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Members’ Mailbag: Kinder Morgan Preferred Shares Yield 10.9%

From time to time, we like to share investment-related questions/ideas from our readers. Today's "Members’ Mailbag” comes from John W. Specifically, John asks:

What is your thinking on KMI now that they have announced a schedule for future dividend increases? Their preferred shares have 4 dividend payments before conversion so would it be smart to simply invest in KMI-A as a way to begin a long position in KMI?

Thanks for the question John, and we have a pretty strong opinion on this one…


About Kinder Morgan

Kinder Morgan is the largest midstream energy company in North America, with more than 80,000 miles of pipeline and 155 terminals. KMI participates in the transportation, storage and processing of natural gas, crude oil, and carbon dioxide, and it is also the largest handler of ethanol in the U.S. Most of KMI’s cash comes from fee-based contracts, which help keep the business and the dividends steady as long as those contract holders to go out of business. And if the industry expands then KMI will be right there to expand and grow with it.

KMI’s Dividend

To the chagrin of shareholders, KMI cut the big quarterly dividend payment on its common shares from $0.51 at the end of 2015 to only $0.125 in the first quarter of 2016 (at a time when energy prices were low, and many energy companies were going bankrupt), and the stock price subsequently declined dramatically (technically it was declining for months before the dividend cut because the writing was on the wall). The dividend yield for KMI currently sits at 2.4%.

Future Dividend Increases

Recently (on July 19, 2017), KMI announced plans to increase the dividend to $0.80/share in 2018, a 60% increase, beginning with next year's Q1, and rising to $1.00/share in 2019 and $1.25 in 2020. The market liked the news, and the shares are up roughly 6% since the announcement. However, for the rest of this year, KMI expects to keep the dividend at $0.50/share and use cash in excess of dividend payments to fund growth investments.

KMI’s Preferred Stock

In addition to common stock, the company also offers preferred shares (KMI-A) with an impressive 10.9% yield. However, before jumping in head first any buying some of this impressive yield, it’s important to read the fine print. Here are the critically important details (from quantum online)  about the preferred shares:

Kinder Morgan, 9.75% Dep Shares Series A Mandatory Convertible Preferred Stock
Kinder Morgan, Inc., 9.75% Depositary Shares each representing a 1/20th interest in a share of Series A Mandatory Convertible Preferred Stock, liquidation preference $50 per depositary share. The preferred shares are mandatorily convertible on 10/26/2018 into a variable number of Kinder Morgan, Inc. (NYSE: KMI) common shares based on the then current price of the common shares for 20 consecutive trading days immediately prior to the conversion date. The conversion settlement rate will be 1.5440 depositary shares per unit if the then current market price is equal to or greater than $32.38 and 1.8142 depositary shares per unit if the market price is equal to or less than $27.56. For market prices between those values the settlement rate will be $50 divided by the market value. The last reported sale price of the common stock on 10/26/2015 was $27.56 per share. The preferred shares are convertible any time at the holder’s option into 1.5440 depositary shares of common stock. Distributions of 9.75% per annum ($4.875 per annum or $1.21875 per quarter) will be paid quarterly on 1/26, 4/26, 7/26 & 10/26 to holders of record on the record date that will be 1/11, 4/11, 7/11 & 10/11 respectively (NOTE: the ex-dividend date is at least 2 business days prior to the record date).

The most critical point to consider is that these shares are mandatorily convertible on 10/26/2018 into a variable amount of common shares. Specifically, if the common shares are trading at $32.38 or more, then your preferred shares convert to 1.544 shares of common. And if the common shares are trading at $27.56 or less, then your preferred shares convert into 1.8142 shares of common.

Based on the current market price of the common ($20.69), the preferred shares would convert to 1.8142 shares of common in a little over a year from now. Said more directly, if you pay $44.64 (the current price of a preferred share now), it would be converted to only $37.53 worth of common stock in a little over a year (i.e. $20.69 x 1.8142 = $37.53). Even though you’ll get paid the 10.9% dividend on the preferred, you’d lose $7.10 (or approximately 15.9%) in price loss. This is NOT a good trade. Now granted the common share price will move between now and the 10/26/2018 mandatory conversion date, but the common shares would have to gain 18.9% (all the way up to $24.61 just to breakeven from a price standpoint.


Conclusion

Kinder Morgan is a far safer company that it was just 18 months ago. By cutting the dividend, it was able to get its debt and its balance sheet under control. Further still, the energy industry is far safer too now that energy prices are stronger than they were, and now that the weakest companies (which threatened to wreak havoc on the system) have filed for bankruptcy. And as the industry continues to improve its health and grow, Kinder Morgan’s common shares are worth considering. We believe the share price and the dividend are likely to increase steadily in the coming years. Given the choice between Kinder Morgan common and preferred shares, the common shares are far more attractive, in our view.

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