If you love dividends, you’ve probably found yourself looking into the midstream sector. It is home to some of the highest yields in the market, but a big yield alone isn’t enough of a reason to buy a business. Investors should focus on industry giants, with size presumably coming as a byproduct of success. In the midstream space, two of the most prominent players are Enterprise Products Partners (EPD -1.49%) and Kinder Morgan (KMI -1.99%). Here’s how they compare on six points.
If you are looking at Enterprise and Kinder Morgan, you probably care a lot about yield. In this matchup, Enterprise offers slightly more, with a distribution yield of 7.4%. Kinder Morgan’s dividend yield is a touch over 6%.
Obviously, Enterprise wins if you are looking to maximize the income you earn today. But yield alone doesn’t tell the full story; you need to dig deeper.
2. Distribution safety
In the fourth quarter of 2022, Enterprise covered its distribution by 1.9 times with distributable cash flow. That’s a very attractive number that leaves room for distribution increases and a margin of safety if there’s adversity ahead. Basically, there’s no particular reason to worry about the 7.4% yield getting decimated by a distribution cut. Kinder Morgan also had a coverage ratio of 1.9, so all of the same information applies. So far, Enterprise still looks like the more attractive income investment.
In 2016, the energy sector was going through a difficult period and Kinder Morgan cut its dividend. It was the right move for the company, which was forced to choose between continuing to pay a big dividend or funding its capital investment projects. Dividend investors, who had been told shortly before the cut to expect an increase, were understandably unhappy with the move.
There’s a trust issue here that should probably keep conservative investors on the sidelines, even though Kinder Morgan has been steadily growing its dividend since 2018 in a bid to rebuild credibility on the dividend front.
The story at Enterprise is a little less dramatic. It has increased its distribution every year for the past 24 years. That’s an impressive streak, particularly in light of the inherent cyclicality of the energy sector. Once again, it wins out in this comparison.
There’s another view that’s also quite illuminating. If you consider the total return to investors, which assumed the reinvestment of dividends and distributions, Kinder Morgan has been a rather large disappointment for investors over its public life with a total gain of just 2% or so. By comparison, Enterprise unitholders have been much better rewarded over that span, with a total return of over 150%. Clearly, one of these two is creating value for investors with management’s capital investment choices and the other is not.
Given the elevated yields on offer from both Kinder Morgan and Enterprise, investors need to go in understanding that the yield is likely to represent a huge piece of the investment return profile. That presumption is backed by the fact that these companies tend to grow via building or buying large infrastructure assets in the energy sector, most of which are tied to carbon fuels. The majority of the best investment opportunities have already been built after a long period of heavy investment. The opportunities for material expansion going forward aren’t as exciting as they once were, particularly given the increasing role of clean energy in the world. That’s not to suggest that their fee-based business models are at risk; oil and natural gas are still in high demand (and should remain so for years to come), but growth is likely to be slow, at best.
And that means slow growth in the income streams these midstream giants produce. Over the past decade, Enterprise’s distribution has increased roughly 4% a year. That’s enough to keep up with the historical rate of inflation, but it certainly isn’t going to knock your socks off. Kinder Morgan’s dividend growth since the cut has been far more rapid, with a 17% annualized growth rate over the past five years. However, that’s off of a low base thanks to the cut. Over the past three years, the dividend has grown at around 5% a year. Clearly, these are high-yield investments, not dividend-growth monsters, and they both pretty much have similar distribution growth profiles from here.
On the balance sheet, there are some material differences. Enterprise has a debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of 2.7. That’s pretty modest. Kinder Morgan’s figure is 5.1, which is materially higher. That’s not to suggest that it can’t handle the added leverage, but if you have a conservative bent, Enterprise looks like the safer option.
6. Form and function
At the end of the day, however, one of the biggest differentiators between Kinder Morgan and Enterprise is likely to be their corporate structures. Kinder Morgan is a typical company — there’s nothing unusual to take into account before investing in it. Enterprise, however, is a master limited partnership (MLP), which is a far more complex structure that comes with tax issues. For example, MLPs don’t play well with tax-advantaged retirement accounts and you’ll have to deal with a K-1 form come tax time each year. If you like to keep things simple, Kinder Morgan is the better choice. And even if you don’t mind some complications, you’ll still probably want to talk to a tax advisor before you buy Enterprise.
And the winner is…
When you add up the points here, Enterprise is probably the better option for most investors. That said, tax issues could make it a bad choice for certain investors, particularly those who are investing in their tax-advantaged retirement account. Still, given Kinder Morgan’s weak history of creating value, and that troubling dividend cut, investors may want to look at other options.