PAGP - Better Buy After Q4 Results: Kinder Morgan Or Plains?

Summary

• Plains and Kinder Morgan are two high yield midstream businesses that recently reported Q4 results.
• Both boast investment grade balance sheets and have been growing their dividends of late.
• We compare them side by side and offer our take on which is the better buy right now.

Both Plains ( PAA )( PAGP ) and Kinder Morgan, Inc. ( KMI ) are midstream businesses that offer high dividend yields. KMI has an investment grade balance sheet while AM offers a significantly higher yield. In this article, we will compare them side by side and offer our take on which one is a better buy.

Plains Vs. Kinder Morgan: Q4 Results

Plains reported solid Q4 FY 2022 results , completing a year in which it turned in a strong performance. In fact, it surpassed its February adjusted EBITDA guidance by $310 million (a 14.1% increase). It also generated $1.61 billion in free cash flow (18.4% of the current market cap), reduced its leverage ratio to 3.7x (below the long-term target range of 3.75x-4.25x), and announced a return to significant distribution growth, including a $0.20 per unit increase and $74 million worth of unit repurchases. The company credits its success to market-based opportunities, higher commodity prices, and increased tariff volumes, especially in the Permian systems.

Going forward, the company expects flat adjusted EBITDA year-over-year due to inflation-linked escalators on increased tariffs being offset by fewer market-based opportunities and asset sales. While free cash flow generation is also projected to be flat, free cash flow net of asset sales is likely to significantly increase this year. Plains plans to use its free cash flow to pay distributions, fund capital expenditures, and pay down debt as it matures, accelerating deleveraging. In the coming years, Plains expects to grow its payouts to equity investors at a pretty rapid clip until it reaches a 1.6x DCF coverage ratio while also remaining within its leverage targets.

KMI had a very successful Q4, with EBITDA increasing by 8% year-over-year and distributable cash flow rising by 13% year-over-year.

The company's natural gas pipeline business was a particular standout, with earnings increasing by 11% year-over-year due to 4% year-over-year volume growth.

In 2023 KMI expects adjusted EBITDA to increase by approximately 2.7% year-over-year and its leverage ratio to decline from 4.1x at year-end 2022 to 4.0x, providing significant flexibility below its 4.5x long-term leverage target. The company has also increased its share repurchase authorization from $2 billion to $3 billion and announced a 2% increase in its total dividend payout for the year.

Plains Vs. Kinder Morgan: Balance Sheet

Plains has made significant progress in reducing its leverage ratio to 3.7x by year-end and paying down debt, which could result in an upgrade of its BBB- credit rating to BBB in the near future. The company plans to continue reducing its leverage ratio and pay down at least $600 million in debt while maintaining a steady adjusted EBITDA this year, bringing the leverage ratio down to 3.5x by the end of 2023.

Additionally, the company is considering opportunistically retiring some or all of its preferred equity, as recent increases in distribution rates on those preferreds due to higher interest rates have made them more costly.

Management was asked on the earnings call about their long-term leverage ratio expectation, given that they have already fallen below the low end of their long-term target. They responded with:

we intend to migrate further below the low end and kind of operate there. And I think what our view is we'll assess [whether we want to lower our target leverage range]. We do believe that probably broader energy industry leverage probably needs to be lower than it's been historically. But we'll take a little time and assess that in the future, but for now, just kind of look at it and pass along the math that we just intend to kind of operate below the low end.

KMI has a solid investment grade credit rating (BBB with a stable outlook) from S&P and a net debt to EBITDA ratio that is well below its long-term target of 4.5x. In fact, KMI finished 2022 with its lowest year-end net debt level since 2014. This provides KMI with ample room to increase its leverage ratio to take advantage of attractive opportunities as they arise.

To sum up, both companies are in great financial condition and face minimal risk of financial distress in the near future. Moreover, both management teams seem to suggest that their balance sheets will continue to strengthen over time.

Plains Vs. Kinder Morgan: Business Model

In recent years, Plains has been divesting non-core assets and using the proceeds primarily for debt reduction, as well as some opportunistic unit repurchases. The company plans to sell around $270 million of its assets in 2023 as part of this strategy.

Plains' core assets, particularly in the Permian Basin, are of very high quality, with its crude and refined products midstream businesses contributing around 80% of its adjusted EBITDA. The network is strategically positioned and is expected to generate strong long-term performance for the business, as long as the Permian Basin remains an attractive production basin. In addition to its crown jewel Permian assets, the company also has some NGL assets in Western Canada that complement its portfolio.

KMI has a significant presence in mission-critical midstream infrastructure, including North America's largest CO ₂ transportation business, the largest independent refined products transportation business, the largest independent terminal business, and the largest natural gas transmission businesses in North America. Moreover, it transports around 40% of all U.S. natural gas and 50% of its LNG, serving almost all of the country's major gas supply and demand regions.

The company's competitive advantages and durability are further enhanced by its reliable cash flows, with 88% of its EBITDA generated from commodity price resistant take-or-pay and/or fee-based contracts and an additional 6% hedged. As a result, only 6% of its EBITDA is commodity-price sensitive. Additionally, the vast majority of its counterparties are investment grade, which provides KMI with a very stable cash flow stream in various macroeconomic environments.

Plains Vs. Kinder Morgan: Track Record

When it comes to track record, both have put forth similarly abysmal performances:

That said, KMI has slightly outperformed Plains over both their longer term and shorter-term histories. Of particular note is the fact that KMI's share price and dividend payout weathered the COVID-19 energy market crash much better than Plains' did:

Plains Vs. Kinder Morgan: Risks And Catalysts

As midstream businesses, the risks and catalysts facing KMI and Plains are very similar. That said, KMI is more focused on natural gas and NGLs whereas Plains is more focused on Permian-based oil commodities. As a result, Plains is a pretty heavily concentrated on Permian oil production whereas KMI is a more diversified bet on the broader midstream industry, particularly the natural gas and NGL sectors.

Furthermore, KMI is more defensively positioned than Plains is, making Plains a more likely outperformer in a bullish scenario for energy whereas KMI will likely outperform Plains in a bearish scenario for energy.

Plains Vs. Kinder Morgan: Valuation

Based on the below valuation metrics, PAGP clearly looks to be trading at a greater discount relative to its own history as well as relative to KMI:

Investor Takeaway

Both KMI and Plains have solid balance sheets, business models, and reliable dividend payouts. However, KMI stands out for its superior credit rating, larger and better-diversified business model, and slightly better/less bad track record.

Nevertheless, Plains has made significant progress in improving its balance sheet, and its valuation and near-term dividend growth potential are considerably better than KMI's.

Our view is that investors seeking a one-stop-shop midstream business should choose Kinder Morgan, Inc. due to its greater safety and diversification. However, for investors looking for a specialized value and income growth pick to complement their midstream portfolio, Plains is a more appealing choice, with higher total return potential and only slightly more risk.

We rate both companies as a Buy at present, and note that they issue 1099 tax forms rather than K1 tax forms because they are C-Corps. While we are not tax experts and this is not tax advice, we believe this makes them suitable investments for IRAs and 401ks.

At High Yield Investor, we hold PAA due to its attractive yield and distribution growth profile and prefer other well-diversified blue chip midstream businesses over KMI, so we do not hold it currently. For more information on PAA/PAGP, you can read our full investment thesis here and our exclusive interview with PAA here .

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