The fall in the price of Kinder Morgan’s stock has caught my attention. The former MLP, which has delivered returns of near 20% annually since CEO and Chairman Richard D. Kinder purchased hard assets from Enron two decades, has seen its share price come under stress. The reasons for the decline have been fundamental, psychological, and political.
The general trend from $44 per share towards $29 per share has been due to legitimate concerns about the business.
First, the bad news:
It is true that Kinder Morgan has seen 12% declines in revenues in the past year, as the price of transporting oil, chemicals, and other commodities has come down a bit alongside the decline in the prices of commodities themselves (because oil that makes sense to ship at $70 per barrel doesn’t make sense to ship at $50 per barrel.)
Kinder Morgan does not pass Benjamin Graham’s balance sheet requirements of an investment for a conservative investor, as it carries $42 billion in debt. That is over ten times the distributable cash flow.
Also, Kinder Morgan has a low amount of cash on hand, with only $163 million in cash liquidity compared to over $1 billion four years ago.
After providing a five-year plan guidance to investors that dividends would grow at a rate of 10% per year, Kinder Morgan recently revised the guidance to the 6-10% range.
The latest election results in Canada, which signaled a liberal shift for the country, will bring about increased scrutiny of Kinder Morgan’s $5.4 billion Trans Mountain project that expands existing pipelines.
Despite these concerns, there are also reasons to believe that Kinder Morgan is currently undervalued at $29 per share.
With an energy company, especially during a time in which the underlying commodity is fluctuating, revenues will always be cyclical because the uncontrollable price of the product in the short run will dwarf any sales gains.
In Kinder Morgan’s case, it owns 80,000 miles of pipelines and 180 different terminals, and has monopolistic powers over the western coast of Canada as there are no other pipelines transporting oil to the region. It actually grew the number of commodity transports by 4% this year; it’s just that the lower price of those transports have resulted in revenue declines of 12% for 2015 so far.
The balance sheet concerns are more palatable when you dig into the specifics and make projections over the full course of the business cycle. In the past twenty years, Kinder Morgan has grown from tens of millions to almost $70 billion. It took a lot of merger and acquisition activity to accomplish this, and it is rare to see significant acquisitions without the presence of considerable debt (the only large company that makes supersized acquisitions without overburdening the balance sheet is Berkshire Hathaway, although a tech company like Apple or Google may also be worth mentioning.)
The advantage of Kinder Morgan’s strategy is that the debt acquired has been tied to new construction projects that grow volume–and once the production gains are taken into account, the debt load becomes more manageable. Kinder Morgan owes $42 billion because it is launching things like the almost $4 billion Northeast Energy Direct Pipeline that will transport gas to New York and Massachusetts. It is spending over $5 billion on the Trans Mountain project that will create triple the capacity for Canadian shipments between Edmonton, Alberta, and Burnaby. It just bought out a North American joint venture with Shell. The high debt is tied to projects that grow volume.
If oil returned to 2013 prices, the cash flow generated from operations would more than double from the current $4 billion to over $8 billion. Suddenly, that $42 billion debt load would be classified as “moderate” compared to Kinder Morgan’s then existing earnings power. None of these projections taken into account Kinder Morgan’s billion-dollar projects that are still in the works.
And, as an additional matter of consideration, Kinder Morgan structured its debt exceptionally well. It may owe $42 billion in aggregate, but it only has to pay $11 billion of that over the next five years. Even if oil traded in the $30s, it could make its debt payments based on current production without taking into account the expected increases in production from the new projects.
The short-term issue is that Kinder Morgan is paying out $1.95 in dividends while generating $1.70 in cash flows while simultaneously investing heavily into new pipeline projects. That’s the tension point. Kinder Morgan has raised its dividend every three months since the last two quarters of 2011, and the new $0.51 dividend is a 4% increase from what investors collected in the third quarter.
I think this does illustrate the dangers of acquiring a shareholder base that pays far more attention to the income received rather than the intrinsic value of the business. To raise the dividend under current conditions, Kinder Morgan needs to dilute the share count because cash flow does not cover the dividend payments and the current balance sheet debt hardly has any room to be extended.
This inflicts harm on the intrinsic value of the stock, as it is not good for long-term shareholders to see their ownership position sold at this price of $29. Although it will never be reported to the IRS nor will it show up in a brokerage statement, shareholders are effectively selling 10% of their stock at a $29 price. That’s what happens when you expand the pie at a time when the price is low.
That said, this dilution can be mitigated. The current dividend offers a yield of 6.5%. For someone that reinvests at these prices, you will rack up additional shares at a nice discount and this will likely be a moment that you look upon years later favorably.
However, if I were managing Kinder Morgan, I would announce a two-year suspension of the dividend to get the balance sheet in order. That would give the company at least $8 billion to knock out the highest interest debt, and it would also mean that shareholders would not need to get diluted at the current prices. It would be a wildly unpopular move–especially with the income-focused shareholder base–but it would maximize value over the long term by removing the ill effects that come with carrying an overleveraged balance sheet.
If oil stays in the $40s for an extended period of time, I do think you would eventually see a dividend cut. If it rebounds above $70 for an extended period of time, then you will likely see the continuation of the dividend hikes. And note: even if there is a dividend cut, it does not necessarily mean that the current price was a bad investment. If you bought GE at $10 or Wells Fargo at $10 or American Express at $10 during the financial crisis, you would be grateful for the decision in hindsight even though the timing of your investment corresponded to the company’s cutting their dividends. In a way, it can be in the best interest of shareholders as the retained profits can shore up the balance sheet and have a “spring back” when the business conditions improve.
The nice thing is that officers and directors own 17.6% of the common stock. Their fortunes are tied to the performance of this company in a way that the executives at Lehman Brothers were not tied to the stock in 2008. The pipelines are excellent assets in an industry that has a high barrier to entry. They throw off $4 billion per year in excess of the expenses required to run them. The new projects will grow this figure even more. Kinder Morgan is friendly to investors in that management goes to great lengths to translate every dollar generated from transporting oil into income that reaches the owners. Richard D. Kinder is a dealmaker and operator of unusually great skill. Even with the share dilution, the income and new projects offer a countervailing benefit to shareholders. The truly patient investors that have diversified portfolios and can withstand significant volatility in both share price and potentially dividend income while waiting years for an outsized payoff would be the ideal candidates to buy the stock at this time.