Last week, Goldman Sachs (NYSE:GS) added Kinder Morgan Inc (NYSE:KMI) to its conviction buy list after a tough year for the General Partner as analysts like Hedgeye and Barron's came out with negative commentary (details on Goldman's call available here). Goldman's optimism was rooted in its belief that Kinder Morgan Energy Partners (NYSE:KMP) would be able to grow its distribution by at least 5% annually in coming years. KMI is KMP's general partner and receives incentive distribution rights ("IDR") based on how much KMP can distribute to its unitholders. In the first quarter, KMI received $527 million in total compensation from KMP (KMI's financial and operating data available here), which is nearly five times what it gets from the other MLP it manages, El Paso Pipeline Partners (NYSE:EPB). Simply put, KMP is the main driver of KMI's business, and to have an opinion on KMI, one must have an opinion on KMP.
Now, it is worth noting that Goldman was forced to issue a second report on Monday because clients had a "negative reaction" to the upgrade. This negative reaction is actually very good news for KMI and KMP. At first, it might seem counter-intuitive that incessant pessimism about the Kinder Morgan family is good for the stock, but that is actually the case. The majority of the street has bought into the bear case that KMP is too big to grow and that KMP's E&P segment will be a drag in coming years. The time to buy is when others are pessimistic. If everyone already believe in KMI/KMP, there would be no incremental buyers and shares would be topping out. Instead, sentiment is negative, and we are in the process of exhausting sellers. I am not sure when this process will end, but barring a serious deterioration of fundamentals, I believe these stocks are poised to move higher as investors realize the doom and gloom case is simply not happening.
The tremendous pessimism around the Kinder complex is providing a solid entry point in the stocks. While Goldman is very positive on KMI with a $44 price target (suggesting 33% upside), I prefer KMP. KMP offers a superior yield, though distribution growth will be slower over time. KMP yields 7.2% now and should grow that distribution 6% annually over the next five years. KMI yields 5% with dividend growth of 8-10% over the next five years. I think investors should go with KMP for its currently higher yield and still decent annual distribution growth.
Kinder Morgan Energy Partners is expanding its network of pipeline into high-growth areas like the Utica and Marcellus Shale regions and across the Canadian oil sands. These projects should lead to significantly higher transportation volumes and fee revenue. Because KMP is paid on volume and not price, KMP is mostly immune from fluctuations in the price of natural gas and oil, which is important as increasing US production could pressure prices. KMP has a robust project backlog of growth projects that will power distribution growth. As of last quarter, KMP has a backlog of $14.9 billion, which could increase the distribution by 25% over 3-4 years (KMP's financial and operating data available here). KMP has also identified an additional $13 billion of growth projects not yet added to the timeline. If these potential projects are built, they could power another 20% of distribution growth, leading to solid distribution growth through 2020.
As these expansions to the natural gas pipelines increase distribution, KMP's E&P segment will become less relevant at merely 10% of revenue by 2020. KMP is moving towards more stable fee-based businesses, which generate consistent revenue and are the perfect play on expanding U.S production. Given its large size, it will grow slower than it has in the past, but its massive backlog can still power substantial growth. With an over 7% yield, the market is essentially discounting almost all of KMP's growth prospects. In reality, a backlog with a focus on areas like the Utica shale will deliver substantial growth.
Now, this growth at KMP will flow through to KMI through increasing IDRs. Now, KMI is also general partner for El Paso, which is struggling with a lower contract renewal at its Wyoming pipeline. Stagnating results at EPB will slow KMI's growth rate. Still, KMP's growth will outweigh problems at EPB because it provides far more cash flow to KMI. Additionally, KMI investors should not worry about the outstanding warrants as they are unlikely to dilute existing holders by more than 5% and do not threaten the dividend. Improvements at KMP will facilitate dividend growth of 8-10% per annum.
With KMP's massive backlog, Goldman is right that the Kinder stocks are undervalued, but I think KMP is the better buy as its higher yield more than compensates for a slower growth rate. As investors realize KMP has the backlog to power substantial growth, it could move towards $90 while I expect KMI's upside to be capped around $35-$37 due to its lower dividend yield. Intense pessimism is actually a bullish catalyst as strong results can power short covering and buying. Goldman is right to be bullish on the Kinder Morgan companies, though I prefer KMP to KMI for income investors. Investors should buy the Kinder companies as plenty of growth remains.
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.