Description

I believe the KMI stock presents an attractive investment opportunity over the next 5 years due to the following reasons:

Re-contracting risk which has been the major headwind for EBITDA growth over the past four years, will be largely gone by the end of this year. 2023 should be the last year with meaningful recontracting risk: despite $200m gross hit to EBITDA expected in 2023, this should be more than offset with $300m from favorable new contracts / rate escalations for the net benefit of $100m.

This is how the incoming CEO, Kim Dang, describes the re-contracting risk that has played out in the past several years:

One [reason EBITDA has not grown much since 2015] is we went through a big build cycle in 2008, 2009, on what we call a lot of supply push pipelines, which were basins, we're increasing production and you needed to get the production out of that basin into the interstate gas market. And so, you build these pipelines coming out of the basin, connecting into the interstate gas market. Well, a lot of that was coming out of the Rockies, it was coming out of the Barnett Shale, it's coming out of the Fayetteville Shale. Well, now there's more productive basins. And so, when those contracts rolled after 10 years, we couldn't renew them at the same rate.

The chart below shows why the company underperformed recently through the lens of EBITDA bridge between 2019 ($7.9bn) and 2023 ($7.7bn guidance). $1.0bn of incremental EBITDA from new, mostly natural gas-related growth projects was offset with several headwinds, including 1) contract renewals; 2) underperformance of CO2 segment and 3) disposal of assets among others.

Recently these headwinds have masked the fact that KMI remains a growing business: its core segment – gas pipelines (accounts for almost 2/3 of EBITDA) – has increased natural gas transportation volumes between 2015 and 2022 by 38%, while segment earnings increased by 20% over the same period. As a result of the gas pipelines segment's growth relative to other segments, its share increased from 54% in 2015 to 63% in 2022, and will continue to grow in the coming years. Growth of the natural gas segment also leads to marginally higher quality of KMI business – gas pipelines are 1) less cyclical; 2) have secular tailwinds as compared to other segments - Products pipelines, CO2, and Terminals.

Improved capital discipline in the industry overall, and at Kinder Morgan in particular, will be a positive for future returns. Over the past five years the company (and most of the pipeline industry) reduced capital expenditures to levels not seen since early 2000s. In 2021-2022 median capex/revenue ratio for a group of US midstream companies was in 5-6% range. Last time capital investments were at such low levels is 2004.

There are three reasons midstream companies cut capex post COVID-19:

• companies’ renewed focus on capital discipline;
• slow growth and recovery of the upstream oil and gas industry;
• new regulatory and ESG pressures from the government and investors, respectively. The regulatory environment under the Biden administration has made starting new projects more difficult for midstream companies by giving states the right to block off certain regions and make the application for new pipelines much more complicated.

In case of Kinder Morgan improved capital discipline has resulted in expanding return on incremental invested capital and a more resilient financial profile:

• Since 2016 all capex were internally financed.
• Capital expenditures declined from $2.9bn in 2018 to $1.6bn in 2022. Going forward the company guides for $1-2bn of growth capex per year vs $2-3bn previously (in addition to $1bn/year of sustaining capex).
• Capital build multiples (Capital invested / year 2 Project EBITDA) improved from 7.0x in 2018 to 4.6x in 2022 and further to 3.4x for the $3.3bn backlog of investment projects at the end of 2022.
• Management is targeting 15% unlevered after-tax return on new investment projects, which is substantially above KMI’s cost of capital. 15% hurdle is a much higher bar compared to 2018 when management was looking for a positive project NPV as their key decision criterion.

The company has the strongest balance sheet in a decade allowing it to pursue i) opportunistic share buybacks and ii) M&A deals. Since 2015 Kinder Morgan reduced debt by $13B and management expects to end this year with 4.0x Net debt/EBITDA. While over the past decade capital allocation was focused on deleveraging efforts, going forward, this factor is no longer in play, which unlocks opportunities for management to either pursue share buybacks (over the last 4 quarters, KMI spent $0.5bn buying back shares in the $16 to $17 range) or M&A deals.

Kinder Morgan has a strong and well-incentivized management team with 13% insider ownership.

• The founder, executive chairman, and the largest shareholder – Richard Kinder – is still involved despite his respectable age (78).
• Current CEO – Steven Kean who has been running the business since June 2015 – leaves the company in August 2023. Today the company is in a better financial shape than it was in 2015.
• During Kean’s tenure, KMI deleveraged substantially (repaid $12bn of debt and reduced leverage from 8x Net debt/EBITDA to 4.5x) while increasing exposure to a more lucrative Natural gas business.
• Over the same period the company remained disciplined about its share count (unlike many of their peers).
• Kimberly Dang, who will succeed CEO Kean in August, is the current company president and a former CFO. With a background in finance and a track-record as a company CFO, Dang is more equipped to run Kinder Morgan which after a period of deleveraging enters a new phase with more flexible capital allocation. An important detail: Dang thinks like a value investor when talking about capital allocation. Below is her recent commentary about assets disposals:
  • And then we sold an equity interest in our Elba JV. And so, people say, well, why are you selling assets? And the answer is, we're economic creatures. And so, if we can sell an asset at a high multiple and reinvest that capital at a much lower multiple then that is a value-generating transaction for our customers. So we sold Elba at about 13x. If you look at the multiple on our backlog, it's less than 4x. If you look where our shares trade today, it's less than 10x. And so, we can take that money and reinvest in more attractive opportunities. And so where we find those opportunities, we don't find them often, but when we find them, we are happy to pursue them.
• While it’s too early to form a strong opinion on Dang as CEO, as we will need more time and evidence of her operational and capital allocation decisions, her early commentaries, as well as her background, are encouraging.

US natural gas demand will keep growing this decade providing a tailwind for KMI’s core business. According to the energy research consultancy Wood Mackenzie US natural gas demand is expected to grow from 106 bcf/d in 2022 to 127 bcf/d in 2030 (including exports). Higher exports will be driven mostly by expanding LNG capacity.

Industry analysts projecting gas processing and transportation capacity to be tight in the medium term:

Infrastructure for crude has plenty of capacity relative to production with the possible exception of long-haul pipeline to Corpus Christi, Texas, said Stephen Ellis, energy strategist at Morningstar. In contrast, gas gathering, processing and transportation face an inflection from ample capacity now, to tight in the medium term, to balanced in the longer view. On the gas side, “there is an undersupply,” of transport “at least in the next few years: 2024 and [20]25, maybe into [20]26, Ellis said.

As a result of strong demand for natural gas transportation and renewed focus of midstream companies on capital discipline, capacity utilization ratios in the industry are expected to remain high, potentially increasing pricing power of midstream players:

In all the examination of specific basins and individual projects, it is important to bear in mind the broader context, noted Kate Hardin, executive director of Deloitte’s Research Center for Energy and Industrials. “We are seeing gas production at more than 100 Bcf/d. That is significant production in response to real demand, especially in power generation and LNG.”

That is a major success story, but a very recent one. “If you look at infrastructure in the Permian, we are at about 90% utilization for gas but only about 70% for oil,” said Hardin. “Looking ahead to 2026, gas takeaway is expected to be at 80% to 100% of capacity, with oil at plus or minus 60%. So, it is clear to see where the infrastructure investment has been to this point.”

Kim Dang recently expressed similar sentiment:

Now when you look at the base business, you've seen huge increases in natural gas flows, about 35% since 2015. And then we've got more coming. There's been natural gas capacity built in this country, but it hasn't kept up with the demand. And so -- what's happened as a result of we've seen average utilizations on our pipelines go up dramatically. And so, for example, we've got a pipeline that goes from Texas out to California. The utilizations increase from somewhere in the 60s into the mid- to upper 80s, and that's on average utilization. TGP, which is a pipeline that goes from Texas, Louisiana, into the Northeast. Utilization went from the 80s into the high 90s, right? And so you've got a pipeline that on an average day is basically sold out. And so as a result of that, that gives you some pricing ability to increase prices, ability to increase length of contracts so that you're not faced with rolling contracts in bad markets.

The combination of continuing growth of natural gas demand, historically low oil and gas capex, hostile regulatory regime and investors’ push to take capital out of the industry on the back of historically low inflation-adjusted natural gas prices creates an opportunity for asymmetric outcome in a couple of years.

Pipeline earnings multiples are near multi-decade lows. At the time of this write-up, a group of pipeline companies is trading at a median EV/EBITDA of 8.5x. This is one of the lowest levels over the past three decades (on par with COVID lows of 2020 and lower than trough GFC levels of 2008). To give this another perspective, when Richard Kinder started Kinder Morgan in 1996, pipeline assets were trading at 6-7x EV/EBITDA. The average level since 1994 is around 12x.

Valuation. At the current stock price I see potential for 14%-15% IRR over the next 5 years.

Assuming $1.5bn per year of growth capex (management is guiding for $1-2bn of growth capex per year) and assuming a 4.5x EBITDA build multiple on growth capex (in line with 2022 results and below the current backlog multiple of 3.4x), over the next 5 years, we should get $1.7bn of incremental EBITDA from the current basis of $7.7bn (expected in 2023).

I assume that sustaining capex (as defined by management) are enough to keep the existing cash flow at the current level. $1.7bn of incremental EBITDA would support $7.7bn of incremental debt, assuming their 4.5x target debt/EBITDA leverage ratio. Management could use these $7.7bn to buy back around 20% of the current share float or to support even higher dividend payout.

In such a scenario, over the next 5 years, we get:

• 6.7% dividend yield;
• 22% growth in EBITDA = 4% per year (e.g. the uplift in EBITDA can support 4% dividend growth vs current 2%);
• 20% reduction in share count = 4% per year.

This is equivalent to 14-15% IRR. The calculation does not account for:

1. The potential impact of higher oil and gas prices; and
2. Changes in midstream earnings multiples.

Risks. One of the risks is that current executive compensation scheme focuses on DCF (distributable cash flow) instead of ROIC/ROE rewarding management for growth without taking into account the efficiency of capital allocation. While recent change in capital allocation framework towards 15% IRR hurdle rate for new investment projects is notable, we are yet to see how committed the incoming CEO Kim Dang and her team will be to this new policy.

Products pipelines / Terminals / CO2 segments could remain a drag to earnings due to their exposure to Crude oil/products/coal.

Catalyst

de-risking (re-contracting risk)

improved capital discipline

new CEO