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Summary

  • 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).

(click to enlarge)

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).

(click to enlarge)

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.

Source: Kinder Morgan: Valuation Matches Fundamentals