Description

Executive Summary

Kinder Morgan Canada (“KML”) went public in May 2017 but due to political turmoil in the province of British Columbia, the stock has had a poor public market reception.  As part of its broader balance sheet restructuring efforts, Kinder Morgan spun ~30% of KML off in an IPO in order to reduce its exposure to the significant growth capex needs associated with the expansion of KML’s primary pipeline asset.  We think the tumultuous political environment and tepid public market appetite for KML has created an incredible opportunity to invest in a high quality pipeline asset with massive equity upside.  At current levels (~17CAD/sh), we believe that the risk/reward of KML is highly asymmetric.  We think that KML is worth CAD30/sh (~80%+ upside including 4% div yield) if the pipeline expansion goes forward, and CAD15/sh (~10% down including 4% div yield) in the low probability event that the BC government manages to block the expansion of KML’s primary pipeline asset.  While the new BC government continues to publicly denounce the expansion of KML’s primary pipeline, our conversations with experts in Canadian constitutional law and regulatory affairs have indicated that there is very little BC can do to stop KML from moving forward.  We also note that the BC government has significantly tempered its language around the pipeline in recent weeks, suggesting they are trying to move on to more pressing political issues while saving face with their base.

Brief Overview 

The primary asset at KML is the Trans Mountain pipeline (TMPL), a pipeline asset that runs to the coast of Canada and allows Canada tar sand oil to access export markets outside of the United States.  The TMPL pipeline is effectively a low-risk and predictable toll road asset that consistently runs at full utilization.  However, the main attraction of Kinder Morgan Canada is the planned expansion of the Trans Mountain pipeline (“TMEP”) that, if successful, will effectively triple the capacity at TMPL and approximately triple EBITDA at KML.  The TMEP expansion already received effectively full federal and provincial regulatory approval last year.  However, as a result of change in leadership in the province of British Columbia, which is now led by a weak minority government (New Democrat Party) that was forced to forge a cooperation agreement with the Green Party, the future of the TMEP project has become more uncertain. 

A summary of KML’s assets from a Credit Suisse initiating coverage report (including a map of the pipeline) is reproduced below:

Political/Regulatory Considerations

The TMEP project has been publicly supported by Canadian PM Justin Trudeau.  In fact, last year he held a public press conference in which he personally came out and announced it.  The decision to approve the Trans Mountain pipeline was necessary because Trudeau publicly campaigned on finding a way to get more Canadian oil off the continent.  See this article: https://www.theglobeandmail.com/news/politics/trudeau-didnt-just-approve-trans-mountain-he-put-his-weight-behind-it/article33096600/

The TMEP expansion is effectively the best way for Canada to expand its oil export markets beyond the North American continent.  The pipeline is also seen as being a clear positive for job growth in the Alberta region that has already been hard hit after years of weak crude prices.  The pipeline had also already received all necessary provincial regulatory approvals.  If the BC government had not turned over, it is unlikely that there would have been any controversy around the future of the TMEP project.  In fact, when bankers initially took KML on the road, the IPO was set to price at a range of CAD19-22.  However, the BC government happened to turn over just as the KML IPO was set to price.  As a result, KML priced well below the range at only CAD17, and subsequently broke the buck and traded poorly for some time.  The stock remains pinned near the IPO level despite obvious signs that the BC government’s “opposition” to the TMEP expansion is nothing more than blustering. 

Christy Clark’s liberals (who supported the TMEP project) were unseated by the New Democratic Party (NDP) in May 2017.  However, the NDP lacked enough seats to have a majority and were forced to forge a power-sharing arrangement with the Green Party of Canada.  In conjunction with the Green Party, NDP now has a very weak majority of ~44 seats of the 87 seats in the BC assembly.  As the name suggests, the Green Party of Canada is a niche party focused on environmental issues.  The TMEP project was a top level issue for environmental groups in Canada.  Despite the fact that the current Trans Mountain pipeline has been running for decades without causing any environmental disasters, the Green Party and its followers stand in opposition to any expansion of crude oil capacity.  The main issue opponents to TMEP have flagged is that there will be many more oil tankers in the waters of BC as a result of the TMEP expansion. 

We will not provide opinion on the merits of the claims put forth by opponents of the Trans Mountain pipeline because we believe that the expansion is likely to go forward in almost every scenario. 

We have spoken to Canadian constitutional law experts, Canadian regulatory experts, and individuals who were intimately familiar with a recent Enbridge project that did in fact get scrapped.  All of our conversations leave us convinced that the BC government can do very little to stop the TMEP expansion. 

While we will not get into the nuances of the arguments in this write-up, we note that the Canadian courts recognize Federal superiority.  With Trudeau throwing his full support behind the TMEP expansion, and KML having gone through extensive regulatory permitting for the past several years, our understanding is that while BC can attempt to delay the TMEP project through various local permitting tactics / First Nations lawsuits, these maneuvers will ultimately prove to be nothing but delay tactics.

We believe this is why the NDP/Green BC coalition is already publicly changing its tune around the TMEP pipeline.  We point to language shifts below as evidence that the coalition is simply trying to appease its base and save face as it slowly pivots away from blocking the pipeline.

 First, the Premier of BC (John Horgan) has publicly changed his tune and dialed back his opposition to TMEP.  When he initially ran for office, his official platform position was to “stop the expansion of TMEP”.  However, in a recent public meeting with Trudeau, a reporter asked Horgan about his current position.  The reporter specifically asked if Horgan’s position was “still that the pipeline should not proceed”.  Rather than outright stating he was against the pipeline, Horgan talked about tanker traffic, a review of the province’s legal position and permits, and the potential impact on First Nations.  We think it is highly notable that Horgan did not publicly denounce the pipeline when provided with an opportunity to do so.

His tone around the pipeline has also changed meaningfully in written prose and he has been attempting to distance himself from the pipeline issue by delegating matters relating to PR around the pipeline to his Energy Minister.  While the platform position of NDP was to “employ every tool available to stop the pipeline”, more recently in a letter Horgan sent to the BC Energy Minister, he tweaked his marching orders to state that the Energy Minister should “employ every tool available to defend BC’s interests in the face of the expansion of the Kinder Morgan pipeline, and the threat of a sevenfold increase in tanker traffic”.  We find this statement fascinating because it essentially admits that the pipeline is likely to go forward in its very language.

Finally, on August 10^th, the BC Energy Minister (Heyman) held a press conference with the Green Party in which he outlined BC’s “next steps” on the TMEP expansion project.  See this article: https://www.theglobeandmail.com/news/british-columbia/bcs-ndp-government-kinder-morgan-pipeline/article35936471/?utm_source=twitter.com&utm_medium=Referrer:+Social+Network+/+Media&utm_campaign=Shared+Web+Article+Links

KML shares traded off ~3% on the day of this press announcement but we think the market is getting this one wrong.  For some context, as is to be expected in any large pipeline expansion, some First Nations groups (indigenous groups) have filed lawsuits to try to stop the expansion of Trans Mountain through their lands.  Environmentalists often work in conjunction with these groups to stop pipeline expansions.  We view these lawsuits are largely meritless given that Christy Clark’s liberal government had done extensive work with First Nations prior to providing KML with TMEP approval permits.  Furthermore, we have spoken with individuals who were previously involved in TMEP’s approval processes and gotten comfortable that TMEP did an extensive amount of work with First Nations as it developed its expansion plan.  These are important fact patterns that courts will look at when evaluating First Nations cases.

This op-ed is worth a read: https://www.theglobeandmail.com/opinion/dont-count-out-bc-ndp-approving-trans-mountain-site-c/article35887254/

It should also come as no surprise to anyone following the KML situation that the BC government is going to try to insert itself into some of the First Nations lawsuits.  The current BC government must save face and appease the environmentalist base by continuing to publicly stand against the TMEP expansion.  Claiming intervenor status in First Nations lawsuits is one way for BC to save face and then blame the court system when those lawsuits are eventually thrown out allowing KML to proceed with expansion. 

As can be seen in Premier Horgan’s evolving commentary around the TMEP expansion, it appears that the current BC government has its hands tied.  Federal law prevails and essentially every piece of the Canadian political apparatus supports the TMEP expansion other than the NDPs who already hold a flimsy majority in BC.  We therefore think that last week’s press conference and rhetoric, as well as the BC’s claim that more environmental permits are required of KML are merely delay tactics.  KML put out a press release after the Energy Minister press conference re-affirming that they plan to start construction in September 2017.

Therefore, we ascribe a very low probability to KML being stopped from going forward with the TMEP expansion.  We acknowledge a 1-year delay is certainly possible, however that does not materially alter the attractiveness of this investment opportunity.  KML shareholders are earning a 4% yield along the way while holding an incredibly valuable call option on TMEP that we believe is very likely to end up in the money.

In fact, we view the August 10^th press conference as a way for the BC government to slowly distance itself from the TMEP expansion opposition.  The Energy Minister will insert BC into some lawsuits and the BC government may delay the pipeline a bit with some more extensive environmental permitting application requirements.  However, Courts in Canada have in the past ruled that a single local government entity cannot abuse the permitting system to attempt to indefinitely delay a project.  So we think the decision to employ intervenor status is simply setting BC up for a way to “blame the court system” when the pipeline ultimately goes forward.  With a flimsy majority, we hardly think that stopping an environmentally safe pipeline is truly a top priority for the BC government when there are far more pressing issues to address such as Chinese money laundering driving up BC home prices.

Valuation

Today, KML is unlevered and has ~$6B market cap (the Bloomberg metrics appear to be off because KMI retained a ~70% interest in KML after the IPO).  KML was left intentionally unlevered because the company will take on almost $7b of debt over the next few years as part of the TMEP project.  KML has already gotten financing arranged so there is little funding risk associated with the TMEP expansion.  Furthermore, we expect the pipeline to run full given that Trans Mountain currently runs at full utilization and also due to the Federal focus on expanding Canadian oil export markets beyond the continent. 

Once the project is complete, KML’s EBITDA will approximately triple from current levels (EBITDA will go from ~400M to ~800M).  If the project faces no delays (which admittedly seems unlikely but not impossible), then the TMEP project will be online by the end of 2019.  Assuming an 80% payout ratio and holding the dividend yield constant, we believe that KML shares will be worth about CAD30/share after the TMEP project comes online (so by YE19).  KML will also pay a ~4% dividend yield along the way.

Scenarios

Bear Case: We ascribe a 10% probability to the BC government successfully stopping the pipeline.  If this is done early, then we think KML will essentially no capital into the ground in preparation for construction.  In this scenario, similar pipelines trade at ~13.5x EBITDA.  At that valuation level, we believe that KML would be worth about CAD15/sh.  KML is also unlevered so would have significant balance sheet flexibility.  Therefore, in a general downside scenario, there is about ~10% downside in KML shares from current levels.

Base Case: We ascribe an 89% probability to the TMEP expansion going forward.  Assuming the current dividend yield holds and assuming KML operates at an 80% payout ratio, this values KML shares at CAD30/sh, or ~80% upside.  This does not include the 4% annual dividend yield.

Extreme Downside Case: We ascribe a 1% probability to an “extreme downside case”.  In this scenario, KML actually goes and spends a significant amount of capex to start building the pipeline in regions that are not contesting the TMEP expansion (i.e. Alberta).  However, in this scenario, after years of litigation, somehow the BC government manages to stop TMEP after KML has already spent significant sums of capex.  In this scenario, KML could be worth as little as CAD12/sh because it has effectively wasted money on construction.  We see this outcome as very low probability because we think KML management is wise enough to not deploy capex before feeling very good about their legal standing.  However, it is a tail risk.

Using our decision tree, we arrive at an expected value of CAD28/sh versus a current share price of CAD17/sh.  Given this is a high quality, high visibility and strong cash flowing asset, we view KML as an incredibly compelling investment opportunity at current levels.

Catalyst

Construction progress, regulatory resolution.