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By Josh Peters, CFA and Jeremy Glaser |

Peters: More Pain to Come for MLPs

Kinder's 75% dividend cut is not going to be the last in the industry, says Morningstar's Josh Peters, but a small number of high-quality MLPs are worth nibbling at today.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters, the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. We're going to talk about Kinder Morgan's recent dividend cut and what impact it could have on the rest of the pipeline sector.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy. Wish it was for better news.

Glaser: Kinder did have a 75% cut in its dividend this week. Let's take a look at the context. How did Kinder get to the point where they had to make such a big cut?

Peters: It's really a function of just having been too aggressive financially. Kinder, as well as other midstream businesses, have been out there for many years selling the virtue of these pipeline, storage, and other midstream assets as providing very steady cash flow, which for the most part is an accurate statement. There are some areas, like gathering and processing, that can have direct commodity price sensitivity and be a lot more volatile. But a portfolio like Kinder's is in pretty strong shape still.

But when you take even a reliable stream of cash flow and then you dump a tremendous amount of debt leverage onto the balance sheet, and you're paying out 90%-95% of the cash flow that is being generated while you're still spending billions of dollars on growth capex and you're going to fund all of that externally, you have no margin of safety. You have no room for anything to go wrong. Even a pretty reliable business can't operate with no net at all. And that is the type of position that has come back to haunt them and has cost their shareholders quite dearly.

Glaser: Now this is not the first cut we've seen in the midstream space, but it's by far the biggest. Do you think this is a canary in the coal mine? Are we going to see some substantial distribution cuts, substantial dividend cuts, across the space?

Peters: Boardwalk Pipeline was the canary in the coal mine; that was in early 2014. This is before the oil price collapsed and the commodity collapsed generally. But here you had a partnership, a pipeline business, toll road, everybody's supposed to feel good and safe about it. It cuts the distribution 80%. It was a great wakeup call--I actually hate that phrase, "wakeup call"--but a wakeup call that even these businesses can have problems and experience challenges. And when they get shut out of the capital markets, when they're no longer able to raise debt and equity on reasonable terms, that means they have to turn inward for cash, and that means cutting distributions to investors.

Now KMI is not really an early warning sign; the storm has hit. It's 100 times worse in order of magnitude and the impact on the industry and the way investors are going to look at the industry than Boardwalk had. But I don't think it's going to be the last. I think you're going to see a few more dividend and distribution cuts from other businesses that were similarly aggressive: too much leverage, too high of payout ratios, too thin of coverage ratios, as people talk about with the partnerships. They're going to have to reckon with the fact that they can't do it all. They can't pay out all their cash flow, grow really rapidly, raise all that capital externally on reasonable terms, and maintain investment-grade credit ratings. It's just too much to do in a stressed-out environment.

So I would be worried about Plains All American and its general partner, Plains GP Holdings. They've already kind of floated the idea that they may have to make some changes in their capital structure, their financial policy. ONEOK is another name--both the GP and LP have been hit very hard.

I think you have to keep an eye on the whole Energy Transfer and Williams deal. Here you have companies that are paying out everything that they generate, and there's a lot of debt in that whole panoply of individual businesses now. It's really hard to evaluate the sustainability from the outside; it's just such an opaque organization. Those are some names that you want to be worried about.

And then among the smaller fry--lots of names, lots of partnership that we don't presently cover because they're too small. If they're gathering-and-processing businesses that have sprouted up like mushrooms after a couple of days of heavy rain, those are vulnerable businesses. I think you want to be very careful with those types of names.

Glaser: We have seen a big sell-off in the whole space. Has it opened up any opportunities? Are you thinking about increasing any of your exposure in your portfolio to midstream?

Peters: Well, the first point is, if you're in these for income, if your portfolio in general is conservative and oriented around dividends, don't be thinking in terms of swinging for the fences. Not here, not in any sector. That's just not how you want to play it.

You want to maintain proper allocations, proper diversification among different sectors that reflect the concentration of risks. Kinder Morgan cuts its dividend; it's not going to be the last. There are going to be other partnerships. If you had a portfolio that was 80% MLPs, maybe you own 10 or 20 different partnerships, but they're all going to face a lot of the same pressures at the same time. You don't want to be that concentrated.

And even now you don't want to say, "Now is the time to double or triple up on my exposure, because they're cheap." I think you want to play a much more disciplined, much more cautious game. I'll say that right off the bat.

I will say there are a couple of partnerships out there that I'm still very comfortable and very confident in. Magellan Midstream Partners, Spectra Energy Partners and its parent Spectra Energy Corporation. Enterprise Products. I actually took a very small position for the first time just in August in Enterprise. These are the ones that have been much more conservative than at Kinder Morgan. Much more conservative than they needed to be back in the boom days, and now they collect the benefit of this type of environment, and they have a lot more financial flexibility. They can continue to grow their dividends and distributions while others are forced to cut.

And the longer this lasts, you're going to see distressed asset sales, and a partnership like Magellan, with very conservative leverage metrics, they've got plenty of room to go out and increase debt opportunistically and add high-quality assets to their business. They're actually going to gain ground before this is over because of this downturn.

So, those are some names I'm comfortable with. It's very hard to endorse any beyond that. The area of names that I have a lot of confidence in is pretty tight right now. But think in terms of... if you have no exposure, you can start to nibble. If you've got some, maybe you paid some higher prices in these very high-quality names, you can think about averaging down. But don't double, triple up. Don't move 50% of your portfolio into midstream partnerships. My exposure right now is in 10%-11% range. I might go to 15%, but I'm not going to 50%.

Glaser: Josh, thanks for your thoughts today.

Peters: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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