Recently, multiple articles have hammered Kinder Morgan (NYSE:KMI) on the basis of overvaluation by three metrics: price/earnings ratio, dividend yield, and exuberant investor sentiment. None of these reflect the actual bull case for KMI: substantial dividend growth. Below, I will demonstrate the flaw in the bearish arguments and the strength of the bullish argument in determining that Kinder Morgan is undervalued.
P/E Ratio and Dividend Yield Are Never Appropriate Valuation Tools … By Themselves
In recent articles, Seeking Alpha contributor David Alton Clark has determined that KMI is overvalued because of a high P/E ratio and low dividend yield. Unfortunately, this analysis makes the fatal mistake of focusing on these two metrics in a complete vacuum.
If P/E ratio is the be-all, end-all of stock valuation, then companies like Amazon are essentially worthless (with its P/E ~ 290), and investors should be buying Gilead (P/E: 7) hand-over-fist. What a focus on the current (or next year's) P/E ratio lacks, however, is any sort of consideration of future growth or decline; Amazon could change strategy to maximize earnings, while Gilead could see stiff competition to its products and poor use of cash cause future earnings to plummet. In the case of Kinder Morgan, earnings are artificially deflated by the overly-aggressive depreciation schedule for pipelines enforced by the IRS, leaving the P/E ratio on its own to be a very poor estimation of the company's value.
Similarly, dividend yield is also a poor substitute for valuation, for obvious reasons. If a low dividend yield screams "over-valued", then companies like Apple (NASDAQ:AAPL) (2.52%) and Disney (NYSE:DIS) (1.41%) are unworthy of investment, while companies with high dividend yields like GameStop (NYSE:GME) (5.15%) and Viacom (NASDAQ:VIAB) (4%) are screaming buys. Of course, this neglects to consider any future changes in the dividend that might occur, with AAPL and DIS sure to see dividend increases in the coming years while equities like GME and VIAB are at risk of deteriorating business and dividend cuts. I'm somewhat surprised that Clark doesn't believe that KMI, with its ~3% dividend yield, sports enough of a dividend yield to be interesting; regardless, to neglect the almost-certainty that Kinder Morgan will massively increase the dividend in the near future is a serious failure of analysis.
Generally, the P/E ratio and dividend yield can be a nice starting point for analysis, but to use these as the bulwark of a valuation case is both misguided and insufficient.
Dividend Discount Models Demonstrate Kinder Morgan is Undervalued
Instead, the proper way to value a stock is to project forward, with conservative assumptions, the earnings, free cash flow, or total dividends that a stock will pay back to shareholders. This "future cash" is then discounted back in time, since a dollar today is worth much more than a dollar in 5 years. For a C-Corp like Kinder Morgan, which has in the past attempted to pay out close to 100% of "distributable cash" in the form of dividends, a Dividend Discount Model is a particularly appropriate method, as we can assume that most of the tangible benefit to shareholders will be in the form of dividends. How does the dividend discount model work? Essentially, it takes the expected yearly dividend for every year in the future, discounts those dividends for how far away they are, and then adds them all together to calculate the "intrinsic value" of the stock today.
As a reminder, here is the 2016 budget for Kinder Morgan, after recently decreasing its budgeted DCF by 4% in the latest conference call:
- Distributable cash flow: $2.05/share
- Dividends: $0.5/share
- CapEx: $1.5/share
At this level of capital expenditures for growth projects, Kinder Morgan will complete its $14.1B in growth commitments over the next half-decade, ending in 2020. If the 2016 budget is projected forward, that would actually allow for ~ $15.5B in growth capex spending. This makes the model even more conservative, by neglecting the additional $1.4B that could be paid out as dividends.
Here are the assumptions (and whether they are conservative, neutral, or optimistic) I've used to build the dividend discount model below:
- Kinder Morgan will continue to fund growth capex from internally generated cash: conservative. If KMI is able to access either the debt or equity markets in the coming years, it will come with further dividend increases.
- Over the next 4 years, dividends will increase by ~ 20% per year: neutral. Although a 20% per year increase seems extremely large, in terms of total outlay, it is actually quite reasonable; distributable cash flow only needs to increase by ~6% per year to cover this, or growth capital expenditures could decline by ~13%, or some combination of the two.
- In the year 2021 the dividend is greatly increased, up to $2/share: neutral/conservative. At the conclusion of the growth capital expenditure program, it will be possible for Kinder Morgan to return to its policy of distributing >90% of distributable cash flow as dividends. Additionally, this point assumes that DCF will not grow substantially from now until 2020; otherwise, the dividend would be much in excess of $2 per share.
- Discount rate = 11%: conservative. With equities currently fully valued, a discount rate of 11% is fairly conservative; it seems unlikely that index funds will actually return 11% per year in total returns for the foreseeable future. However, small changes in discount rate can cause large differences in the calculated intrinsic value, so we will leave the discount rate at 11%.
In the table below, I calculate the intrinsic value using the dividend discount model for a couple different scenarios of the size of the resumed, larger dividend after the capex program ends as well as a few different terminal growth values.
So, in the most conservative scenario, we arrive at an intrinsic value of ~$17.00 per share for KMI. It's important to emphasize the overarching conservative assumption in this model: despite spending some $14B in growth capital expenditures over the next 5 years, Kinder Morgan is essentially unable to grow DCF at all by 2020. This is why I believe the $2/share dividend in 2021 to be extremely conservative; Kinder Morgan could afford to pay this large of a dividend today, were they to completely stop all growth projects. It is quite likely that actual distributable cash will be greatly in excess of $2/share by 2021.
For an even more conservative scenario, consider what happens if dividends aren't grown at all for the next 5 years, and don't ever grow once the original (2015) $2/share dividend is resumed:
Still, in this extremely bearish case, we find KMI to be worth ~$16.30 per share, or about 5% less than it trades at today.
Finally, what's the most bullish scenario? Consider what happens if dividends grow for 20% for the next 5 years, and Kinder Morgan is able to generate $3 per share in DCF in 2021, of which they distribute 100% to shareholders in dividends; although seemingly ultra-bullish, this meshes well with the run-rate projected by KMI at the time of the roll-up of all of the Kinder Morgan companies into KMI. We find the following:
In this case, Kinder Morgan is massively undervalued.
So, using the dividend discount model of valuation, we arrive at a value for KMI of $16.30-$48.00. Of course, I believe that the lower end of that range is being extremely and overly conservative, while the upper end is perhaps too optimistic. Regardless, the model demonstrates that Kinder Morgan is, if anything, just slightly overvalued with a very real possibility that it could be vastly undervalued.
Covered Calls Remain Attractive
In mid-December, I detailed how to take advantage of the ludicrous amount of volatility in Kinder Morgan's common stock by selling covered calls. By doing so, investors would have already booked gains of ~7% in the course of a month in call premiums; rolling the calls forward and up would have been extremely lucrative for the past few months, as call premiums have remained large while KMI has remained range bound.
Covered Call Paradise
Today, options prices are still relatively high compared to the limited downside risk that KMI presents; unfortunately, they're nowhere near as large as the premiums we saw in December when KMI was in the midst of its nosedive, but still large enough to be worth giving up some appreciation upside. For the conservative investor wishing to enter KMI today, covered calls may be a way to avoid some of the volatility and pocket some extra cash income. Here are a few strategies which I find attractive today:
Near-term, OTM covered call
Using this strategy, one would sell a covered call at a strike price of $18 for expiration in September of this year, yielding cash income of $1.16 per share, for a total return of 11.82% if KMI closes above $18 on expiration.
Far-term, OTM covered call
Using this strategy, one would sell a covered call at a strike price of $19 for expiration in January of 2017, yielding cash income of $1.55 per share, for a total return of 20% if KMI closes above $19 on expiration. I personally find this strategy more appealing, as I believe that volatility in KMI (and oil names more generally) will continue to fall in the coming months as the oil shakeout continues. Selling the farther out, January expiration covered call would allow me to capture more option premium when volatility is a bit higher.
Using more rational valuation models, Kinder Morgan is at minimum fairly valued today, and at maximum a screaming value-buy. Additionally, selling covered calls may be a way for new investors to enter a KMI position without experiencing too much volatility.
Disclosure: I am/we are long KMI.
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: I am additionally short KMI puts and covered calls.