We've been critical of MLPs, but generally for different reasons than the popular media. We don't think the group is skimping on maintenance capital spending or under-reporting expenditures to bolster distributable cash flow in order to raise distributions. Instead, our general criticism of the MLP structure rests on facts - the very real idea that MLPs have to fund growth with external capital, and this necessitates heavy dependence on the healthy functioning of the capital markets. The scenario with respect to Boardwalk (NYSE:BWP) also signaled to all that MLP distributions are not always safe, even if they are backed by a strong investment-grade sponsor and relatively stable operating performance. Though we emphasize that the MLP business model has unique risks compared to a general corporate that cannot be ignored, we accept these risks in the case of Kinder Morgan Energy Partners (NYSE:KMP) given the many attractive attributes of the entity - not the least of which is a steadily growing payout. Let's take a look at shares.
Understanding How the Stock Market Works
For those that may not be familiar our boutique investment research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense. Let's continue.
Kinder Morgan Partners' Investment Considerations
• Kinder Morgan Energy Partners is a leading pipeline transportation and energy storage company. The MLP operates like a giant toll road and receives a fee for services, while avoiding commodity price risk. We think this is one of the entity's most attractive qualities. Kinder Morgan Energy Partners' cash-flow profile and ongoing access to the capital markets will facilitate continued increases in its already-robust distribution, in our view. The entity is a holding in the Dividend Growth portfolio. The general partner of Kinder Morgan Energy Partners is owned by Kinder Morgan (NYSE:KMI).
• We like Kinder Morgan Energy Partners quite a bit, but it's worth noting that MLPs are inherently risky enterprises. The view is not based on their business operations, but instead is grounded on the riskiness of their business structure, which is always reliant on new capital. Growth spending is typically financed externally (via the equity and debt markets), and the pace of distribution growth is partly dependent on management's assumptions of maintenance spending. Kinder Morgan Energy Partners' valuation and distribution are completely dependent on the continued existence of the structure of its business in its current state.
• Kinder Morgan Energy Partners' distribution growth is a sight to see in graphical form. Declared distributions have marched ever higher since the beginning of this century, and current management has increased the distribution 50+ times since 1997. The firm's current distribution of $5.52 represents a ~7% annual dividend yield (the images below do not reflect the company's most recent increase). The company boasts a strong Valuentum Dividend Cushion score.
Image Source: KMP
Image Source: KMP
• At the core of the Valuentum Buying Index, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Kinder Morgan Partners posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. With the MLP already a holding in the Dividend Growth portfolio, we'd only grow cautious on shares if they were to register a low rating (1 or 2) on the Valuentum Buying Index.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Kinder Morgan Partners' 3-year historical return on invested capital (without goodwill) is 12.8%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Kinder Morgan Partners' free cash flow margin has averaged about 38.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Kinder Morgan Partners, cash flow from operations increased about 79% from levels registered two years ago, while capital expenditures expanded about 168% over the same time period.
We think Kinder Morgan Partners' shares are worth $89 per share. Shares are worth $80 each at the time of this writing. Our model reflects a compound annual revenue growth rate of 8.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 15.8%. Our model reflects a 5-year projected average operating margin of 15.7%, which is below Kinder Morgan Partners' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.2% for the next 15 years and 3% in perpetuity. For Kinder Morgan Partners, we use a 9.7% weighted average cost of capital to discount future free cash flows. Though we note that any asset is worth the present value of its future free cash flows, investors should be cognizant of Kinder Morgan's sensitivity to interest rates. Should interest rates advance significantly, not only would a higher discount rate be appropriate in the valuation, but investors may opt for higher-yielding riskless assets to achieve income goals.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those that drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Kinder Morgan Partners to peers Energy Transfer Partners (NYSE:ETP) and NuStar (NYSE:NS).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $89 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Kinder Morgan Partners. We think the firm is attractive below $71 per share (the green line), but quite expensive above $107 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Kinder Morgan Partners' fair value at this point in time to be about $89 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Kinder Morgan Partners' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $99 per share in Year 3 represents our existing fair value per share of $89 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: KMP is included in the Dividend Growth portfolio.