Just over a year ago, the share price for the Houston-based Kinder Morgan Inc (KMI) exceeded $44 for the first time. Shortly before announcing he was stepping down as CEO, Richard Kinder, current executive Chairman and the brains behind the operation, appeared to have blazed yet another trail in the booming U.S. energy space.
In late 2014, he successfully merged together three separate (yet related companies) he controlled. But the enthusiasm was quickly curbed by a huge, and by many measures, historical collapse in oil prices.
The stock has settled at around $17 since oil prices plummeted. But Kinder hasn’t sat still and announced another pioneering move by Kinder. His bold move was to cut the dividend by 74% and ensure the company bearing his name live within its means going forward.
As strange as it sounds, most energy infrastructure firms (including Kinder Morgan) unsustainably operated many of their assets and businesses under a master limited partnership model. The MLP model avoids the double taxation that most public corporations have to pay and had a reputation in the energy space as paying very high dividends. Income-minded investors bought into the shares as quickly as possible.
The problem with the MLP energy model is most firms, including Kinder Morgan, paid out dividends that were too generous and funded by debt. They also raised billions of dollars in debt to build and acquire pipeline and terminal assets. Little focus was placed on generating enough from the existing businesses to pay shareholders.
Kinder was no exception, and as a result has saddled itself with $40 billion in long-term debt. Booming oil and gas production in the United States was anticipated to run indefinitely. The good times stopped, however, when volatile energy prices hit the market. Fortunately, that volatility appears to be quickly subsiding. Now Kinder should be able to easily finance its interest expense going forward.
Kinder’s Bold Response
The company has responded in bold fashion to the volatile energy markets and unsustainable aspects of the MLP business. In December it announced it was cutting its dividend to $0.125 per quarter, down significantly from 51 cents previously. Its internal projections suggest it can support the new dividend, debt service costs and all capital projects with internal funds. Ideally, it will no longer need to rely on raising debt to fund both of these endeavors. Management suggests that will be the case.
Industry peers have yet to follow suit and look much less appealing in comparison. Energy Transfer Partners (ETP) is caught in a nasty dispute with Williams Companies (WMB) as both companies look to merge and agreed on the price before oil collapsed. ONEOK Partners and Cheniere Energy Partners are still separate from ONEOK Inc. (OKE) and Cheniere Energy Inc., (LNG), (so is Williams Partners), and may need to consider merging their entities, just as Kinder already has.
Kinder the Company
Kinder Morgan bills itself as the largest infrastructure company in North America. It owns pipelines and terminals that transport oil (and related petroleum products), natural gas, C02 (that is used to make fuel and is injected into wells to get oil and gas out) — and lots of them. At the end of 2015, it boasted 184,000 miles of pipeline and 180 terminals.
The company also notes that most of its business operations are fee-based, meaning clients pay it for transporting oil and gas at set prices. The important point here is that most of its revenue (save for its C02 business) is not subject to fluctuating energy prices. Every dollar change in oil prices affects its cash flows by $6.5 million, and every 10 cents per MMBtu affects cash flow by $0.6 million.
In other words, as energy price volatility returns to more normal levels, the impact to Kinder Morgan’s cash flows will be less significant.
Kinder’s first quarter results suggest it is on track to meet its new financial goals. It reported generating $954 million in cash above of its needs for paying a dividend. Its commitment to capital spending dropped from $18 billion to $14.1 billion — due to better budgeting, but also closing certain terminals and pipeline construction projects as a result of lower demand.
The Value is There
Kinder’s current dividend yield is very respectable at right around 3%. That is a far cry from past levels ranging from 7% to 9%, but it’s better to run stable and sustainable operations. Its rivals will soon have to figure this out too.
Analysts project between 70 cents and 80 cents in earnings in each of the next two years. That puts the forward price-earnings ratio around 25, but there are many moving parts to Kinder’s cash flow generation. Free cash flow productions has averaged 71 cents over the past five years, or right around the reported earnings levels.
It appears a safe bet Kinder can operate within its budgets and support its dividend going forward. The real wild card is the value of its massive pipeline and terminal assets.
There is little question that Kinder owns one of the largest and most valuable energy infrastructures in the country. The book value of these assets (as reported at historical cost on its balance sheet) is right around $16 per share.
That should represent a floor value, which happens to be right at the current share price. Oil prices have quickly bottomed and are back above $45 per share, which also helps stabilize the industry.
If Kinder proves to the market that it can operate within its means and boost cash flow generation consistently above $1 per share, the stock should continue to recover toward its former high.
Conservative estimates suggest a market value of its assets in the low $20 range. If oil prices return to the $50 to $70 per barrel range, U.S. oil and gas production will continue to recover. These operators will need Kinder to help transport these important commodities, which will allow it to maintain, and eventually expand its infrastructure assets.
The bottom line is that Kinder Morgan is a relatively safe bet in the energy infrastructure space at current levels. It has high debt, but has quickly rationalized its business and has an enviable collection of billion-dollar assets that can be used as collateral to continually tap capital markets to run (and grow) its business.
All indications are that the company will live within its means and return to boosting returns for shareholders.
This include increases to its current dividend, more stable and ample cash flow production, and a stock that could reach $30 within a few years. This would represent a 75% gain from current share price levels.
As of this writing, Ryan Fuhrmann did not hold a position in any of the aforementioned securities.