Why I added Kinder Morgan Energy Partners to my dividend portfolio on February 3

02/24/2012 3:08 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

In my February 3 post http://jubakpicks.com/2012/02/03/looking-for-higher-dividend-yields-and-dividend-growth-here-are-three-picks/#more-8475  I added three stocks to my dividend income portfolio http://jubakpicks.com/ and dropped three.

The reason, I argued then, was that the growing popularity of dividend paying stocks at a time when income vehicles such as Treasuries and CDs pay almost nothing had created a glorious but still real problem for income investors. As investors flocked into dividend-paying shares, they drove up share prices. That was great for investors already fully invested, but for investors looking to get into new positions or for investors looking to put more cash into existing positions, it meant that yields were in constant danger of erosion. In this situation, income investors needed to look for stocks that paid higher yields now and that were also positioned—by their growing cash flows and by management disposition—to keep raising dividends. Look for those stocks, I advised, and beware dividend payers that didn’t seem to be in a position to keep raising dividends.

And with that as background I tweaked this portfolio by adding General Electric (GE), Westpac Banking (WBK) and Kinder Morgan Energy Partners (KMP) while dropping Potlatch (PCH), Merck (MRK) and Abbott Laboratories (ABT).

Today I’m going to give you more detail on one of those adds, Kinder Morgan Energy Partners (and also actually make the change on the dividend portfolio page. The remaining three changes will follow in what I will try to make short order.)

Deciding to invest in an income vehicle such as a real estate investment trust (REIT) or a master limited partnership (MLP) is, in concept: you want to see that the trust or partnership has the cash flow to keep up current payments to unit holders, and you want to see a path forward that would let the trust or partnership increase payments over time.

The Great Recession was a big test for Kinder Morgan Energy Partners. As the U.S. economy slowed, the company’s revenue from its network of pipelines fell too. Cash flow from operations bottomed at $518 million in the first quarter of 2011. Since then the rebound has been extremely strong with cash flow from operations climbing to $1.25 billion in the second quarter of 2011 to $1.98 billion in the third quarter to $2.87 billion in the fourth quarter.

That’s let the company raise dividend payouts from $538 million in the first quarter of 2011 to $2.24 billion in the fourth quarter of 2011.

Great but investors need to ask not just what have you done for me lately but also what will you do for me tomorrow.

Master limited partnerships make their money by borrowing (since they pay out most of their net income they don’t have a lot of retained earnings to re-invest) and then using that borrowed cash to invest in assets with a rate of return above what they’ve paying on the money they’ve borrowed.

The challenge right now isn’t borrowing cheaply—for a company like Kinder Morgan Partners money is cheap and plentiful—but finding enough new projects with high enough potential returns.

That’s where the proposed acquisition of El Paso (EP) by Kinder Morgan (KMI), which acts as general partner for Kinder Morgan Energy Partners. If the deal goes through, and I think it will despite an attempt by some shareholders to stay the March 6 vote, Kinder Morgan would be able to drop El Paso pipeline assets down to the Kinder Morgan Energy Partners master limited partnership (in return for cash, of course.) That growth pathway would increase the earning assets at the master limited partnership and enable Kinder Morgan Energy Partners to increase distributions by about 6% a year, Morningstar calculates. (Without the El Paso deal and those assets, Morningstar puts the annual increase at a not to shabby 4%.)

Kinder Morgan Energy Partners currently pays a 5.1% dividend.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Kinder Morgan Energy Partners as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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