Description

Kinder Morgan is the largest midstream and fourth largest energy company in North America.  Its main assets consists of natural gas pipelines, products pipelines, terminals, CO2 source fields and transportation.  82% of KMI cashflows is fee based (i.e. stable and predictable cashflows), 94% including hedges for the CO2 segment.  Kinder Morgan is benefitting from the secular growth in the energy sector in the US and from a structural point of view, participates in all segments of the growth (i.e. natural gas and oil through pipelines and terminals).  Assets have significant barriers to entry from both replacement cost basis (80,000 miles of pipelines and 180 terminals) and regulatory standpoint (need FERC approval to lay out competing pipelines). 

As a public investor, one can gain exposure to Kinder Morgan through KMI; KMI warrants, KMP, EPB, and KMR (same as KMP except the distributions are in shares rather than cash).

KMI owns the GP interests to KMP and EPB as well as ownership stakes in the LP of KMP (9%), KMR (13%) and EPB (41%).  The GPs own incentive distribution rights (IDRs) which gives the GP a % of the distributions and shares increase as distributions increase (from 2% to 50%).

KMI has been public since 2011 and has exceeded its dividend guidance every year, from $1.2 in 2011 to $1.6 in 2013. Looking at KMP’s track record, KMP’s actual distributions exceeded guidance 13 out of the last 14 years.  Management has grown KMP distributions by over 3x from $1.71 in 2000 to $5.33 in 2013. EPB has grown its distribution from $2.25 in 2012 to $2.55 in 2013.

Management is also great operator as their ROIC has consistently exceeded its cost of capital by ~300bps.  Since 2000, ROI has been between 12%-14% unlevered ROI on a predominantly fee based/regulated asset base is very impressive, especially taking into account the large footprint of its assets. Taking account the use of leverage, ROE has been in the 20%+ range.

Stock price has taken a beating since the end of 2013 dropping from ~$40/s to $31/s.  Main issue was lower distribution guidance from EPB (probably taking longer to create the synergies from the big acquisition) as well as some negative press regarding how Kinder Morgan accounts for its maintenance capex, rehashed again in a recent Barron’s article.  Kinder Morgan has since come out publicly and posted its arguments against the Barron’s article (http://www.kindermorgan.com/investor/presentations/KMP_Responses_to_Barrons.pdf).

A reflection of the attractiveness in KMI's valuation today is the recent insider purchases, espcially from Richard Kinder.  Richard Kinder owns 24% of KMI, 5% of KMP, and less than 1% in the other entities.  For reference, Kinder “receives a salary of $1 a year, no bonuses, no stock options and no restricted stock.”  Since December 2013, Richard Kinder has bought back ~1.1mn shares worth about $35mn.  In the last conference call, Kinder said: 

“While we had an excellent year at the Kinder Morgan companies, both financially and operationally, our units and stocks underperformed the market by a wide margin. Now perhaps we failed to adequately communicate our story, although we certainly tried, and maybe we did communicate it, and the message was not accepted. I don’t know the answer to which it was, but I do believe that particularly at KMI and KMP, these securities are trading at the greatest disconnect to appropriate valuation since the period in 2006, just before we took the first KMI private. Like now, back in 2006, we had an enormous backlog of projects. And like now, many experts will find that we were too big to be able to continue to grow at an acceptable rate. We proved the doubters wrong the first time around, and I anticipate the same result this time. Reflecting this belief in the Kinder Morgan companies, as many of you know, I’ve been a buyer of KMI shares. I’ve purchased over 800,000 shares in December alone. So I guess my message to those who saw the story less positively was you sell, I’ll buy, and we see who comes out of the best in the long run.”

Richard Kinder has provided guidance in the last investor meeting as to what he thinks KMI should be worth by providing a set of yield comps that he thinks KMI should be in the range of: diversified natural gas at 2.7% yield, REITs at 3.6% and utilities at 4.2%.  This compares to KMI’s current yield of 5%.  If we apply these comps to 2013 dividend results in a price range of $37-$58/s.  Using 2014 dividend guidance of $1.7 results in a range of $40-$63/s.

Forward guidance provided by management on KMI is dividend growth of 8% through 2016. Assuming this growth rate and a yield that does not change from today’s levels of 5%, share price is $40/s in 2016.  Using the 8% growth rate and the yield comps provided by management, the share price range is $45-70+/s.

An alternative way to play this is through the warrants.  Warrants provide holders to purchase stock on a 1:1 basis at an exercise price of $40/s and have an expiration date of May 25, 2017.  Warrants are currently priced at $1.85.  Implied leverage of ~17x at today’s price.  Assuming a stock price of $45, warrants could return over 2.5x.

Based on latest 10K, management has repurchased ~157 million warrants at an average price of $5. Company also issued 8K on 3/5 approving additional $100 million warrant buyback program. 

Clearly significant upside as it is a levered play on the underlying stock. Plus is that on the upside scenario, the return is much more attractive than the common. On the downside, the risk is that if the stock does not appreciate to over $40/s by 2017, then you lose 100% of the investment even if common is higher than today’s price.  Another risk, although small, is that Kinder could take the company private, thus warrant holders would hold worthless piece of paper. Or alternatively, if there is a buyout of the company, premium is not high enough as management would not want to dilute current shareholders.

An alternative to the warrants is buy call options.  Longest dated are Jan 2016 calls with a strike of $37.5 currently priced at $1.3.

Catalyst