Over the past six months, shares of Kinder Morgan Energy Partners (NYSE:KMP) and sister company Kinder Morgan Management (NYSE:KMR) have been on a generally downward trend. While investors never enjoy seeing the value of their holdings decline, I believe investors should not be upset about this decline. If anything, they should be happy about it. In this article, I will try to explain why this is the case.
First, it is important to recognize that there is a difference between company performance and stock performance. Based on sentiment, risk-appetite and perception, a stock's performance can diverge from underlying fundamentals. I believe this can partly explain KMP's performance. In early September, Hedgeye Risk Management came out with an extremely negative report on the Kinder Morgan companies, declaring them a "house of cards." Given the fact that KMP has actually been delevering its balance sheet and has cash flow certainty by signing customers to long-term contracts, I believe this assertion is far too negative. Nonetheless, the report did send shares lower by several percent and likely have capped potential upside in the immediate term.
Moreover, the quarter the company reported three weeks ago was somewhat disappointing as I explain here. There were some seasonal factors that weighed on results, and some of its acquisitions and expansions have not quite turned accretive for existing unitholders, though that should change in coming months. Management did hike its distribution even though it had a coverage ratio of less than 100%. This was an aggressive action that suggests management expects strong quarters ahead, though personally it was a little aggressive for my blood. I would have preferred management to hold the distribution and increase it next quarter when cash flow justifies it. With a relatively average quarter, there was no compelling reason for shares to soar and change some of the negative perceptions on the margin of the market, leaving shares roughly unchanged since the release. Shares appear poised to remain range bound between $78 and $82 for the time being.
Importantly, this quarter did nothing to change the long-term bull thesis in KMP. Investors do best in the long run when strong business fundamentals are not reflected in the stock, and that is the case in KMP. With increasing drilling activity in the United States, the need for pipelines continues to grow, which should buoy KMP cash flows for years. The company has a project backlog of $14.4 billion up from $12.6 billion a year ago. From these projects, KMP will be able to grow its cash flow over time by 40%, and given its lower leverage ratio of 2.47x, management has the flexibility to fund the expansion with some debt rather than equity, which will make them even more accretive for unitholders.
In fact just this week, KMP announced a $500 million pipeline expansion from the Marcellus shale to the Northeast along with a $65 million Marcellus Pooling Point project. With production growing dramatically in the Northeast from the Marcellus and Utica shale formations, KMP is poised to significantly grow its network in the region with more projects like this, which will help it to continue growing its distribution. As the US begins to slowly export liquid natural gas in 2015, demand for pipelines should grow dramatically. Kinder Morgan is perfectly positioned to expand its network to profit from the domestic energy boom. Moreover, the company will be stepping up fees to use its pipeline, which will further boost distributable cash flow. KMP should be able to grow cash flows 5-7% annually through 2020.
This is why investors should be glad KMP shares have trended slightly lower and should hope they stay low as your money will compound at a faster rate. In fact, I tell my friends that I hope the stocks I own actually fall while company performance stays strong. If a stock is falling because performance is deteriorating, that is bad thing. But if a company is still doing well, it will be able to grow its dividend, which can be used to buy more shares when the stock price is lower. In the following chart, I prove this point. Assuming 6% distribution growth, which is the midpoint of my estimate, and commensurate unit appreciation, by reinvesting dividends, you will have an annualized return of 12.91%. If the stock price rallied $5, your future return would drop to 12.1% while you would do better when the stock drops by $5 with a return of 13.77%. This is because you would own more units of KMP thanks to the faster compounding, which drives returns. If you don't plan on selling shares or units of a company, you should actually root for a price decline!
Therefore, investors should be happy KMP shares have lagged the past six months as the decline has made KMP's dividends more valuable. While there is no reason to expect a near term bounce after an average quarter, KMP's growth prospects remain on target. With a massive expansionary backlog and growing production, KMP should be able to grow its distribution by mid-single digits through the decade. By reinvesting those dividends, I believe KMP can provide an annual return in excess of 12% and can be a stable cornerstone in a portfolio. This decline is good news for investors.
Disclosure: I am long KMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.