Kinder Morgan, Inc. (NYSE:KMI) is a blue-chip midstream business that is highly popular with income-oriented investors due to its investment grade balance sheet, stable cash flow generation profile, attractive dividend yield, strong dividend coverage, and good dividend growth potential.
While we do not deny that KMI could be a welcome addition to an income investor’s portfolio, we believe that Energy Transfer LP (NYSE:ET) offers much more compelling income and total return potential without meaningfully more risk, particularly in the current environment.
Here are three specific reasons why:
#1. Much Higher Current Income Yield
The main reason investors buy midstream businesses like KMI and ET is for the income. With the industry’s lengthy pipeline contracts that are mostly commodity price and demand resistant, indexed to inflation, and backed by fairly financially healthy counterparties (especially in the current environment), supporting high payouts to investors is very feasible.
On top of that, given that interest rates are on the rise, inflation is raging at four-decade highs, and the political and regulatory climates are such that significant new pipeline projects are extremely difficult to complete and the growth prospects for this industry are low. That means that just about all of the operating cash flow can be returned to investors, as competing sources for that capital are increasingly few. If investors want growth, they are better served investing in places like tech (QQQ) or even the S&P 500 (SPY). If they want income, the midstream sector (AMLP) is arguably the best place to invest, with yields that are better than anywhere else right now. Not even traditional income plays like utilities (XLU) or REITs (VNQ) can come close:
Only BDCs (BIZD) are running in the same league. However, their business models are much more sensitive to economic conditions than MLPs are, so with the economy increasingly likely headed for a recession, it is certainly a higher-risk place to invest than midstream.
On the current income front, ET crushes KMI. ET’s current forward distribution yield is 6.7%, whereas KMI’s is 5.5%. However, in addition to its 120 basis points of higher current yield, ET also has a distributable cash flow yield of 20.2%, whereas KMI’s distributable cash flow yield is barely over half of that at 10.7%. ET also wins on the EV/EBITDA metric, with an 8.1x multiple compared to KMI’s 10.6x multiple.
A big reason why ET has a significantly superior distributable cash flow yield to KMI is that – in addition to its cheaper pre-tax enterprise valuation – it is an MLP, whereas KMI is a C-Corp for tax purposes. This means that ET does not have to pay corporate income taxes, whereas KMI does. While some years KMI’s taxes are miniscule, in other years they can number in the hundreds of millions of dollars. ET can then send that cash flow to unitholders instead of the Federal Government. The tradeoff is that ET unitholders have to file a K1 tax form every year, whereas KMI shareholders only have to deal with a 1099 tax form.
Of course, there is also the matter of the safety of the current income stream. KMI’s portfolio and balance sheet are stronger than ET’s, but only incrementally. KMI earns a BBB credit rating from S&P whereas ET earns a barely worse BBB- credit rating. Both of them are investment grade, both have very large and well-diversified asset portfolios, and both have balance sheets with plenty of liquidity and no concerns about paying off or refinancing debt maturities as they come due.
When it comes to track record, both businesses have spotty track records and have inflicted nasty payout cuts on investors, while both also have significant skin-in-the-game from insiders, including the backing of some big-name billionaire founders in Kelcy Warren (ET’s founder) and Richard Kinder (KMI’s co-founder), both of whom continue to buy up large swaths of equity in their respective businesses.
Most importantly, ET’s distribution coverage ratio is vastly superior to KMI’s, though both businesses’ coverage ratios look quite conservative. ET’s is ~3x and KMI’s is ~1.95x, so – especially when combined with the stable cash flow business models and investment grade balance sheets – neither looks even remotely close to having to weigh a distribution cut.
No matter how you slice it or dice it, ET is generating significantly more cash flow for investors at current prices than KMI is and is also distributing more cash to investors than KMI is. If you are buying an MLP for income, ET is the clear-cut choice.
#2. Much More Aggressive Payout Growth Potential
On top of its superior current income profile, ET is also poised for much more aggressive distribution growth in the coming years than KMI is. Analysts are forecasting miniscule 2.8% annualized dividend per share growth for KMI through 2026, whereas they are expecting ET to grow its distribution per unit at a 15.4% annualized pace through 2026.
This largely stems from the aforementioned fact that ET has a much higher (~50% higher, in fact) distribution coverage ratio than KMI has, so it can afford to hike its distribution at a much brisker pace.
ET’s management has laid out its growth expectations for the near term, stating on its latest earnings call that:
On April 26, we were pleased to announce a quarterly cash distribution of $0.20 per common unit or $0.80 on an annualized basis, which represents a more than 30% increase over the first quarter of 2021. As a reminder, future increases to the distribution level will be evaluated quarterly with the ultimate goal of returning distributions to the previous level of $30.5 per quarter or $1.22 on an annual basis, while balancing our leverage target, growth opportunities and unit buybacks.
This means that the board will likely be hiking the distribution by another 52.5% in the near future. Given that distributable cash flow per unit is expected to come in at $2.41 this year, capital expenditure requirements are lower than they have been, and the balance sheet continues to get stronger quarter after quarter thanks to an immense amount of retained cash flow being applied towards reducing net debt, there is little reason to believe that it will take longer than a year or two at most to boost the distribution to $1.22 on an annual basis. That would be a distribution yield of over 10% at the current unit price. There is simply no way that KMI will be able to match that level of payout growth anytime soon.
#3. Much More Impressive Growth And Deleveraging Potential
Finally, ET’s greater amount of retained cash flow as a percentage of the current equity price enables it to invest more aggressively in new growth projects and acquisitions, pay down more debt (thereby reducing interest expense more rapidly), and/or repurchase common equity in greater amounts than KMI can. This in turn could turbocharge its per unit distributable cash flow growth rate.
Given that ET remains dedicated to deleveraging its balance sheet, it would not surprise us at all if it achieves an upgrade to a BBB credit rating in the near future, which would put it on the same level as KMI from a creditworthiness standpoint.
Additionally, ET is pursuing growth projects quite aggressively, thanks to its superior amount of retained cash flows. These projects include:
- A Permian Basin natural gas pipeline in a project named “Warrior” that would connect natural gas from the Permian to the existing ET intrastate pipeline network
- A massive Lake Charles LNG facility
- Potential Petchem acquisitions and/or growth projects
Of course, KMI has its own ambitious growth plans as well, with the expectation of spending between $1 and $2 billion per year on growth projects moving forward. However, ET’s spending will likely be a bit higher in absolute terms and – given its smaller market cap than KMI’s – we expect it to generate higher growth rates relative to market cap moving forward.
To us, the choice is clear: ET offers investors a convincingly superior current income, income growth, deleveraging, and cash flow per unit growth profile relative to KMI.
While KMI does have a slightly lower risk profile thanks to having a bit stronger of an asset portfolio and also offers investors the convenience of a 1099 compared to the K1 issued by ET each year, these are really just minor factors when considering how superior ET’s total return proposition is.
We rate ET an attractive Buy right now and KMI as a Hold.