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investor clinic

I've never owned shares of U.S. pipeline giant Kinder Morgan Inc. – thank goodness. But a lot of U.S. income investors own the stock – including plenty of retirees – and they're rightfully upset about the collapse of what had seemed, until recently, to be a relatively safe investment.

The Kinder Morgan case is a cautionary tale for dividend investors, so today I'll summarize what happened and discuss a few lessons that the episode highlights. I recognize that some of this is easy to say with 20-20 hindsight, but it's still a useful exercise if it helps people spot trouble at other companies before it's too late.

First, a quick recap. On Tuesday, Houston-based Kinder Morgan slashed its dividend by 75 per cent. It was a stunning reversal for a company that had been steadily raising its dividend for years – including a 4-per-cent increase announced just two months ago. The reduction was all the more surprising given that, when the company announced the most recent increase, it also projected that the dividend would grow 6 per cent to 10 per cent in 2016.

What went wrong? First, the price of oil plunged, taking everything energy-related down with it, including Kinder Morgan's share price. That made it less attractive for the company to issue equity to raise funds. Second, the company's balance sheet became stressed: After a recent acquisition added about $1.5-billion (U.S.) to Kinder Morgan's already onerous debt load, rating agency Moody's put the company – which was one downgrade away from speculative or "junk" status – on credit watch.

Rather than lose its investment grade status – a move that would have had massive financial consequences – Kinder Morgan took the least bad option and cut its dividend, which staved off the rating downgrade and frees up about $3.3-billion annually to fund expansion internally. The share price rallied following the announcement, indicating that investors were relieved to have the matter resolved, although not without a lot of pain for dividend investors.

What can we learn from this debacle? Here are some key takeaways.

A rising dividend alone does not guarantee anything

The investment landscape is littered with companies that raised their dividends for years – only to slash them when the business outlook changed for the worse. In Canada, examples include the former Yellow Pages Income Fund, AGF Management and Reitmans. A rising dividend can indeed be a good sign, but only if it is supported by growing cash flow and earnings, a healthy balance sheet and a favourable business outlook. In the absence of strong fundamentals, a rising dividend can be an accident waiting to happen.

High yield = high risk

Even before Kinder Morgan cut its dividend, the stock's outsized yield was a warning sign. In early September, for example, with Kinder Morgan's shares trading at around $31, the stock was yielding 6.3 per cent – high, but not necessarily egregious. By mid-November, as the shares continued to fall, the yield shot up to nearly 9 per cent. By the time the dividend was cut, the stock was trading at less than $16 and the yield was a clearly unsustainable 13 per cent. When a yield starts to look completely unrealistic, the stock market is telling you that the story might not end well.

Payout ratios matter

Particularly when looked at in combination with Kinder Morgan's rapidly rising yield, its aggressive payout ratio was a red flag. Through the first nine months of 2015, the company reported distributable cash flow per share (before certain items) of $1.58 and shelled out $1.42 in dividends – a payout ratio of about 90 per cent. In the third quarter, the payout ratio was close to 100 per cent. This left little cash for reinvestment in the business and limited the company's financial flexibility.

Debt ratings matter, too

Companies that are one notch above junk bond status – as Kinder Morgan was, and is – have little room for error. If a project is delayed, the business faces unexpected headwinds or has to add to its debt load, a credit downgrade can dramatically increase its cost to borrow money. As we saw with Kinder Morgan, even the threat of a downgrade can cause a company to throw dividend investors under the bus. The lower the credit rating, the higher the danger to investors.

Don't count your dividends …

These days, a lot of companies like to project their dividend growth rates years into the future. While that can be a sign of management's confidence, it's worth remembering that dividends aren't official until they're declared by the board. Companies can – and do – change their minds, which is perhaps the most important lesson from the Kinder Morgan collapse.

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