Source: Energy Transfer Equity
My last article about Kinder Morgan Inc. (NYSE:KMI) received a lot of flack from Kinder bulls who thought it was unfair to claim that Kinder Morgan made an inferior investment to midstream MLPs such as Magellan Midstream Partners (NYSE:MMP) or Enterprise Products Partners (NYSE:EPD). That's because Kinder is a c-Corp instead of an MLP. Many readers requested I compare Kinder to other pipeline c-Corps, such as MLP general partners.
So that is what I did and to my great surprise, discovered that Kinder Morgan actually compares very favorably to some of the most popular midstream GPs such as: Spectra Energy Corp. (NYSE:SE), ONEOK Inc. (NYSE:OKE), and Energy Transfer Equity (NYSE:ETE). In fact, it's possible that over the next decade Kinder Morgan could return spectacular market crushing total returns that beat most of these peers. BUT only if three important things happen.
Kinder could make a great investment...IF you are willing to wait a decade AND energy prices rebound strongly…
While Kinder bulls might once again get mad at me for focusing on dividends here, the fact is that most midstream investors are looking for generous yield and good dividend growth prospects. That makes sense since a good rule of thumb for long-term total returns is yield + dividend growth.
|Pipeline c-Corp.||Forward Yield||Q1 2016 Dividend Coverage Ratio||10 Year Analyst Dividend Growth Rate Projections||10 Year Annual Total Return Projection|
|Energy Transfer Equity||9.0%||1.16||6.3%||15.3%|
|Spectra Energy Corp.||4.8%||1.85||6.3%||11.1%|
From a current yield perspective Kinder seemingly offers slim pickings, courtesy of 2015's 80% dividend cut. While painful, this was ultimately in the best interest of long-term investors. The $954 million in DCF remaining after dividends in just the last quarter alone, along with a term loan and expanded credit revolver secured in January, means that Kinder's capital needs should be fully met this year.
Meanwhile Kinder might be able to avoid having to sell new shares until 2019 or beyond. That could this give energy prices sufficient time to recover, which in turn should lift Kinder's stock high enough to provide large amounts of cheap capital to further fund growth. It would also minimize dilution of existing shareholders which should help improve future dividend growth prospects.
Speaking of which, analysts expect Kinder to EVENTUALLY be able to start growing its dividend quickly; potentially much faster than its large competitors. Of course 10 years is an eternity in the world of investing, and thus these strong dividend growth projections are highly speculative, and deserving of massive skepticism.
That being said they could happen, if a large number of factors tip in Kinder's favor. How is that possible? The answer is two fold.
The first reason is the fact that Kinder's business model. General partner gain cash flow from two main sources: distributions from their MLPs, and incentive distribution rights or IDRs. However, even at the top tier of IDRs a general partner usually only gets 50% of marginal distributable cash flow, or DCF. Kinder, because it's not a real general partner, (it simply owns its midstream assets outright), will be able to claim 100% of that DCF.
That in turn could mean the ability to raise its dividend at a much faster rate than most large GPs. However, energy prices would have to rise sufficiently and stay high long enough for American energy producers to go through with their earlier plans to invest $641 billion into America's midstream infrastructure through 2035.
That's likely the only way that Kinder Morgan, already America's largest midstream operator, could achieve enough needle moving cash flow growth to make such predictions realistic.
...AND it manages to get its massive debt under control and avoids over leveraging again…
|Pipeline c-Corp.||Net Debt/EBITDA||Q1 2016 Operating Income/Interest||EBITDA/Interest|
|Spectra Energy Corp.||7.32||3.27||3.2|
|Energy Transfer Equity||8.10||1.64||3.0|
Kinder's $44 billion in total debt, when combined with the worst oil crash in over 50 years, shut it out of debt and equity capital markets to such an extent that the dividend cut became necessary. It was the only way to internally fund its growth plans and preserve its investment grade credit rating. The good news is that management is well on its way to getting a handle on deleveraging its balance sheet. For example, it expects its net debt/EBITDA ratio to be 5.5 by the end of the year.
However, while Kinder's absolute debt levels are high compared to most corporations, relative to midstream GPs its balance sheet doesn't appear so bad. This is due to the difference between Kinder's complete ownership of its assets and cash flows compared to the partial cash flow stream built into the midstream GP business model.
General Partners usually serve as financiers of their MLPs, acquiring or constructing assets, (or organizing hopefully accretive acquisitions), and then dropping assets down to the partnership to recoup some of the cost. Often this is partially in the form of additional equity, which when combined with IDR fees, usually allow GPs to achieve faster payout growth than their partnerships.
However, the downside of this relationship is often large debt loads investors must keep an eye on lest they eventually threaten the sustainability of the dividend.
...AND it's able to raise its profitability to match or exceed its competitors
|Pipeline c-Corp||Q1 2016 Return on Invested Capital||Q1 2016 Weighted Average Cost of Capital||Q1 2016 Net ROIC|
|Spectra Energy Corp.||7.01%||5.24%||1.77%|
|Energy Transfer Equity||9.41%||7.53%||1.88%|
Net return on invested capital isn't a perfect metric, (for one thing WACC is calculated using share volatility which isn't directly tied to project profitability), none the less you can see that Kinder has struggled recently to grow profitably.
In fact, Kinder has spent the last three quarters slashing its growth backlog by nearly $8 billion. That's been necessary because, with energy prices as low as they are, it's been unable to secure sufficiently lucrative long-term contracts to move forward with some of its biggest potential projects.
For instance, it recently had to cancel its $3.3 billion Northeast Energy Direct pipeline which was supposed to bring vast quantities of very cheap gas to major Northeast markets such as New York City, and Boston. In addition, billions of projects Kinder recently put on hold pertain to its CO2 gathering, storage, and injection business. These could once more be put in play if oil prices rise high enough to get oil producers interested in enhanced oil recovery projects.
Of course the reason that these CO2 initiatives were the first projects to get cut from Kinder's backlog were because they aren't as profitable as its bread and butter gas pipelines. Finding sufficient large projects in the coming years while simultaneously improving profitability will be vital to Kinder being able to generate sufficient DCF growth to generate both strong dividend growth and market beating total returns.
Which brings me to the major risks that you need to consider if you want to invest in the Kinder Morgan turnaround story.
Risks to consider
There are two major risks to a strong potential Kinder turnaround.
First, energy prices would need to not only recover, but do so strongly and stay relatively high for many years. That's because oil and gas prices were much higher when the majority of Kinder's current long-term fixed-fee contracts were signed.
Since a turnaround is predicated on not just sustaining, but also growing cash flow, low energy prices could result in lower pipeline fees once Kinder's existing contracts start rolling off. That in turn could stall DCF growth and harm both Kinder's ability to maintain a strong balance sheet, and achieve the kind of dividend growth that would be key to making Kinder one of the best pipeline stocks of the next decade.
In addition, if energy prices don't rise high enough then Kinder's growth backlog might not be able to grow fast enough or big enough to achieve sufficient cash flow growth and turn around investor sentiment.
Finally, since this is a 10 year turnaround we're talking about you need to remember that interest rates could rise, significantly raising Kinder's debt costs. While the Federal Reserve just lowered its 2018 interest rate target to 3%, that still represents a 2.5% increase in debt costs. By 2025 rates could rise even higher, (long-term historic average is 4.96% compared to 0.37% today). With Kinder's ROIC as low as it is, management would need to not only maintain but also increase its profitability enough to overcome what might be significantly higher costs of capital.
Rising rates could also hurt Kinder's share price, (and thus its ability to raise cheap equity capital), simply because yield hungry investors would have higher paying alternatives. For example, investors could generate sufficient income from less speculative investments such as bonds, savings accounts, or CDs, potentially lowering demand for Kinder shares.
Bottom line: Kinder COULD prove a great long-term investment BUT a lot has to go right, and you need to be VERY patient
I'll admit that from a longer perspective, and compared to other midstream c-Corps Kinder shows great potential. However, be aware that A LOT needs to go right. Energy prices need to rebound aggressively and stay high, Kinder needs to deleverage and keep its debt levels manageable from now on, and most importantly, it needs to find a great deal of highly profitable projects to grow its cash flow off an already huge base.
Thus, while Kinder could potentially prove a great long-term energy investment, it's also one of the more speculative ones in the midstream industry.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.