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Equity research: Is Kinder Morgan an attractive investment?

Part 5
Equity research: Is Kinder Morgan an attractive investment? (Part 5 of 5)

Why is Kinder Morgan’s stock undervalued?

Mis-pricing and valuation

We grade KMI’s valuation at B+. The price ran up a little bit on us while we were trying to get this report completed. Under $34, where Rich Kinder recently bought another $28 million worth, would be somewhere in the A range. Notwithstanding, the current price represents a sound bargain on a stock with a wide moat and great management team that could very reasonably occupy a spot in our portfolio for a decade or more as the United States capitalizes on its wealth of natural gas reserves. We expect Kinder Morgan to benefit from that. The recent drop in prices would suggest that investors are extrapolating the 2014 “pause” in distribution growth out forever. We don’t think that’s realistic as KMI’s size and experience gives them a seat at the table for every major energy deal in North America. If we assume only a 4% growth rate in distributions, we can very easily make the case that the stock is worth $40.

We mentioned these points in the previous section on “investing highlights and interesting data points,” but most apply as the reasons for their mis-pricing:

  • Complicated ownership structure: Much of the value to KMI is tied up in the IDR’s due to the parent company. These are unusual and difficult to value. This is discussed in detail in the previous sections.
  • FERC case cited in intro: KMI has estimated its exposure is between $0 and $50 million in its 10Q filing here. FERC rat cases are ongoing in nature and KMI will always be exposed to this risk. We have spoken with the management team and believe that the current market price has pessimistically assumed that any such headwinds as these will virtually cancel all future growth for KMI. This is too bearish and creates opportunity.
  • Negative press from Hedgeye analyst: Links to the actual story have all been taken down, but you can find a good summary of the report from Barron’s here. You can find a rebuttal from Hedgeye here.
  • Management thinks they can take the stock to the mid-$40s in the next three years. This conviction is evidenced by recent insider buys totaling nearly $28 million by Rich Kinder under$34.
  • PEG ratio = 0.75; EV/EBITDA = 12.9
  • Net debt/EBITDA consistently @ 3.5x since 1997.
  • Discount to net asset value (NAV) creates 15% to 30% total return opportunity over the next 12 to 18 months.

CUSH models that KMI is worth between $35 and $45. We use several valuation methods to define this range. Our dividend discount model produces a price target of $35 using an 8% discount rate and a very conservative 3% growth rate. Peer group analysis would suggest an EV/EBITDA multiple of 13.4 and implies a price target of $36. Our sum-of-the-parts model takes a closer look at the value of KMI’s Incentive Distribution Rights under various scenarios and produces a range of values from $35 to $45.

KMI6Enlarge Graph

Risks

As with any investment, there are risks. For Kinder Morgan, these include:

  • Declines in the price of crude oil, natural gas, and natural gas liquids; economic downturn
  • Tax or regulatory changes that could affect KMP’s MLP status
  • Changes in regulated pipeline tariffs
    • They have an inflation-adjusted tariff structure in place.
  • Capital investment risks
  • Pipeline spills, explosions, ruptures; terrorism
    • Safety statistics are updated for the public every month.
  • Interest rates increasing
    • This is a concern and something we watch closely as a full-year impact of 100-basis point increase in floating rates equates to ~$48 million increase in interest expense at KMP (this number was ~$54 million as of 6/30/2013).
    • As of 9/30/2013, approximately $4.8 billion of KMP’s total $19.1 billion in net debt was floating rate. Can be more hedged if need be.
    • Fixed rate debt at KMP-70%; EPB 100% and KMI 60%.

To counter the Hedgeye analyst referenced above, we feel confident looking at a few key metrics. EV/EBITDA and ROIC have remained consistent over the years. Also, if you have a spare hour-and-a-half, you can listen to a special conference call that Rich Kinder and his management team held special on September 18, 2013, just to refute the charges, one-by-one, that that analyst leveled against Kinder Morgan.

Conclusion

The shale gas revolution is not a new story. KMI’s recent decline provides a great entry price to participate in one of the least risky ways to benefit from this trend. Growth opportunities have not dried up. As the company executes in coming quarters investors will realize this and the stock will re-price itself. We expect a total return of 15% to 30% in the next 12 to 18 months and see a high likelihood that KMI could be a core holding for many years.

The Market Realist Take

In the last few years, hydraulic fracturing and access to shale reservoirs has led to an increase in production of domestic oil and gas. The “Annual Energy Outlook 2014″ report from the U.S. Energy Department’s Energy Information Administration predicted that oil production is expected to see an increase in the coming years, proving that the U.S. is witnessing an oil and gas revolution. An increase in production leads to a demand for transportation, storage, and fractionation. This bodes well for companies such as Kinder Morgan, which owns a huge network of pipelines and 180 terminals.

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