Kinder Morgan: The Market Smells A Distribution Increase

| About: Kinder Morgan, (KMI)

Summary

DCF is forecast at $2.10 per unit. Cash flow from operations is similarly healthy. Current distribution is excessively covered.

Unit distribution coverage will remain higher in the past, while coverage will decrease in the future. This will allow earnings compounding to a much greater extent than previously.

While the stock has nearly doubled from its low, it should double again to reach its old high and eventually surpass that old high.

The sizable amount of capital projects indicate a reasonable future to allow management to grow earnings at least 10% per year.

Richard Kinder obtains all his income from his unit holdings as the largest shareholder so he is firmly aligned with the shareholder interests.

Mr. Market was all upset when the distribution was cut. There was no future, the business would never grow again. There were even articles questioning the sustainability of the reduced dividend. Even now the stock price reflects the reduced payout, it does not reflect the underlying business strength. The stock price is far lower now than it was a couple of years in the past yet Kinder Morgan (NYSE:KMI) management just announced about an EBITDA 5% budget short fall.

Statistically, 5% might not even be meaningful, yet the market acts as though the company completely fell apart. The reaction was similar to many companies previously covered that actually had some serious problems. One would have thought that the only thing that mattered to the market was the distribution.

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Source: Kinder Morgan, Sept. 8, 2016, Barclay's Energy CEO Conference

Now in some ways the above graphs do mix apples and oranges because the company changed its corporate structure a few years back. But it is hard to deny that the company clearly made good progress through the years. After all, KMP did represent a significant chunk of the company. The key point, however is on the right side of the chart. Notice that the projected distributable cash flow is a whole four cents lower for this year than last year. My personal favorite, cash flow from operations is also very healthy. Yet the stock price is about one-half of its previous high.

Most likely Mr. Market was insanely optimistic about future prospects at the stock high. So Mr. Market is now overly depressed about future opportunities for this company. This was a company that traded over $40 per unit about a year ago. Yet earlier this year, the stock traded briefly below $12 per unit. This is a prime characteristic of "group think" that investors can take advantage of. But it takes a lot of nerve and determination as well as patience to go against the market. Clearly, the stock is up nicely from its low as the market realizes the company would still grow and there are some decent future prospects, but there is still a lot of failure priced into this stock.

More importantly, Richard Kinder, the company chairman (along with upper management) and largest shareholder, has announced a change in long term policy going forward. The market and the lenders demand greater coverage of distributions than in the past. Lenders also want more equity and a lower loan-to-value ratio. So going forward, this stock will have greater distribution coverage. It will also allow earnings to compound to a far greater extent than was allowed historically.

That means that the earnings will be re-invested in the business. Therefore earnings will now compound and growth will be relatively higher than in the past when a non-compounded growth rate prevailed. This will counteract the lower growth rates projected because the company is now much larger. Previously, the company sold more units to grow and obtained earnings growth from the spread between profitability and borrowings. So in many ways earnings grew without the compounding as any available earnings were distributed. So there really was not much, if any cash available to re-invest in the business. Dilution from more unit offerings was the rule.

In addition the market has forced the company to "upgrade" its future projects in order to obtain the necessary borrowing. But that means that future projects will have increased profitability or they will not be approved by lenders. But the market is still focused on the dividend cut. So it downgrades any future prospect upgrades forced by the lenders.

But really all of this makes the future brighter than it ever was before. This management clearly has a successful long term acquisition and growth strategy. Now that the stock price remains low (but climbing) this stock is still on the bargain table. There is absolutely every reason to believe that the long term track record will continue.

Source: Kinder Morgan, Sept. 8, 2016, Barclay's Energy CEO Conference

The company's credit rating is currently BBB- or so according to the latest presentation. It is up to management to decide the best capital structure to maximize returns to shareholders as well as the profit maximizing credit rating. With Richard Kinder as a major shareholder who derives much of his income from his shares, and practically nothing from his job, his interests are clearly aligned with the shareholders. So expect growth enhancing deals to be made in the future. All the Warren Buffet fans should love a company run like this. Maybe the dividend cut was painful, and it sure would have been nice to avoid that cut. But the results are becoming apparent.

Management admitted to slowing down the capital projects somewhat. But the increased profitability of future projects combined with the greater earnings reinvestments has to be a big plus for shareholders going forward. Less dilution from periodic unit offerings is in the cards. The company is only distributing $.50 per unit right now. But the cash flow is far in excess of that distribution. Management is ahead of their goals on some key financial items, so an initial increase within the next 18 months is a certainty. More than one is definitely possible. Right now, the market is not giving any valuation to the superior profitability of future capital projects or the effect of compounding earnings. This is another reason that the units are cheap.

So an investment right now, could easily realize a $1 distribution per unit within the next 18 months, and it will grow more rapidly than expected for the size of the company because of the compounding earnings. Most investors average about an 8% return per year. This company not only offers capital gains as the distribution is restored but also offers a future distribution that will exceed 5% of the current price within five years. That would be a very worst case-near disaster scenario. It probably will exceed 10% really. This company is very well diversified and has grown through the latest industry downturn. That downturn was an industry worst since the end of the 1970s to early 1980s. Investors will probably not see such a severe downturn again in their life times. Investors should expect cash flow growth to resume a few percentage points lower than the slide shown above. Yet the stock is priced as though another disaster is just around the corner.

Net debt-to-adjusted EBITDA is now ahead of schedule at approximately 5.3. The market had a very subdued reaction to that news. Especially when the reaction is compared to the distribution cut announcement. But the underlying business is clearly sound. The credit rating indicates that borrowing is available and the company can refinance its debt with reasonable terms. In short the world of Kinder Morgan did not end. So if anything, the market will probably be surprised with an early distribution increase. This management has beaten its own conservative forecasts in the past. So one would think the market would expect a "beat" on an issue as important as this.

But the unit characteristics will change going forward. As a result of the revised distribution policy this stock will offer a generous distribution as well as capital gains from earnings reinvestment as well as the spread between interest costs and profitability of projects. The market appears to be expecting a strictly income type "old fashioned" limited partnership that is now antique. Charles Almon used to say "buy straw hats in January" and that saying was never more appropriate than now.

The income offered by these units was never safer. The current distribution is extremely well covered and future ones will be also (even if less well covered than now). Management has a goal to make distributions far safer than they were in the past. Distribution coverage has promised to be higher going forward and the capital structure more conservative. The distribution "catch up" phase may be priced into the stock a little bit, but future business growth is clearly not. Yet this company should manage to grow earnings 10% per year well into the future. These units will definitely double in price over the next five years without much of the risk that usually accompanies such an investment.

Larger company units tend to have longer buying opportunities than smaller companies. Their stocks tend to move more slowly as it takes far more volume to move the stock price. But this bargain will not be on the table that much longer as the market is slowly catching on to this company's prospects. So even though this stock has nearly doubled from its low, it has a lot further to go. Sometimes you do not have to be speculative to obtain a speculative-sized return.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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.