|Shares Out. (in M):||2,262||P/E||8.9x||8.5|
|Market Cap (in $M):||44,494||P/FCF||0||0|
|Net Debt (in $M):||34,988||EBIT||0||0|
Who is having trouble finding places to put capital? We all are. It’s a tough time to take on additional market exposure or cyclical exposure and yet the high quality safety stocks are generally very expensive. One exception, we submit, is Kinder Morgan (KMI), a 45B market cap pipeline company, trading at a single-digit multiple of Distributable Cash Flow. We believe KMI’s 2 year total-return should be around +40%. Multiple expansion should come with the ramping of dividends (25% dividend-growth CAGR 2017-2021) with limited risk and low market exposure. Unlike most stocks, we find KMI is easy to justify buying in size right here and now.
Kinder Morgan remains unreasonably cheap in world of richly-valued yield plays for some of the following reasons:
Disastrous comp set. Since the oil collapse of 2014, Energy MLPs have become basically a failed asset class, with many MLPs suffering true earnings degradation from adverse contract resets. Kinder has very low exposure to commodity prices and is ahead of the curve in converting back to an investible C-corp. No one wants to buy a GP/MLP messy structure with IDRs anymore at any price. This has held back KMI’s obvious comp group – Alerian MLP ETF (AMLP) trades at around an 8% yield. But for all reasons herein, KMI should not trade with this awful comp set.
Underpayment of dividends. Kinder’s foresight in restructuring to a C-Corp left it over-levered for much of the past 4 years. As a result, KMI has been prioritizing de-leveraging over dividend payouts despite the capacity to pay much higher yields. Finally, as of today, Kinder has successfully reduced leverage from a peak over 6x to today’s 4.5x. This is their stated target leverage ratio – they do not need to de-lever further. Both S&P and Moody’s have recently recognized this and upgraded KMI’s debt rating once notch above their lowest investment grade rating. As the balance sheet has been cleaned up, they have begun to grow the dividend – from 50c/year in 2016 and 2017, to 80c in 2018, to $1.00 in 2019 – a 5% yield today. However, even at today’s payout rate, Kinder’s dividend coverage exceeds 2.0x, leaving substantial cashflow for growth projects and/or stock buybacks. We expect a dividend of $1.25 in 2020 and $1.50 in 2021.
Other issues. KMI intrinsic cheapness and well-telegraphed dividend growth has been cited before on VIC by rosco37 in October 2017. So why is it only barely higher 1.5 years later? In addition to the Energy MLP space de-rating significantly, Kinder has been working through some complex issues. The principal issue was their commitment to build the Trans-Canada pipeline (TMX) through their public subsidiary, Kinder Morgan Canada (KML.CN). Though KMI arranged non-recourse funding for TMX through KML, investors did not believe the KMI deleveraging story while the fate of TMX was being decided. Ultimately, TMX failed to get regulatory approvals and the financing overhand has gone away. KMI recently decided to leave KML independent, though could decide to fold it back into KMI down the road. But either way, it’s a much less material issue now. Another controversy that has been holding back the stock relates to Kinder’s most commodity-sensitive unit supplying CO2 to rehab depleted wells. Investors have worried disproportionately about this CO2 unit in energy sector downdrafts and have urged Kinder to sell it. After KMI has experienced more energy cycles post-2014, we think now the CO2 unit’s impact on overall EBITDA growth has proven to be quantifiable and reasonably immaterial. There have also been rumors that there is buyer interest in this entity, potentially in the $4-5bln range. While a sale would be near-term 5-10% dilutive to DCF, we believe the resulting overall multiple uplift would more than compensate for that.
Furthermore, we believe the market overlooks the following positive catalysts ahead for Kinder:
Growth opportunities. Trading at 8.5x current year DCF, we feel the market is currently valuing KMI as if cash flow will stay flat or shrink over the long term. We believe the market misses the potential for KMI to continue to grow its project backlog as the sale of the TMX project frees up capital for smaller potentially higher return projects in the US. For example in the first quarter KMI’s project backlog increased $400mln to $6.1bln. Since the TMX project came out of KMI’s backlog we believe KMI has identified numerous smaller projects that offer good returns, and is the reason the backlog has remained relatively stable since early 2018. In 2020+, projects such as an incremental Permian gas takeaway pipe can drive further backlog growth. The current backlog should drive about +4% DCF growth over the next 2-3 years alone assuming reasonable returns on about $2B per year of growth capex. The dream case is KMI earns comparisons with utilities as it proves out its track record of getting steady returns on capex. This could be a massive re-rating way above what is factored into our assumptions.
Significant recent insider buying. Richard Kinder, the co-founder and executive chairman of KMI, has significantly increased his insider stock purchases year-to-date. This has been a huge change compared to the last 3 years. Kinder has bought $103mln worth of stock YTD, compared to last year where he only bought $8.7mln of stock. Kinder’s recent insider buys, going back to March 26th have been purchased through a 10b5-1 trading plan, suggesting he is going to continue. Even though Kinder is worth around $7.1bn, spending more than 100mln on stock purchases is no small expense for him and signals confidence in the growth trajectory ahead.
Potential CO2 sale. After some news flow last year, expectations for a CO2 division sale are not high now. If a sale does happen, with expected 5-10% near-term DCF dilution, we believe a) the proceeds would allow for a further step up of capital return and b) the resulting KMI portfolio would most definitely deserve a better multiple for its near-complete absence of commodity sensitivity. We believe investors would welcome a CO2 unit disposition and it would help trigger the re-rating KMI deserves.
Valuation and Price target
We believe Kinder is now poised to grow DCF at a 4% long-term CAGR which is in line with sell-side estimates and unofficial company guidance. We believe the KMI 2021 dividend will be $1.50 representing a dividend coverage of 1.7x – still at the high end of the midstream space. We assume the length of Kinder’s tax shield will keep getting extended as they spend capex such that they will pay no cash taxes for the foreseeable future. Conservatively, we assume Kinder keeps this above-average coverage ratio and only grows the dividend in line with cash flows after 2021. Thus at constant leverage of 4.5x, KMI will have annual excess cash flow of over $2B to support growth projects and/or stock buybacks without resort to the capital markets.
The combination of consistent dividend growth, appropriate leverage and modest buybacks should drive multiple expansion here. We believe that the right target multiple for KMI is 10-11x forward DCF which implies $25-27 per share by the end of 2020. The NTM yield will thus be about 6% for an expected forward total return at the target price of ~10% (dividend + DCF growth). Interest rates are of course a factor, but our view is that there will always be a market for a low risk ~10% total return. Again we note how favorably Kinder will then compare with utilities which yield more like 4% on LSD growth and tighter coverage ratios. You will collect $2.00 in dividends over the remainder of 2019 and 2020. Thus the 2-year total return is approximately 40%.
Buybacks starting later this year and ramping into 2020, combined with another large dividend increase next year.