Kinder Morgan Looks Very Undervalued

| About: Kinder Morgan, (KMI)

Summary

The company has been returning less capital per invested dollars for four years now.

This means that the reduced earnings power should be accounted for which results in a discounting of the assets.

The company looks very undervalued, but in fact is not.

Introduction
Kinder Morgan (NYSE:KMI) looks very much undervalued compared to its historic valuation. Of course this is not surprising considering the recent oil glut. Still there are a number of ways to assess whether this discount is warranted. The most obvious thing that I presume is happening, is that investors are discounting the value of the assets. Presumably, the assumption is that these assets have a lower earnings power and therefore deserve a discount. The market is discounting the balance sheet value by 58% when compared to the company's 5 year average valuation. When comparing KMI's discount to that of its peers, the discount is less substantial and comes in at 44%. This last fact clearly indicates that there are other issues at play here, besides the oil glut, which are resulting in the company's discount.

Earnings potential through return on invested capital
There are multiple ways to determine an assets earning potential. The most straight forward way is discounting the estimated future cash flows to its net present value. However, to do this we'd have to have access to a lot more information than is currently publicly available. Luckily, this is finance and finance is, believe it or not, a very creative field. For example, we can try and determine the company's return on invested capital. With that, and the company's cost of capital, we'll be able to determine whether this company is earning more or less on a per dollar basis.

This might sound confusing so allow me to explain. Calculating the return on invested capital (ROIC) is common practice in the oil and gas industry, because the companies in this industry invest large amounts of capital. The roic is in essence a measure of how much cash is going out of a business in relation to how much is coming in. This means that roic is expressed on a percentage basis. For example, a 1% roic means that every invested dollar will return $0.01.

Money isn't ever free

The second equation to this is a company's weighted average cost of capital or wacc. Before a company is able to invest a dollar it must acquire a dollar. Every company starts of by acquiring capital through either equity or debt. For investors to become shareholders, they must be convinced that the equity will appreciate.

After all, that is the rationale behind investing in the first place. In finance, this is called the cost of equity. Debtholders follow the same rationale and this cost is then called the interest rate. Debt and equity together are referred to as the capital structure and after creating a weighted average of the cost of equity and debt combined, we get the weighted average cost of capital.

Eroding or creating value?

After acquiring the roic and wacc, we simply subtract wacc from the roic to see if a company is creating value. If the number is negative, it implies that while a company may be making money on a nominal basis, it is actually destroying value, which becomes more evident as the trend persists. In the case of KMI, the company's trailing twelve months (TTM) roic is 0.72% which, to be frank, by itself is quite poor. It is so poor, that there is really no need for me to go through the hassle of calculating the wacc, but of course I will. Depending on how aggressive I calculate this, KMI's wacc is anywhere between 4% and 5.5%. The value proposition here is -3.28% to -4.78%, which means that this actually isn't a value proposition, because the number is negative.

So now I've determined their current value addition, but it is extremely helpful to backtrack a few years so that we can establish a trend. One thing immediately pops-up when we do this: the company's roic has been declining since 2012. However, what's far more interesting is the rate at which the roic has declined. Consider the table below.


Source: author's calculations

The decrease is particularly nasty after 2014, which would seem to correspond with the oil glut, since that was the year it started. However, the fact that this trend started earlier, made me have another peak at the balance sheet. The book value as well as the share count increased in the 2014-2015 period with both more than doubling. In other words, this was probably the work of an acquisition and after some more digging, sure enough, the company did in fact acquire another company. In November 2014 KMI acquired its MLP limited partners for $76 billion. What the company got in return for that was a cash flow stream of $2 billion dollars per year. That is a return of 2.63% per annum, which is ridiculously low. The acquisition gets even more absurd as more complicated facts are revealed. Another author was kind enough to dedicate a whole article to the acquisition, which you can read here. I'll just quote his biggest point and leave it at that:

"Essentially, they cooked and ate their own golden goose giving up the IDRs and limited capex contributions all the while fully assuming 100% of the burden of the MLP's sky high debt."...
"Put it all together and it looks like KMI essentially gave half of itself away to its MLPs and received less than nothing in return."

This opinion certainly corresponds with the roic decreasing from 1.62% to 0.29%.

Key take away

Investors shouldn't be fooled in to thinking that the decrease in value is due to the oil glut. The company made a very disastrous acquisition, since they are returning less capital to the business on a per dollar basis. The reason for such an acquisition is quite puzzling, since it should have been fairly evident prior to the acquisition that it was not value accretive. I'm always rather cautious to assume incompetence at the academic and executive levels of society. This is not because I am so mesmerized by authoritative titles, but simply because it is very unlikely that these people are in fact grossly incompetent. After all, they have dedicated a large portion of their lives in becoming adept in their field. So I'm quite curious if there might have been other motives at play. Of course, I have no evidence of this other than what the numbers are whispering. Still, even if this was solely the result of gross incompetence across many executive layers, is that really a better scenario? So while the stock looks quite juicy and a 2.35% dividend might look attractive, it is a much better idea to stay away. This is simply a business that is being run very poorly.

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.

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