Shares of Kinder Morgan (KMI) were trading about 1.5% lower after the company reported fourth quarter results on Wednesday afternoon (press release here). Investors tend to focus on KMI's cash available to pay dividends to value the stock, and the results were pretty much in-line with what management had been forecasting. In the fourth quarter, the company generated cash of $0.46 per share and declared a $0.41 dividend. Management also confirmed guidance for a payout in 2014 of $1.72. This would suggest an average payout in 2014 of $0.43 and would represent 8% growth from what KMI paid out in 2013. As you can see, KMI shares have not performed very well over the past 12 months.
For investors who are unaware, I first want to briefly explain what Kinder Morgan is. It has two primary business. First, it owns some midstream oil and gas properties. These assets tend to generate 15-20% of KMI's cash on a gross basis. However after accounting for interest expense, they burned $4 million in cash in the quarter and $16 million over all of 2013. While these assets (mainly terminals and pipelines) are an important part of KMI, they clearly are not the driver.
That is where KMI's second business comes in. It is a general partner (GP), which means it operates limited partnerships. It makes investment and operational decisions on behalf of the partnership while limited partners (LP) simply own equity. It is analogous to how investors in John Paulson's hedge fund have equity in the fund, but Paulson, as the general partner, decides what stocks to buy and sell. KMI is the GP in two MLPs (Master Limited Partnerships): Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB).
Now, KMI is compensated as the General Partner through Incentive Distribution Rights (IDR), which essentially entitle KMI to a portion of the cash flow that KMP and EPB generate. As they generate more cash, KMI gets a bigger payment. However, there is further incentive for KMI to ensure its MLPs perform well because the IDRs are not a constant rate. Instead as KMP and EPB pay higher distributions, KMI gets a higher share of each incremental dollar generated.
Thanks to the strong performance of KMP and EPB over the past decade, KMI is now in the top IDR bracket where it earns 50% of each additional dollar earned. As a consequence if KMP pays a 5% higher distribution to limited partners this year, KMI's IDR payment will be roughly 8% higher. In this sense, KMI is a levered play on the success of its MLPs. As such, it is important to consider the health of KMP and EPB when deciding whether or not to invest in KMI.
First, let's discuss Kinder Morgan Energy Partners, which is the most important part of KMI's operation. In this quarter, KMI received $462 million thanks to its GP status up from $397 million last year. For all of 2013, it received $1.756 billion. Now, KMI also owns some limited partnership units. In total, KMI owns about 10% of the limited partnership; this investment is worth roughly $3.5 billion. It owns this investment through a 9% stake in KMP and a 13% stake in Kinder Morgan Management (KMR), an LLC that owns units of KMP (KMR was created as a tax efficient way of owning KMP as it pays stock dividends and K-1's are not required). This LP interest generated $59 million in the quarter.
Clearly, KMI wants to increase KMP's distributable cash flow so that it can generate a higher IDR and LP payment. Fortunately, I expect this as KMP should grow its distribution about 5% to $5.59 in 2014. Further, with a backlog of $13.5 billion, KMP has many growth projects in developments. As these projects come on-line over the next five years, its cash flow should continue to increase at an annualized 5-7% pace, which means increasing cash paid to KMI.
El Paso is a smaller entity, but it still matters to KMI. In its role as GP, KMI earned $56 million up from $46 million last year. KMI also owns 41% of EPB's limited partnership units, and this investment is worth about $3.3 billion. Its limited partnership distribution was $58 million up from $55 million a year earlier. Interestingly, KMI generates more from its LP stake than its GP role in EPB unlike KMP where its GP role accounts for nearly 90% of its cash flow.
While KMP is chugging along well with a solid balance sheet and solid growth prospects, EPB is the problem child. In 2014, it anticipates paying a quarterly distribution of $0.65, which is what it declared in the fourth quarter. As such, KMI's LP distribution income will stay roughly flat at $58 million per quarter. EPB is struggling because it is now receiving a lower rate for usage of its Wyoming pipeline network. However, the picture is a little worse from KMI's perspective.
KMI is dropping down assets to EPB: the Ruby Pipeline and Gulf LNG. A drop down is when a GP sells assets it owns to its LP. These assets are part of the midstream oil and gas properties that generate a small proportion of KMI's cash flow I discussed above. Now while KMI will get paid for these assets, it no longer directly gets their cash flow. Instead, the LPs in EPB now get a piece. These assets will help KMI's GP payments and sustain its LP payment, but some of its cash will be diverted to other investors in EPB to pay their dividend. When you realize that EPB is only able to hold its distribution flat thanks to a drop down from KMI, you realize that EPB will actually be a mild drag on KMI's results in 2014.
Therefore, KMP will contribute to solid growth for KMI while EPB will be a slight drag. KMI will own fewer assets thanks to the dropdown, and KMI can use some of the proceeds to pay down its debt, which totals $10 billion. As KMP is a bigger cash contributor than EPB, KMI will be able to grow its cash available for the dividend. I am looking for KMP's cumulative payment to KMI to grow 8-10% while EPB and cash from other assets to be flat to down 2%. Overall, that means KMI will grow its cash available for the dividend about 8%, which is in line with management's guidance.
That mean's 2014 dividend guidance of $1.72 should be pretty accurate. The 4th quarter dividend of $0.41 translates to a yield of 4.62%. With 8% dividend growth, is that yield attractive enough? The first thing I would note is that 8% growth is below management's 9-10% target, which is primarily the result of EPB's struggles. If EPB turns around, KMI could grow more quickly, but I don't foresee this. EPB carries twice as much debt as equity, which makes expansion projects difficult while lower contract rates could be a 2-3 year headwind.
Assuming a 5% growth rate for KMP's dividend and 8% for KMI, KMI's yield on invested capital would reach KMP in year 15. At 9%, KMI would catch up in year 12. If KMI could grow at 10%, its yield on invested capital would catch up in year 10. Given these factors, I have been in the camp that investors will be better off in KMP than KMI, but CEO Richard Kinder made a statement today that caught me by surprise (transcript available here).
He said, "Reflecting this belief in the Kinder Morgan companies as many of you know, I've been a buyer of KMI shares, I purchased over 800,000 shares in December alone. So, I guess my message to those who saw the story less positively was you sell I'll buy, and we'll see who comes out best in the long run." I often discount when management talks up their stock as its part of the job. Further, Richard Kinder is worth about $10 billion, so an 800,000 share purchase is a drop in the bucket, and he can afford to buy them when they are a bit overpriced.
Nonetheless, this statement caught my attention because it was so emphatic. Kinder has made it clear what he feels about the stock, and I would not advise betting against Mr. Kinder. With KMP's backlog, it has the capacity to grow its distribution closer to 7% over 5 years, which will help to reaccelerate KMI's annual growth even if EPB continues to languish. At $35.50, I think the stock is a little expensive compared to KMP due to problems at EPB. Assuming a required long term rate of return of 8%, the stock is worth $40-$45 depending on whether KMI can reaccelerate its growth to 10% in 2015-2018. As such, KMI has about 30% upside, making it an attractive long term stock. More tactical investors could probably pick up shares below $34.50 as there is no near term catalyst to push shares higher and sentiment has been a little down. At that price, I would definitely buy KMI. For long term investors, I would start buying here as KMI works as both a yield and capital appreciation play.
Additional disclosure: In the next 3 trading sessions, I may go long KMI.