP but a C-Corp), Richard Morgan forced many long time investors in his companies to pay up on deferred taxes. This is the action of someone more concerned with empire building than doing what’s in the best interest for MLP investors.
The massive sell-off in Kinder Morgan stock has created an interesting opportunity. The company’s shares are likely undervalued today. Value investors may want to dig deeper into the prospects of the company.
What is very clear at this point is that Kinder Morgan is not a shareholder friendly company. Investors should no longer trust in management to act in their best interest. As a result, Kinder Morgan stock does not possess the qualities I would look for in a long-term investment.
Hindsight is always 20-20. Kinder Morgan is not a stock I typically analyze, as it doesn’t have the 25+ years of dividend payments without a reduction I screen for with The 8 Rules of Dividend Investing. Were there warning signs that the company was going to cut its dividend and not act in the best interest of shareholders? Yes, but they weren’t blatant.
Investors who missed these signs should not beat themselves up over it. Rather, take this as an (expensive) learning experience. Look for high quality businesses with shareholder friendly managements trading at fair or better prices. When a company isn’t shareholder friendly and management can’t be trusted, it’s time to move on.