Kinder morgan (KMI): Asymmetric upside potential
So let’s move on from focusing on the bad things and look at the the things that I like at Kinder Morgan. While I was writing this post, I found a very good blog post from Glenn Chan from 2 years ago which I can only recommend and includes a lot of interesting points about Kinder Morgan.
Rich Kinder, age 71 owns 11% of the company and was famous for paying himself only 1 USD salary during his time as CEO.
In 2014 he stepped down as CEO but remains Executive Chairman (and still earns only 1 USD). As it is mentioned in a Forbes article from 2015, this does not mean retirement:
“I’m not going anywhere and will remain involved in all major company decisions, including acquisitions and capital projects,” Kinder said in the company’s release. “As the largest shareholder of KMI, I remain very enthusiastic about the future of the company. I have never sold a share of stock and don’t intend to now.”
He started out at Enron but left when he didn’t become CEO in 1996. There is an interesting article about him from 2012 in Forbes. I found another Fortune article from 2003 which is also interesting. He seemed to have declared personal bankruptcy in 1980:
In 1980, Kinder and his first wife Anne filed for Chapter 7 bankruptcy protection. He listed $2.14 million in debts and $130,750 in assets. The couple said they had only $100 in cash. (Kinder says that in 1999 and 2000, he repaid every penny he owed.
Maybe this experience had some influence on his decision to cut the dividend aggressively when the rating agencies threatened him with a potential downgrade ? Who knows….
For an “Oilman” he seems to have been always very cost conscious:
While Houston’s energy elite were indulging in lavish lifestyles–flying in private jets, naming ball fields after their companies, building ostentatious mansions–Kinder was pinching pennies. He was flying coach. He and his Morgan execs were staying at Red Roof Inns. He was laying people off. “People thought we were curmudgeons or stick-in-the-muds,” acknowledges Kinder. “But we wanted to drive home one culture here: Cheap. Cheap. Cheap. We were tightwads.”
As mentioned he was also famous to pay himself only 1 USD salary:
I get $1 a year [in salary],” he says, jamming his finger down on the conference table for emphasis. “No bonus. No additional options. I own a significant stake in the company. If the distribution is raised, that’s good for me. My interests are as aligned as much as possible with the shareholders’.”
Rich Kinder as a capital allocator / capital manager
Calling him an “active capital allocator” would be grossly understated. He is a very active and ultimately very succesful capital allocator/manager
- in the late 90ties when everyone wanted to be an energy trader, he bought any pipeline he could get
- He pioneered the MLP structure
- went private in 2006
- went public again in 2011
- dissolved the MLP structure in 2014 because the structure made growth difficult
- made opportunistic & countercyclical acquisitions such as the 2015 purchase from Continental Resources
- slashed the dividend in order to maintain the rating in 2015
The 2014 reorganization
Why did Rich Kinder disolve the MLP structure ? One argument was that they could better finance growth. The second argument however clearly seems to be a 20 bn USD tax saving.
This is the 20 bn USD argument:
The deal sets a new value for the pipelines and terminals that KMI is getting from the partnerships, based on the price it pays for them rather than their depreciated historical cost. This has the effect of increasing the value of the assets and enables Kinder to deduct more from its income taxes because of depreciation.
For me, this reminds me a lot of John Malone, the creator of the Liberty empire. Both grew quickly in capital intensive businesses, using leverage and taking opportunities of company structures to increase returns for shareholders.
John Malone never showed an accounting profit. His strategy was to use a lot of leverage and write off his acquired assets as aggresively as possible in order not to pay taxes and to enable him to reinvest without paying cash taxes.
This is a John Malone quote (via 25iq)
“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings..” “The first thing you do is make sure you have enough juice to survive and you don’t have any credit issues that are going to bite you in the near term, and that you’ve thought about how you manage your way through those issues.”
“I used to go to shareholder meetings and someone would ask about earnings, and I’d say, ‘I think you’re in the wrong meeting.’ That’s the wrong metric. In fact, in the cable industry, if you start generating earnings that means you’ve stopped growing and the government is now participating in what otherwise should be your growth metric.
I think that the very unpopular dividend cut of last year clearly fits into this John Malone statement. As an “owner” you care less about short term stock price movements than a “hired gun” CEO who has some share options vesting at the end of the year. As I mentioned in the last post, the communciation was clearly not optimal, but on the other hand this might be exactly the opportunity for a value investor with a longer time horizon.
Clearly, Rich Kinder had some tailwinds like the Shale Boom, but turning a 40 mn Equity investment into a 40 bn market cap company within 20 years is a pretty amazing achievement.
There are many ways to value a company like Kinder Morgan. Using dividends however is pretty stupid as the amount of dividend payed out has very little (if any) signifcance on the intrinsic value of the company.
Kinder Morgan is mostly an asset play. That’s why one should value the assets on an unlevered basis and then deduct the debt like a Private Equity investor.
From my own experience I assume that the going rate for regulated pipeline assets is on average ~7% to 8% EBITDA yield on an unlevered basis or somewhere between 14 and 15x EV/EBITDA in the absence of any growth.
Of course not all assets at KMI are regulated pipeline assets, on the other hand, KMI has clearly demonstrated that they can grow over time. To show the sensitivity of the valuation, I always find it helpful to create very simple valuation grids.
If we assume that :EBITDA is ~6,8 bn p.a. and the market value of the debt ~40 bn, we can calculate per share net asset values for a grid of discount rates and growth rates:
|Net debt MV||40||bn USD|
For me, the “expected case” would be something like a 8% discount rate and 1% growth resulting in a fair value of around 25,60 USD per share. Also, under my assumptions, the downside is relatively limited. Based on 18 USD per share (at the time of writing), that would imply an upside of around +42% which for me would be an acceptable return over my typical 3-5 year investing period (plus any dividends).
Risks & upside
Clearly there are many risks in the business (accidents, demand shifts, bankruptcies of oil & gas companies or municipalities etc.). But this is similar to any other business. Nevertheless, the risk of a new competitor for a pipeline asset is a lot lower than for a “normal” company, especially if you own a large part of the network like Kinder Morgan does.
Also, I do think that there is a “double upside” chance for the stock.
KMI does have a history of growth and to me it looks like that very little growth is priced in. Plus, the 6,8 bn assumed EBITDA is based on 38 USD/barrel oil price which might turn out as too conservative and we will see maybe better earnings from the oil price sensitive businesses than what is currently planned. So in a good case, both energy prices could rise and KMI can grow which then could justify valuations on the left side of the grid.
Compared to any “normal” energy stock; I would argue that KMI has almost the same upside but a lot less downside which in my opinion creates a nice asymmetric risk/return situation.
KMI has issued warrants during the El Paso takeover. The warrants mature in May 2017 and are far out of the money with a strike at 40. For me, this is not interesting as I don’t see the fair value of KMI at 40 USD, especially not within one year.
All in all, I find Kinder Morgan a very interesting stock. It is a rare opportunity to team up with a great capital allocator at a price, where the downside is limited and in my opinion an asymmetric return potential exists.
The dividend cut last year in combination with the general bad image of the Oil & Gas sector could have been the reason that the stock looks to a certain extent mispriced and is maybe indeed “collateral damage”.
For the portfolio, I will buy a starting position of 2,5% at 18,50 USD/share for my “contrarian” bucket although the stock also has “outsider” qualities.