Description

Business Overview

KMI is one of the largest energy infrastructure companies in North America. It owns or operates ~70,000 miles of natural gas pipeline making it the largest natural gas network in North America and owns and operates 155 terminals.

Management’s strategy is to grow our distributable cash flow per share to through capex and acquisitions. Since 1998, KMI has invested $27.3bn and made acquisitions for $31.4bn. Most of KMI’s assets generate stable cash flow with modest direct commodity exposure. Approximately 91 percent of cash flows are fee-based and approximately 97 percent are fee-based or hedged based on their 2017 published budget. Since 2000, KMI has generated an average ROI of 13% and average ROE of 22%; from 2000 to 2014 the LP which owned the majority of the assets up until the GP/LP consolidation generated total returns to shareholders of ~20% per year.

For further detail on the business please see the two VIC write ups from 2014. Please note these write ups were before KMI consolidated their GP/LP structure into a single C-Corp.

Management

Founder and Chairman, Rich Kinder is the largest shareholder with an 11% stake. For as long as we remember he has taken an annual salary of $1; therefore the distributions are his main source of income. The CEO and CFO own approximately 10.1mm shares between the two of them. Apart from poor capital allocation choices before and around the MLP meltdown we believe management have been excellent capital allocators and we believe the ROI’s, ROE’s and share price performance over the long term support that statement.

Background

Before the slowdown in the energy sector, and what seemed to be a large runway of energy infrastructure projects available, management increased debt more than usual to increase capex to generate higher dividend growth. Management also took advantage of their high-teen EV/EBITDA multiple to issue equity and invest in projects at single digit EV/EBITDA multiples. While sentiment was favourable investors believed that KMI paid a dividend from operating cash flow less maintenance capex while funding growth capex from equity and debt issuance. However, during the middle of the energy slowdown doubts began to appear about KMI and its peers’ CF stability. What was a virtuous circle of funding growth through equity and debt issuance turned into a downward spiral. The belief turned and the consensus was that KMI was using debt and equity issuance to pay for dividends.

As the unwind began, investors started to take note of KMI’s high leverage and its reliance on capital markets for funding itself a.k.a. relying on the goodwill of others. Before the MLP meltdown KMI had been giving a long term dividend growth forecast of 10%. In an attempt to stop the share price from dropping management decreased dividend growth guidance down to 6-10%. However the market saw through this attempt and at the same time worries about a debt downgrade started. At this point it was too late for a small tweak to the model and KMI had to cut its dividend by 75% as well as fund itself through a convert deal at 9.75% which didn’t sit well with equity investors. From the beginning of the unwind to the trough the share price declined by 75% in about 6 months.

It is worth noting that the revenues and cash flows of the business stayed relatively stable apart from its actual oil production unit which took a direct hit from lower oil prices. Although there was lots of talk about credit issues with E&P’s who pay KMI for the use of its pipelines, the actual effects on KMI were minor. The company also reduced its backlog which was and is still an indicator of future projects and associated growth. KMI has since then adhered to live within its means, has reduced its leverage through asset sales and JV’s as well as the savings from paying out fewer dividends.

Valuation

After hitting a panic selling induced low of $11.20 in late Jan 2016, the share price has rebounded to around $20. This past year KMI took the decision to give guidance on a dividend increase which is happening in 2018 with the dividend going to $0.80 from $0.50 (was $2.00 pre-cut). Additionally, the company is buying back $2bn of shares (5% of market cap). The yields on KMI’s various traded debt are back to regular levels as the fears of credit issues have subsided with less cash flow outflows and what looks to be open capital markets; however the company seems to be happy for now to live within its cash flow means.

The company has also issued guidance on 2019 and 2020 dividends, which should amount to $1.00 and $1.25 respectively. Given where peers traded on a dividend yield basis, the market price is pricing in next year’s dividend (~4.3% yield). If you believe management’s ability to growth the dividend to $1.25 by 2020 and the yield to be 4.5% (share price of $27.78), then given the dividends you collect until then would generate an IRR of 30%. If you are inclined to believe the sell side and dividends progress in 2018-2024 from $0.80 to $2.52 and assuming a 2% growth rate in the dividend thereafter, the current share price is assuming a discount rate of 11.2%. At an 8% discount rate those same numbers suggest a value of $31 per share.

Catalyst

Management executes according to plan. 

More positive sentiment towards the oil and gas sector (likley due to higher commodity prices).