A Closer Look at Kinder Morgan (KMI) Part I

We posted the investment thesis in October, 2014 [Source] after we estimated Kinder Morgan Inc. (KMI), had the potential for attractive returns in a three to five year time frame. In Part I we take a closer look at KMI’s distribution and the company’s guidance for distribution growth. In Part II, we’ll do the same for the debt level and access to capital. In both posts we’ll address questions that seem to be on some investors minds with the objective to determine if the investment thesis is on track or needs adjustment. Accordingly, you are encouraged to read the investment thesis.

KMI LogoValue investors tend to go against the grain, buying when others are selling and selling when others are buying, so being out of sync with the market is not unusual. The energy industry downturn started mid last year and then spilled over into the midstream sector. This was followed by Kinder Morgan’s consolidation announcement later in the year at that point we saw an opportunity. An opportunity provided that we focus on the long term, look through the cycle, and consider the underlying business appropriately.

KMI is the largest midstream infrastructure company. It seemed well situated to capitalize on the North American oil and gas renaissance that requires massive new infrastructure investments. In late 2014 the company announced the consolidation of its four public entities into one, which significantly lowering their cost of capital and increased the scope and economics of KMI’s growth prospects. The lower stock price, reduced cost of capital, wide protective moat, and large footprint of assets with experience management added up to an attractive return proposition.

The consolidation was initially well received but now seems to be clouding the perception of some investors, either unfamiliar with the industry or the merits of the transaction. Or, did we miss something as the chart below seems to indicate? The S&P 500 about break even, the Alerian Index (KMI’s industry index) down about 18% and KMI down 33% since September 2014.

KMI (blue), S&P 500 (red), Alerian Index (green):

Let’s go through questions that seem to be on investors’ minds to determine if the thesis is on track or needs adjusted. To do this we need to understand KMI’s prospects, the midstream infrastructure industry and the business model.

The Energy Cycle:

As investors we seem to forget energy prices are cyclical. When oil and gas prices are at their highs, we become convinced they will remain high forever, and at lows, they will stay low forever. In mid-2014 the energy sector started a cyclical downturn with Brent crude oil dropping over 55% ($110/bbl. to $50/bbl.) and natural gas falling over 40% ($4.60/MBTU to $2.70/MBTU).

Keep in mind energy remains an essential component of our modern society and the growing global economy. Demand is relatively inelastic and has continued to increase over the long term. It is forecasted to continue growing. Eventually economics and the laws of supply and demand take over and these cycles become another series of blips on the charts. There may be some casualties as weak oil and gas producers fall by the wayside and others are acquired by stronger ones but we still need oil and gas.

The cycle downturns are less significant for the midstream infrastructure companies that transport oil and gas from producers to consumers. That is because the they are largely insulated from commodity price exposure with fee based revenue tied to long term contracts. The relatively inelastic demand for energy support the volumes of midstream operations at almost any price.

Midstream Infrastructure Industry:

First a housekeeping item: Most midstream infrastructure companies are organized as master limited partnerships (MLPs) for tax purposes, so the entire sector is often referred to as “the MLPs” or “the MLP sector.” However, some midstream infrastructure companies are c-corporations (like KMI), and others limited liability companies (LLCs), etc. For this purpose, we are concerned with the underlying businesses of the midstream infrastructure companies and for the most part agnostic to the form of organization for tax purposes. The underlying business prospects and its characteristics are more important than what tax returns they are required to file.

Further, not all companies in the “MLP sector” are midstream companies. Some are “upstream” oil and gas producers, others in coal, shipping etc., but the vast majority of this broad sector are midstream companies.

In total there are about 137 publicly listed companies in the broad sector with a market cap of about $735 billion making it the second largest sub sector in energy behind only the market cap of the integrated oil companies. The oil and gas industry relies on the midstream infrastructure companies to transport large volumes of products. For the most part midstream companies receive a fee for transporting the products. So, by not taking ownership of the commodities being transported most are largely insulated from the volatility of commodity prices.

These companies belong to a class of assets referred to as infrastructure assets that have many desirable investment characteristics. They are costly to construct but once built, have long economic lives that provide the vital service of transporting oil and gas for the largest energy consuming nation in the world. Demand for their low cost per unit transportation and services tends to be inelastic as well given the scarcity of safe and cost competitive transportation alternatives.

KMI Update Midstream Graphic

[Source] Morgan Stanley Midstream Energy MLPs Primer 3.0

To encourage these large concentrated investments over long periods of time, the midstream infrastructure companies require volume and price protection. The concentration, price and volume protection. Their concentration, volume and price protection gives them near monopoly status. So interstate pipelines are regulated by the Federal Energy Regulatory Commission (FERC) and various state agencies regulate the intrastate pipelines. The regulatory structure provides varying amounts of inflation other protection built into the long term contracts to assure sustained cash flows and a “reasonable” return on the invested capital.

Kinder Morgan:

Kinder Morgan is the largest energy infrastructure company in North America. They operate approximately 84,000 miles of pipeline and 165 terminals and are a market leader in each of their businesses. These include; crude oil and natural gas pipelines, product pipelines, carbon dioxide, terminals and Kinder Morgan of Canada.

Kinder Morgan’s Profile:

KMI Update Profile

[KMI Profile] KMI’s Citi One-on-One MLP Midstream Infrastructure Conference

The map below show’s how KMI’s assets are core to North America’s energy industry placing them in an excellent position to capture opportunities and synergies in the oil and gas renaissance. Their financial strength, strong management, and large existing footprint positions the company well for growth or to consolidate the industry through acquisitions.

KMI Update Map

Source: Kinder Morgan, Inc.

As Morningstar writes about KMI [Morningstar on KMI]: “Kinder Morgan’s size is both opportunity and challenge. Favorably, its unmatched asset footprint provides numerous opportunities for expansion, and Kinder has a seat at the table for every new project or deal that comes along and has the financial heft to execute, no matter the size of the project.”

Income oriented Investments:

Investors often view midstream infrastructure companies as income oriented investments because of the stable cash flows available to fund distributions. So the companies are usually valued on the cash distribution paid; the distribution sustainability; and the growth of the distribution. Lets go through each to see where KMI stands:

Sustainability of the Distribution:

One of the first questions investors are concerned with does the company generate enough cash to support the current distribution? Distributable cash flow (DCF) is the cash flow generated and available for distributions so it is an important measure for both investors and management. The DCF is calculated starting with net income, adding back non-cash expenses like depreciation, depletion & amortization (DD&A), and then subtracting maintenance capital with adjustments for any other non-cash related item. The table below shows the year to date 2015 DCF for Kinder Morgan.

KMI Update DCF Table

KMI announced guidance for 2015 and estimated they would pay the distributions and end the year with excess distributable cash of about $654 million. At mid year during the 2Q15 conference they lowered the projection of excess distributable to about $400 million primarily the result of lower than budgeted oil and gas prices. The basis for their budget was $70/bbl. WTI crude oil price and the $3.80/MMBtu for natural gas.

To provide some assurance the estimated level of distributions would be made Executive Chairman Rich Kinder reaffirmed the distribution guidance: “For the second quarter, KMI had steady results and increased its dividend to $0.49 per share. We remain on track to meet our full year dividend target of $2.00 per share.”

Investor concerns were raised because the coverage ratio, total distributable cash flow/distributions for the quarter dropped to 1.02 showing the excess cash for the quarter was only 2%. The second and third quarter are historically the weakest quarters in terms of the coverage ratio and it would not be a surprise to see the 3Q15 ratio drop below 1.0. That would indicate there was no excess cash above the distribution paid for that quarter. However, the 4Q15 is typically stonger and the current estimates are to end the year with $400 million excess distributable cash for a coverage ratio of 1.09 for the year or about 9% more than the distribution paid to shareholders.

Investors may wonder if this level of excess distributable cash flow sufficient to support the dividend? Midstream infrastructure companies attract investors focused on receiving cash distributions and managed accordingly. DCF is the cash flow metric the industry uses to specifically estimate the cash distribution that can be prudently made to investors. However when compared to non midstream dividend paying companies the midstream ratio is significantly higher. The primary reasons for this is the stable cash flows in the midstream sector

Although commodity prices continue to pressure the industry, KMI has a large and diversified asset portfolio with about 87% fee-based cash flows and about 96% fee based or hedged. Of the fee based cash flows, 74% are further supported by take-or-pay contracts. This insulates a large portion of KMI’s cash flows from commodity prices and given the average remaining life on the contracts, and for quite a while:

KMI Update Contract Durations

An important consideration is the 87% stable and contracted cash flows are generated from existing equipment and facilities, long average life contracts, and secure pricing. Maintenance (or non-discretionary) capital is the costs of replacing or restoring existing facilities and equipment to ensure the same level of performance that was originally intended from the assets. So the maintenance capital needed to sustain these operations and cash flows are included in the DCF calculations.

Since DCF is designed to estimate the cash available for payout it must net out other cash requirements like; maintenance capital, interest payments, overhead, etc. So, if estimated accurately; 100% of the DCF calculated should be available for distribution to investors. The excess distributable cash flow is a contingency for unforeseen changes in the business or errors in the estimate. How much margin of error is needed depends on the stability of the underlying cash flows and management’s confidence or ability in making the estimates.

Companies with less predictable cash flow streams, due to more commodity price risk for example, need to retain more cash flow to be able sustain the distribution during challenging times. Lower commodity sensitive businesses target a coverage ratio of approximately 1.0 to 1.1 times and more commodity sensitive businesses may target coverage ratios of 1.15 times to 1.25 times.

The more predictable and stable the cash flow stream, like in Kinder Morgan’s case where 96% of cash flow is fee based or hedged in 2015, the need for excess distribution coverage is less. As of the 2Q15 the company expects to end the year with over $400 million and a cover ratio of about about 1.09.

Should management target a higher coverage ration? That’s certainly easy to do, just cut the distribution, so it boils down to do you want a higher distribution now with a small risk of a potential reduction, or less distribution now with smaller risk of a distribution reduction. Given KMI’s management record of delivering on distribution promises, it seems the company’s coverage ration is within an acceptable range given the nature of Kinder Morgan’s business and track record.

Investors also wonder about the impact of commodity price headwinds on KMI? It a good question, because KMI has some commodity price exposure and may increase as the current hedges expire over time. The company typically hedges the majority of its production volume out for a year. About 13% of KMI’s cash flow is commodity based. Of the 13% about 9% is hedged and the remaining 4% exposed to commodity pricing.

In the original 2015 guidance the excess distribution coverage over the declared distribution was $654 million based on an assumed $70/Bbl. WTI oil price and $3.80/MMBtu natural gas price. The company, in efforts to be transparent but understandably stopping short of trying to forecast energy prices, provided the following table with the approximate full year sensitivities under various commodity price scenarios:

KMI Update Price Crude Oil Sensitivity

KMI’s Goldman Sachs Presentation [Source]

The hedging strategies KMI uses to lock in oil and gas prices on future production eases the impact of price volatility. The company foregoes the benefit of future upside price increases in exchange for the certainty of a certain price and downside protection. During the 2Q15 earnings release conference call management disclosed the company’s hedge position on production for the second half of 2015 and future years.

KMI Update Hedge Postions

There has been a tremendous amount of negative news coverage on energy prices; crude oil prices are down, the Iran nuclear deal may bring more crude oil to market, OPEC’s stance not to curtail production, etc. and by extension this news spills over into the midstream sector including Kinder Morgan.

The players and specifics are different but we’ve seen this cycle before. Like gravity, eventually economics and the laws of supply and demand prevail. The cost to produce a marginal new crude oil barrel will set the price, likely in the $70-$90/bbl. range over time. Although the timing and exact price may be uncertain the marginal cost of new crude oil will certainly be higher than todays price.

The impact on Kinder Morgan, although not positive, is unlikely to impact the current distribution. The table below shows the excess distributable cash flow for a range of crude oil and natural gas prices. With WTI crude oil at $40/Bbl. and Henry Hub natural gas at $2.50/MMBtu. the excess distributable cash flow is $315 million over that needed to pay the distribution.

KMI Update Excess DCF Sensitivity

In 2016, is 58% hedged at $75/Bbl. and assuming the remaining 42% is sold into a (low) $40/Bbl. crude oil market an average price of $60/Bbl. is realized. If natural gas remains at $2.50/MMBtu. the excess distributable cash position would be $515 million in 2016 assuming all else equal.

All else is will not be equal but it seems reasonable that KMI’s 13% cash flow that is not fee based is under control and supports managements guidance. The sensitivities are only approximations and do not show further defensive steps management could take to mitigate the impact of continued low commodity prices should that occur. These steps include offsetting production expenditures, expense reductions and the redirection of capital slated here to more attractive projects. It would appear the current distribution is safe and will be sustained in the commodity price downturn.

Growth of the Distribution:

The current distribution is only part of the distribution story. The investment thesis also depends on about a 10% per year growth in the distribution through the end of the decade along with management’s guidance. So another investor question should be is this guidance and assumption of growth in the thesis reasonable?

It is believed the growth in North America’s oil and gas production from the shale oil basins and unconventional sources creates a need for infrastructure to handle the additional volumes from new locations. The oil and gas growth underway in North America make a compelling case for the need of infrastructure and the opportunities of its largest participant, Kinder Morgan. The following estimates and timing may be continually revised as this story unfolds but the magnitude of the need is compelling.

IHS forecasts oil and gas infrastructure investment over the next 12 years (2014 – 2025) will be $890 billion, with crude oil and natural gas gathering systems and other midstream facilities at 60% of total or about $530 billion. A sensitivity case assuming a 20 percent oil and gas production increase over the base case, increases equivalent investment to about $690 billion over the period. To put this into perspective, the industry’s total capitalization will grow from about $875 billion to $1.4-1.6 trillion over the next 12 years, almost doubling the industry size.

The Interstate Natural Gas Association of America Foundation (INGAA) in a report prepared by ICF International [Source] and cited by Kinder Morgan further supports this forecast with total capital expenditures estimates in North America for natural gas, natural gas liquids, and crude oil at $464 billion in the low case and $641 billion for their base growth case through 2035.

In addition to the growth opportunity is consolidation in the midstream infrastructure sector with more than 120 entities and about $875 billion in enterprise value.

Investors may wonder where the funding will come from to invest in new assets or acquisitions to grow the business and distributions. This brings us to perhaps one of the most misunderstood aspects of the midstream industry.

As the midstream infrastructure companies maximize distributions they generally retain only the cash to maintain the business. Recall earlier we defined maintenance (non-discretionary) capital as the costs of replacing or restoring existing equipment to ensure the same level of performance originally intended from the assets, that is the current distributions.

Growth capital is also needed however to generate new returns or new cash flow. Money to expand or grow through acquisition is referred to as growth (or discretionary) capital. In the midstream infrastructure business it requires access to the external debt and equity capital markets. We can think of growth capital as the capital needed to grow new cash flows, that is increase the distributions.

This mechanism of funding maintenance capital from internally generated cash flows and funding growth capital through external markets is a distinguishing characteristic of the midstream infrastructure business model. It is different because many companies retain more of their internally generated cash flow to reinvest in the business and be less reliant on external markets for funding. The result is they must payout lower proportions of cash flow as distributions. That is because other business model cash flows can be less stable and a more conservative cash flow distribution policy is needed to preserve the cash for other business uses.

Another benefit of the midstream infrastructure model is the capital markets, whether debt or equity, enforce fiscal responsibility on the midstream companies. Management must demonstrate that the growth projects proposed are economically viable with predictable cash flows to obtain outside cash from debt and equity investors.

Assets with predictable cash flows also lend themselves to a more leveraged capital structure. Midstream infrastructure companies usually target to finance with 50% new debt and 50% new equity to reduce risks, satisfying debt rating agencies, and maintain a strong balance sheet.

Another question investors may ask is if funding the growth by issuing more shares dilutive to the existing shareholders? Let’s look at one notional example to illustrate. In the “Base Case” the notional company in the table below has $100,000 in assets on its balance sheet financed with 50% liabilities and 50% equity similar to KMI. The existing assets yield a 12% return on invested capital (ROIC) and generate cash flow of $12,000 per year for a 24% return on equity (ROE). In this example let’s assume the distributable cash flow is $7000/year, after deducting $5000 for maintenance capital from the cash flow, for a distribution yield is 3.5% on the 10000 shares outstanding. For simplicity we will ignore taxes, operating expenses, depreciation etc. but examples with more detail will produce similar results.

Like KMI, let’s assume the Base Case company has opportunities to expand by investing in new assets at a capital cost of $50,000. It anticipates the same rate of return as the Base Case business and funds this growth with 50% debt and 50% equity. Maintenance capital will be 5% per year of invested capital, the same as in the Base Case. It issues 1250 new shares at the market price of $20/share to raise $25,000 of equity funding and borrows $25,000 of debt (50% equity, 50% debt) to fund the growth investment.

The new asset produce the same return as the Base Case business and the outstanding share count increased from 10000 to 11250 with the new shares issued. Notice the cash flow increases proportionately to the investment at 50% to produce the same return as the Base Case, but it did so with only a 12.5% increase in total equity issued, liabilities also increased.

KMI Update Dilution Example Table

Even though more shares are outstanding in the Expanded Case vs. the Base Case, the equity owners are not diluted. The value of their holdings increased as measured by book value per share and potential distribution per share. This is one example and the assumptions used will change the outcome. The point is management can issue shares without diluting existing shareholders.

In the next post we’ll discuss Kinder Morgan’s debt level, credit rating and the reduced cost of capital as a result of the consolidation transaction. We’ll then conclude with some conclusions to consider.

Long KMI

You are encouraged to do your own independent research (due diligence) on any idea discussed here because it could be wrong. This is not an invitation to buy or sell any particular security and at best it is an educated guess as to what a security or the markets may do. This is not intended as investment advice, it is just an opinion. Consult a reputable professional to get personal advice that meets your specialized needs of which that the author has no knowledge. This communication does not provide complete information regarding its subject matter, and no investor should take any investment action based on this information.

 

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