Kinder Morgan: An Undervalued Stock With High Growth Potential

| About: Kinder Morgan (KMP)


Kinder Morgan Energy Partners LP recently reassured investors that it would reach or possibly go beyond its FY 2014 financial expectations.

The company’s strategic moves will aid in taking advantage of the solid tailwinds from an enduring boom in domestic oil and gas production.

Despite its future prospects, the stock is currently undervalued with a P/E ratio of 19.54 times compared to the industry average of 22.46 times.

Kinder Morgan Energy Partners LP (NYSE:KMP) recently reassured investors that it would reach or possibly go beyond its FY 2014 financial expectations. The company serves as a pipeline transportation and energy storage company in North America. Through its portfolio of energy transportation and storage assets that include around 80,000 miles of pipelines and 180 terminals, the company transports and stores natural gas, gasoline, crude oil, CO2 and other products.

There are various reasons behind the company's confidence in its ability to meet its financial projections. These projections include the company expecting to distribute its cash flow per unit well in excess of its budget targets. Therefore, I will analyze what will contribute to the company's bright future outlook for the coming year. I will also discuss the company's business model that may impact the returns to the company's investors.

Let's begin discussing some of the factors that will support the company's revenue and cash flow growth in the coming years.

Cash Flows and Revenue Growth: Returns From Capital Spending

Kinder Morgan operates a vast, diversified portfolio mainly consisting of fee-based energy assets across North America that have traditionally generated considerable cash flow in almost all types of market conditions. This can be seen in the following chart that illustrates the growth in the company's total cash distributions from 1996 to 2013 and forecasts the growth in FY 2014 as well.

Source: KMP Presentation

The company's CEO recently disclosed that the company has recognized around $14.8 billion in expansion and joint venture investments in FY 2013, as shown in the chart below, that will contribute to the company's growth in the coming periods.

Source: KMP Presentation

The following table shows the company's five-year growth capex backlog for the next five years. The company's $14.8 billion official backlog has grown by $2.2 billion compared to the figure reported for the previous year. This indicates the rise in the company's commitments for more projects and income.

Source: KMP Presentation

Since the announcement of the company's FY 2014 budget in December 2014 the company has concluded around $962 million worth of acquisitions of crude oil tankers that are involved in marine transportation for U.S. domestic trade through the Jones Act. Additionally the company's Tennessee Gas Pipeline ((NYSE:TGP)) accomplished a prosperous binding open season for additional north to south natural gas transportation capacity adding up to 500,000 dekatherms per day. This will transport gas from the Marcellus and Utica shales to several delivery points on the Gulf Coast. Since the contracts are spread over several years and usually indexed to inflation these expansions will benefit the company in FY 2014 and beyond.

As a result of the factors discussed above, the company believes it will see outstanding growth opportunities for all of its business segments. Additionally through these moves the company has positioned itself well to take advantage of the growing oil and gas midstream industry. The North American oil and gas midstream industry is in need of more midstream infrastructure to transport and store oil, gas and liquids from the productive shale plays in the United States and the oil sands in Alberta in addition to growing demand for CO2. The outlook for the North American oil and gas midstream industry is further discussed in the following heading.

Oil and Gas Midstream Industry Outlook

The company's strategic moves will aid in taking advantage of the solid tailwinds from an enduring boom in domestic oil and gas production. As a pipeline operator, Kinder Morgan benefits from the rise in production as volumes of oil and gas increase. The company has positioned its growth portfolio to capitalize on drilling hotspots and major discoveries like Marcellus and Utica Shale and a trans-Canada pipeline that will trigger growth in U.S. production over the next five years.

The huge pipeline network that Kinder Morgan is expanding to add coverage of boom areas with its $14-billion backlog could increase the company's distribution by 25%-30% in the next four years.

There are two positive aspects that will favor the industry. First, growth in domestic energy production due to the shale revolution will create a huge demand for new infrastructure. Secondly, the U.S. is speedily converting into an energy exporter and this will also create further demand for new energy infrastructure.

Deloitte expects investments in energy revitalization will endure and move from the upstream sector to midstream infrastructure, refinery operations and petrochemical facilities in 2014.

The following chart projects the potential for growth in midstream volume for the coming years.

Source: Deloitte

Along with positive prospects for the company's top line and cash distribution the company has had strong bottom-line performance to date. The company has plans to increase returns for shareholders in the coming years as discussed below.

Strong Bottom Line and Returns to Investors

In comparison to the oil and gas midstream industry average operating margin of 8.2%, the company has recorded a 25.8% TTM operating margin. The company's TTM net margin of 26.2% is also well above the industry average of 3.4%.

As a result of these factors the company is generating an 8.8% TTM ROA and a 2.3% ROE in comparison to the industry's TTM ROA of 2.4% and ROE of 8.8%.

It is anticipated that Kinder Morgan will announce dividends of $1.72 per share for 2014 reflecting an increase of 8% from $1.60 dividend per share paid in 2013.

The company presumes to declare cash distributions of $5.58 per unit for 2014 reflecting a 5% rise in its 2013 distribution of $5.33 per unit as shown in the chart below.

Source: KMP Presentation

The company expects to surpass its distributable cash flow per unit target mainly as a result of the positive impact of the tanker acquisition, TGP's additional north to south secure transportation contracts (as discussed earlier) are expected to begin operating in April 2014, and further long-term contracts on its El Paso Natural Gas pipeline system. The following table illustrates how the company has kept its promises regarding returns to shareholders over the past years.

Source: KMP Presentation

Before concluding the article on the company's bight growth prospects, I would like the readers to have a glance at the company's business structure as the company operates as a Master Limited Partnership ((NYSE:MLP)).

IDRs: Risk to MLP Returns

The Master Limited Partnerships offer obvious paybacks to an investor's portfolio. They deliver income, have a comparatively less correlation to stocks, and an affinity to outperform the S&P 500 in addition to upholding beneficial tax treatment.

On the other hand, they possess risk with respect to their business structure that may impact an investor's returns. This is because although MLPs are publicly traded, they are organized as partnerships and operate under the direction of a General Partner (GP) that owns a distinctive class of equity in the MLP called General Partner Interest (GP Interest). The General Partner Interest may give the GP right to Incentive Distribution Rights (IDRs).

IDRs are just like performance fees for hedge funds where the managing GP collects an additional share of the profit for surpassing a defined measure of performance. The positive aspects of such a setup include the configuration of manager interests with investor interest as it will cause the managers to grow distributable cash flow. On the other hand, there is a potential risk due to the fact that the holder of IDRs gets a disparate benefit from outperformance while their downside risk is limited like other investors. KMI is Kinder Morgan's GP and owned 11.6% of total LP interests in KMP by December 31, 2013, and received around 49% of all quarterly distributions of available cash from KMP.

Final Take: Undervalued Stock

The company is well positioned to capitalize and generate returns from the booming oil and gas midstream industry of North America. The industry is set to record growth in the coming years due to the shale gas boom as well as new exploration projects that require additional infrastructure to transport and store energy. The company has made record capital expenditures during the previous year in order to gain from the growing industry and will reap the benefits of its activities in the coming years. The company aims to give out higher cash returns to its investors but the company's business structure, as it operates as an MLP, gives IDRs to GP that may be a threat to returns for other investors.

Despite its future prospects, the stock is currently undervalued with a P/E ratio of 19.54 times compared to the industry average of 22.46 times indicating a buying position for the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.