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.

The Management:

Rich Kinder, age 71 owns 11% of the company and was famous for paying himself only 1 USD salary during his time as CEO.

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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

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.

Valuation:

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:

EBITDA 6,8 bn USD
Net debt MV 40 bn USD
Shares 2,231 bn
6% 7% 8% 9% 10%
0% 32,87 25,61 20,17 15,94 12,55
1% 43,03 32,87 25,61 20,17 15,94
2% 58,27 43,03 32,87 25,61 20,17
3% 83,67 58,27 43,03 32,87 25,61
4% 134,47 83,67 58,27 43,03 32,87
5% 286,87 134,47 83,67 58,27 43,03

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.

The warrants

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.

Summary:

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.

 

 

 

15 comments

  • One question I’ve had for the midstream transportation and storage industry is:
    Kinder / Williams / ETE and others all state they build projects at 7x EBITDA. Why do the public markets justify paying 14-15x EBITDA?

    Cable companies do their build outs based on a similar 7x EBITDA (proxy for 15% IRRs), but their public valuation is ~8-11x EBITDA.

    • thanks for the comment. The reason is the same why real estate is not valued just buy the cost to build it or why you cannot buy a new car for the cost to build it: Someone needs to earn a profit, otherwise they won’t build it. As I mentioned in the post, the value of a pipeline is more than the cost to build it.

      Cable companies might be cheap as their businss model is to a certain extent under attack (Cord cutting).

  • The correlation coefficient with oil is 0.96 (1 year, daily close, vs. USO ETF), so in the short term you’re probably just buying a proxy for oil futures.

    As an oil short term bear, I think such stocks are likely to become much cheaper — both because of oil itself, and the chance that the cycle involves a period of them crashing more than oil during the surrender phase. But thanks for the heads up, it’s a good one to watch!

    For cycle agnostics, it may be a good case for a staged allocation, e.g. invest half of the budget now, and other half during surrender if that happens. Is 2.5% your max allocation for the idea?

    • yes, short term the stock price looks like an oil proxy but fundamentalll it is not. I have no opinion on the oil price and clearly, if you invest in such a stock, a 20-30% draw down should be expected.

      2,5% is a starting position. I am prepared to increase the stake to up to 5% (all other things equal).

      • If my thesis works out, the drawdown will likely be much worse, like to $5 or less I’d guess. Surrender is when the probable survivors become insanely good value.

        (Of course, conversely if we are already past the bottom, those of us now waiting on the sidelines will miss the boat.)

        • I am clearly not a very good market timer. Oil and related stocks can clearly go lower, no doubt. However if the “margin of safety” is big enough I don’t care. I do think KMI is already cheap enough but that could be wrong we will see. If history is any lesson, I will clearly be too early. And sell too early too 😉

  • Thanks for sharing! Very good write up as usual!
    It is very positive that they intend to use the cash to allocate their capital to expand business rather than paying this ultra high dividend. Gas/oil related assets and services such as pipeline construction look relatively cheap in North America at present. So timing is good. However, I prefer them having this idea themselves rather than to react to a downgrade threat. Who knows maybe they did. Did you find any statement directly from the management on recent market developments, future strategies and how they want to deal with it?

  • “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.” Not according to Benjamin Graham, but perhaps you are smarter than Buffett and Graham? I like your work but is it necessary to call other approaches and people stupid?

    • I am not aware of Graham or Buffett using the current dividend as only basis for a valuation. On the contrary. there is a very good Buffett shareholder letter explaining why Berkshire doesn’t pay any dividends.

      And yes, I insist on the point that valueing stocks only based on dividends (and not on underlying cash flows / assets) as stupid, actually I meant VERY stupid.

  • Where is the debt trading at ? Maybe there an opportunity might show up in 2016?
    Also, Hedge FUnds may play the capital structure (long bonds, short stock or vice versa at some point)

  • Audio from Q&A FY’15 results (approx. min. 54). But even though I would take the $4 bn number as distributable cash flow reference in order to compare apples with apples because Mr. Kinder is referring to DCF to shareholders post-dividend (but it is not incorporating/deducting maintenance capex). So the overall $4 bn sounds pretty solid once you sum up the dividend and deduct the maintenance capex.

    • So in other words, to be clear on what the CEO is saying:

      +CFO: $4,9 bn
      -Preferred div: $-150 M
      -Common div.: $-1,1 bn
      =DFC of $3,6 bn

      In my opinión one should add back $1,1 bn and deduct $0,7 bn (of maintenance capex). That is the $ 4 bn DFC.
      I hope it helps.

  • Hi mmi,

    Kinda mixed feelings. It has a clear moat but too many open variables (obviously that is embedded in the price correction). Nevertheless at current price yields ca. 13x EV/EBITDA so is definitely not cheap.

    Normalized distributable cash flow, according to its CEO, is around $3.3 bn (rather than $4 bn) on a yearly basis so it would require 2% growth in order to reach the 25$/share at 8% discount rate (which still is reasonable to project in my view).

    My fear would be that oil and CO2 divisions could follow a structural slow down once the shale fever is fading away. Even though I do agree that much of the downside would be covered at current prices.

    At 12-14/$, buy was a no brainer, as it was the case with some of the other energy related stocks -during last Feb correction-. At current prices I personally see upside but practically no margin of safety.

    Good luck and as always thank you for sharing!

    Take care.

    David.

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