- Healthy backlog accumulation will continue to drive distribution growth.
- Current state suggests distribution can grow at almost 5% per annum from 2014 to 2016.
- Current valuation implies ~4.5% distribution growth.
- Return downside is likely below 10%.
The unit price of Kinder Morgan Equity Partners (NYSE:KMP) has dropped by 16% over the past 12 months, compared to a 15% gain for the S&P 500 Index. At the current price level, I recommend income investors to start accumulating shares owing to the partnership's healthy distribution growth prospects, reasonable valuation, and its sustainable 7.5% distribution yield.
KMP reported its Q1 2014 results recently. Although adjusted EBITDA came in at slightly below market expectation, its quarterly distributable cash flow ("DCF") ($693M) was ahead of consensus estimate ($661M) driven by strong performance in Natural Gas segment, higher-than-expected operational cost savings, and lower-than-expected maintenance capex. KMP's project backlog remains a bright spot. The backlog increased from $13.5B in Q4 2013 to $14.9B in Q1 2014. Natural Gas segment saw the largest backlog increase and only Products Pipeline segment experienced a decrease of $100M. In early this year, management also disclosed approximately $24B inventory of project opportunities that are not included in the backlog metric.
I have performed illustrative cash flow projections to show KMP's distribution growth potential over the coming 3 years (see chart below).
My analysis was based on current consensus EBITDA estimates from 2014 to 2016, which have incorporated the Q1 2014 results. My model assumed $3B to $4B annual capital investment, and the growth component was assumed to be funded by both new equity and debt in a 50/50 mix. As such, this results in an increase of cash interest from $950M in 2014 to $1,150M due to increased borrowing over the forecast period (based on a 4.5% weighted average interest rate). I assumed maintenance capex to increase from $450M in 2014 to $470M in 2016, which is slightly higher than management's guidance of $446M for 2014. Based on the fair assumptions, distributable cash flow (to both GP and LP) was projected to reach $5.4B by 2016. Given my estimation that LP units will increase from 416M in 2013 to 500M in 2016 (as a result of equity offering to fund growth capital investment), I projected DCF per LP unit to increase from $5.64 in 2014 to $6.12 in 2016. Assuming a 1.0x distribution coverage ratio, distribution per LP unit was projected to reach $6.12 by 2016, representing a 4.7% distribution CAGR from 2013 to 2016. It is believed KMP's ample project backlog and opportunities are able to support this distribution growth rate over a medium term.
In terms of valuation, I believe KMP's current price is reasonably reflecting the distribution growth potential. Based on the current annualized dividend of $5.52 per unit and management's cost of equity estimate at 12.5%, the Gordon growth dividend discount model suggests that the current unit price of ~$73 implies a distribution growth rate of approximately 4.5%, which is fairly in line with my estimate of 4.7% CAGR through 2016 (see chart below).
To test the price downside, I applied a 3% haircut to the consensus estimated EBITDA from 2014 to 2016 (see chart below).
Based on 1.0x distribution coverage, the distribution CAGR from 2013 to 2016 will decrease to about 3.4%. As shown in the price sensitivity table above, the unit price corresponding to 3.4% distribution growth and 12.5% cost of equity is approximately $63, representing a 14% downside from the current unit price. After accounting for the 7% annual distribution income, the actual loss is only ~7%.
In conclusion, KMP is riding on healthy fundamentals as project backlog continues to accumulate at healthy rate. I believe a 4-5% annual distribution growth is completely achievable given the current state. As the valuation now appropriately reflects this expectation, a buy rating is warranted for KMP.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.