Shares of Kinder Morgan (NYSE:KMI) surged higher on February 17th after news broke that Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) bought into the company, with shares closing up by 10% at $17.18 apiece. Certainly, now that Buffett has bought in, it appears as though some easy money is now off the table, but is this a sign that there's still plenty of upside for shares moving forward?
A look at Buffett's purchase
Based on the data provided, Warren Buffett's Berkshire Hathaway recently acquired 26.53 million shares of Kinder Morgan, a major pipeline company here in the U.S. In his Form 13 filing, the shares were listed at a value of $395.88 million. This does not mean that this is the price Buffett paid to get into the game, but we do know what, since the time of the statement of the worth of those shares, the company's stock has shot up 15.1% to be valued at $455.79 million.
Although this represents a significant amount of cash, especially when you consider that the recent increase in share price has granted Buffett's company a return thus far of $59.91 million if the price they are listed for is the price he paid, it's still a very small piece of the company. Presently, his ownership comes out to about 1.1% of all shares of the pipeline operator, which is fairly small. Furthermore, given the size of the purchase, it's likely that it wasn't Buffett who initiated the buy but was, instead, one of his two portfolio managers.
Regardless of who bought into the company, though, this comes at a time when the business has been facing some troubles and has lost the confidence of its investor base. In what follows, I will touch upon these problems and highlight that, although investors have a right to be concerned about some of Kinder Morgan's problems, shares may still be a very attractive prospect moving forward.
Kinder Morgan's cash flow is strong and shares are cheap
The big issue facing Kinder Morgan is twofold. For starters, many investors are worried about the company's exposure to the energy space since its entire business model relates to energy. The second problem is that management decided, last year, to slash the company's dividend by 75% in an effort to rely on less leverage moving forward. Historically, the company has been a great opportunity for investors who relied on income-oriented investments and, because it used to be an MLP (it has since converted to a C Corp), it would be exempt from income taxes so long as it distributed at least 90% of income to its shareholders every year.
To address its exposure to energy, we must first understand what kind of energy business Kinder Morgan is. If, for instance, it were an E&P operator, investors would have every right to shove its share price down during this tough energy downturn. However, this is simply not the case. Through the third quarter last year (fourth quarter data was released but is incomplete), the company generated 59.8% of its sales from its natural gas pipelines, which transport and sell natural gas and similar products. In this segment, Kinder Morgan owns 48,000 miles of pipelines and has equity interests in another 19,000. Most of its other sales come from the production/sale of CO2, the operation of commodity terminals, and the pipeline operations (similar to what it offers for natural gas) for petroleum products.
Although, at first glance, this may seem like a scary place to be in, we shouldn't forget that, no matter what happens with energy prices, we will always see demand (at least until renewable energy becomes cheap enough to replace these products) for the commodities Kinder Morgan transports. In fact, in its fourth quarter release, the company claimed that the price of oil and natural gas has little impact on its operations. For every $1 change in the price of a barrel of oil that hits the market, the company's cash flow will change by just $7 million, while every $0.10 change per Mcf in the price of natural gas will only impact the company's cash flow by $1.2 million.
To you and I, this is a nice chunk of change, but it's a drop in the bucket for Kinder Morgan. If management is correct in its forecasts, the business will generate distributable cash flow in 2016 of $4.9 billion, $4.7 billion of which can be allocated to common shareholders. This is based on the assumption of oil at $38 per barrel and natural gas at $2.50 per Mcf. If, however, prices were to remain unchanged from current levels (oil at $30.66 per barrel and $1.942 per Mcf, respectively), distributable cash flow would fall from $4.9 billion to about $4.84 billion, little more than a rounding error.
Net of its planned distributions to shareholders of $0.50 per unit, management expect excess cash for 2016 will be $3.6 billion. Using my own estimates, free cash flow for the company last year came out to roughly $4.74 billion so 2016's number will likely be closer to $4.9 billion if management can achieve its targets for the year. Unlike investors who tend to prefer distributable cash flow estimates, I prefer free cash flow as a measure of value since I believe it better incorporates a company's earning abilities.
All-in-all, it appears as though Mr. Market is overreacting to the news of Kinder Morgan's exposure to the energy space. There is no doubt that sales have dropped this year (by 11.2%) but free cash flow for this timeframe has held up really well when you factor out growth-oriented capex. Given the business's current market cap of $38.5 billion and the estimated free cash flow number I provided above, shares are going for 8.1 times free cash flow. To put this in contrast, shares in 2014 placed a multiple on Kinder Morgan of 14 over free cash flow. This is fairly high but for a company whose business model relies largely on the (nearly) for-sure bet of higher natural gas and petroleum product sales in the future, it's far from being unreasonable.
Focus on the big picture
The other issue, as I've already mentioned, relates to Kinder Morgan's decision to cut its dividend. Right now, the company has $41.45 billion in long-term debt, which makes is pretty heavily leveraged. In fact, the fear surrounding this debt load is that the company's credit rating could be downgraded, which could cost the business around $1 billion in additional interest on an annual basis as the debt is rolled over. To avoid this, management elected to try growing organically, by allocating most of its distributable cash flow toward growing without assuming more debt.
In the near-term, this has proven especially painful for investors who have relied on the company for dividend distributions, but I've never really liked dividends. In fact, I've never purchased or sold a company with its dividend in mind (unless I figured it might be cut). It has always been a bonus to me. After cutting its distribution, shares are yielding around 2.9%, a modest level, but the fact that excess capital will be allocated toward growth is exciting.
You see, as opposed to borrowing more capital, the company can save on future interest expense by spending its cash accordingly. Not only this, but the return it receives on that cash isn't terrible. Due, in large part, to its hefty debt load, Kinder Morgan's free cash flow as a percent of equity stands at 13.4%, while its free cash flow as a percent of assets is a modest (but not terrible) 5.6%. Neither of these aspects are home runs but when you consider the stability of the type of company in question, its high barriers to entry, and its strong industry position, these numbers imply that Kinder Morgan has very little risk absent fraud or some other unforeseeable event that would permanently impair value.
Based on the data provided, I believe investors are very much overreacting when it comes to Kinder Morgan and that Buffett likely has things right. What we have here is a business that is changing from being a growth company to one that is more value-oriented but what we need to keep in mind is the long-term picture. Sure, investors will no longer be receiving hefty dividends (at least for now) but the economics of the business, strength the company has, cheap share price, and management's emphasis on growing the business without burdening investors more and without diluting them further, all indicates that the value proposition of Kinder Morgan is very appealing.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KMI over the next 72 hours.
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.