This past June 21st we provided our views on Kinder Morgan (NYSE:KMI), with a focus on the company's bonds. Our view one month ago was that from an equity perspective there was not much to be excited about since EBITDA remained stagnant and the valuation seemed high at 11x EBITDA. Since then the stock is up 12%, even after a sharp decline following the Q2 earnings release filed on July 20th. Is this substantial jump in the stock price justified? How do Q2 results affect our views on the stock and bonds?
KMI's Q2 2016 results simply reinforced our views of KMI from last time. Financial performance remained flat and there is still nothing to get excited about regarding the stock price. Q2 2016 EBITDA came to $1.76 billion, down 0.6% from Q1 2015. This followed Q1 2016 EBITDA, which was up 1.7% above Q1 2015. It would have been nice to see year-over-year increases continue, even if minor. Management reiterated its forecast of $7.5 billion in EBITDA for 2016, unchanged from earlier projections, and 3% below budget. Distributable cash flow is expected 4% below budget. There is no purpose in restating the results and outlook for the various business segments, please read the press release for details.
The conclusion is that after the various parts of the business are added together, the company is treading water. From an equity perspective this is not consistent with stock price growth and we therefore view the recent 12% rise in the stock as not justified. Nothing at all has changed since our June article, except perhaps that after another quarter of consistent results the risk profile of KMI is lower. The company has proven that energy price fluctuations will not jeopardize its ability to easily service debt and remain a powerful cash flow generator. The company also announced certain deleveraging transactions, which is a move typically at odds with investment for growth -- another drag on the stock price, but good for bond holders.
Our negativity on the stock price is not due to dislike for the company, on the contrary, we have consistently believed in KMI's business model and its critical and irreplaceable infrastructure assets. It is a valuation issue. At an $18 stock price, the company was valued at about 11x EBITDA; at $20.95 it's worth about 12.4x EBITDA. A multiple at these levels demands strong EBITDA growth and KMI is operating dead flat and below budget. We recognize that the general market can move KMI's stock price above or below "fair value" but on its own merits we view KMI as a $17-$18 stock. We see more downside likely ahead for KMI stock, even after Wednesday's 5% decline.
What about the bonds? From a credit perspective KMI has clearly proven its investment grade rating. In fact, we believe the Baa3/BBB- rating is too low for the actual credit quality. KMI is a $90 billion company with the largest natural gas pipeline network in the U.S. Natural gas use is growing and will continue to grow. KMI's pipelines are irreplaceable and there is no obsolescence risk, at least for the next few decades. Even with the plunge in oil & gas prices KMI clearly proved that its cash flow to service debt is safe (even if growth is stunted). KMI also announced certain deleveraging actions in its earnings release, which will lower leverage from 5.5x-5.6x down to 5.3x. All this put together should warrant a higher credit rating.
The problem with the bonds now are the low yields. 2020 bonds are yielding about 3% and 2023-2025 bonds in the 3.5%-3.6% range. An investor has to go out to 2028-2030 to get into the 6% range, but with these maturities duration/interest rate risk becomes elevated. What about the Copano Energy bonds (which is the same thing as KMI) we recommended in previous articles? We still recommend these bonds, but availability is limited and be careful about the likely call coming soon at 103.563. The bonds are not practicably available at a reasonable price. Management stated that they can raise debt at 4%, which is far less than Copano's 7.125% coupon. We will continue to hold the Copano bonds in personal and client accounts, which last traded at 103.8.
So is a 3% yield for 4 year bonds worth it? There is no right answer. From a credit perspective there is very low risk, these bonds are truly investment grade, so if an investor is seeking low risk profile capital that can be held for a few years, then it is certainly a reasonable bond purchase -- especially compared to cash or treasuries. For our return hurdles the yield is too low on an absolute basis, as we seek higher yields for our personal and client portfolios (we could not justify charging advisory fees for 3% gross yields). If considering KMI bonds we would only look at the 2020 bonds; the longer dated bonds are too low yielding for the maturity dates offered.
We also hold and recommend the bonds of a KMI entity called KN Capital Trust I (CUSIP 482588AC4, 8.56% of 4/15/2027, callable at par on 4/15/17). Although part of KMI, this entity does not benefit from certain cross guarantees and are thus rated one notch below the corporate rating, at Ba1 (ratings on KMI and this bond issuer specifically was reaffirmed by Moody's on July 12th). However, we view this rating difference as a non-concern, as non-payment on KN Capital bonds would still mean that KMI has to file for bankruptcy, which we again view as an extremely remote event. We were last able to purchase a small amount of these bonds for personal and client accounts on May 10th for 98.3, in addition to small purchases made on April 27th, April 26th and March 30th. We check every day for availability but unfortunately there is rarely any for sale.
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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.
Additional disclosure: We hold positions in KMI bonds in both personal and client accounts.