Kinder Morgan: Patience Will Be Rewarded (And Likely By Late 2017)

| About: Kinder Morgan, (KMI)
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Summary

KMI remains a very compelling investment opportunity. Our valuation approach based on 4Q16 numbers suggests a fair value of ~$30.

Kinder Morgan’s 4Q16 earnings report did little to change the fundamental outlook as 2017 financial projections issued in early December were affirmed.

Yes, the prospect for meaningful dividend hike is nearly a year away - but that eventual increase could be substantial.

Kinder Morgan's (NYSE:KMI) 4Q16 earnings report did little to change the fundamental outlook as 2017 financial projections issued in early December were affirmed. Investors hoping for upward guidance revisions on the back of projects entering service (don't forget the offset of the SNG pipeline interest sale last fall) will have to wait for future reports. And of the course the prospect for a meaningful dividend hike is nearly a year away. Nevertheless, KMI remains a very compelling investment opportunity.

KMI has long been mischaracterized and misunderstood. When the U.S. shale boom was in full swing, KMI and other pipeline companies were seen as a rare investment vehicle that offered a high yield AND high growth. But KMI found itself effectively shut out of the capital markets once energy markets turned south in 2015 - forcing a sharp reduction in the dividend and a change in strategy. Usually, such sharp swings in a stock's price are accompanied by similar changes in fundamentals. Not so in the case of KMI. Segment EBITDA was up 9% in '14, was flat in '15, and down 2% in '16 as the company shrank its asset base slightly in an effort to address its financial leverage.

The overall fundamental picture is hardly boom/bust, but instead reflects a business that generates most of its earnings from renting pipeline capacity - a steady toll-like operation with largely regulated rates of return. Boring stuff. But investors had convinced themselves that shale-inspired growth somehow merited higher trading multiples (it didn't as federal regulators make economic rents hard to achieve on interstate projects), and later that the end of the rapid expansion spelled doom (again, it didn't). The growth in pipeline balance sheets required a steady diet of new equity capital, so all that dividend growth was really on the backs of new investors anyway. At the height of KMI pessimism, investors questioned the counterparty risk of every shipper that sent any type of commodity through the company's vast pipeline network and hyperventilated over the accounting of maintenance capital expenditures.

So what is KMI really worth if it's not a capital-market fueled growth engine nor a wasteland of empty pipes? Rather than focusing on distributable cash flow as defined by KMI, we approach valuation by breaking KMI's value into three components: 1) the value of the midstream businesses excluding the CO2 segment (which largely consists of oil production), 2) the value of the CO2 segment, and 3) the value of the tax shield that was greatly enhanced by the limited partnership acquisitions in 2014.

We estimate that the midstream businesses (excluding the CO2 segment and the additional tax benefits of the limited partnership buy ins) generates free cash flow per share of ~$1.20. Once KMI resumes accessing the capital markets, it would seem likely that the dividend could be restored to at least this level (2.4x the dividend expected to be paid in 2017). Since the cash flows underlying these business vary little with the economic cycle, we apply ArcPoint Advisor's estimated normalized P/E for U.S. large-cap non-cyclical stocks of 20.4x, resulting in a value of ~$25 per share for the midstream businesses. We value the CO2 segment assuming no further investment and a 10% annual decline rate in oil production - yielding an asset value of ~$2 per share. Finally, we estimate that the present value of the tax shield created largely by the 2014 limited partnership acquisitions is worth ~$4 share. Adding up the three pieces gives us an estimated fair value of $30 for KMI stock.

KMI valuation ($ in M except per share data)

segment EBDA ex. CO2:

Natural Gas Pipelines

3,936

4Q16 annualized

(+)

Terminals

1,184

4Q16 annualized

(+)

Products Pipelines

1,232

4Q16 annualized

(+)

Kinder Morgan Canada

152

4Q16 annualized

Total segment EBDA ex. CO2

6,504

(-)

DD&A less estimated DD&A from C02

1,728

4Q16 annualized

(-)

general & administrative

588

4Q16 annualized

(-)

interest expense

1,904

4Q16 annualized

pre-tax income ex. C02

2,284

(-)

taxes @ 35%

799

net income

1,485

(-)

preferred dividends

156

4Q16 annualized

net income to common

1,641

(+)

DD&A less estimated DD&A from C02

1,728

author estimate

(-)

maintenance capex

644

4Q16 annualized

free cash flow

2,725

diluted shares (4Q16 average)

2,230

(NYSE:A)

normalized free cash flow excluding DD&A tax shield

1.22

(NYSE:B)

estimated normalized P/E for U.S. large-cap non-cyclical stocks

20.4

(based upon ArcPoint Advisor analysis)

x

estimated fair value per share of KMI ex. CO2 segment and DD&A tax shield

25

(+)

estimated fair value of CO2 segment

2

(+)

estimated fair value of DD&A tax shield

4

estimated fair value of KMI

30

This valuation analysis suggests to us that KMI is a buy today even if we assume the oil producing assets are worthless and that KMI's tax shield doesn't exist. The only plausible bear case one can argue is that the value of KMI's pipeline network has been greatly impaired. And the trend in EBITDA suggests that this is not yet apparent. A markedly higher dividend in 2018 (likely announced in late 2017) could prove to the be the catalyst to close the gap between the current price and our estimate of fair value.

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.