Kinder Morgan: The Million Dollar Question

by The Compound Investor

Energy infrastructure owner Kinder Morgan (KMI) used to be one of the most popular tickers when I first started reading Seeking Alpha. Admittedly, what follows is a thoroughly unscientific observation, but Kinder Morgan articles used to appear on the front page all the time just a few years ago. It’s not hard to see why either. As a giant energy toll road, Kinder’s model is attractive to income hunters. Getting paid a fat dividend for owning over 80,000 miles of pipeline and 150 or so terminals sounds lower-risk and more predictable than the wider energy sector.

The great energy price slump, and Kinder’s subsequent distribution cut, put the brakes on that. Although a lot ink was spilled at the time, the core problems boiled down to two things. Firstly, Kinder had to redirect its internal cash flow to fund capital spending and shore up its investment grade credit rating. That meant inflicting a severe dividend cut upon stockholders. More importantly, Kinder’s valuation at the time was just too rich.

A Better Place

These days, Kinder looks like it is in a healthier place. For one, its cashflow situation looks much more sustainable. It has generated around $19,000m worth of cash from its transport and storage operations over the past four years. It spent around $11,250m of that on capital expenditure, plus a further $6,500m on cash dividends. Net debt has also fallen by nearly $10,000m over the same timeframe, bringing leverage down to circa 4.3x EBITDA. That’s a level that puts it into a more comfortable place with respect to the ratings agencies.

As for 2020, management originally forecast cash generation again coming in at around the $5,000m mark. Obviously said guidance came right before the most recent hit to the energy space. On that note, Kinder is clearly better placed than most. Around 75% of company-wide profit comes from its Natural Gas Pipelines and Terminals segments, neither of which should be correlated to commodity prices. Most of its Natural Gas Pipelines revenue is based on contracts with fixed pricing and minimum volume guarantees, while the Terminals segment doesn’t require much by way of additional comment. Customers will probably need more storage space if anything.

It has some more obvious issues in its Products segment. End products like jet fuel have seen a collapse in demand for obvious reasons, though a proportion of this segment is protected in the same way as Natural Gas Pipelines above. Overall, I’d still expect the company to generate over $4,000m in operating cash flow in a bad-case scenario.

Million Dollar Question

Last year, the company generated around $5,000m in cash from operations. Total capital spending clocked in at around $3,200m as per the company’s annual report, with 2020 spend set to come in at around the $3,000m mark. Quick math only leaves around $2,000m or so in spare change, less than its current dividend cost of circa $2,250m. It plans to raise its per-share dividend to $1.25, thereby increasing annual dividend spending to circa $2,700m. We should find out today if the proposed raise does indeed go ahead.

At first glance, those numbers look tight. That said, the above capital spending figure obviously incorporates a degree of growth. Or put another way, the bill would be lower if Kinder only spent what it needed to in order to maintain operations. So, what proportion is earmarked growth exactly? That’s the million dollar question.

In order to answer it, I suppose we should start with management’s breakdown of CapEx. It had sustaining CapEx in the $690m region last year, with the remainder down as discretionary. Sounds simple enough, but there’s a twist. Just to confuse matters, management also says that this measure is a physical one rather than an economic one. Most interpretations of sustaining CapEx would be the other way around, I’d have imagined.

On that note, let’s look at some numbers. Kinder’s cash from operating activities has actually been pretty steady in the $5,000m range over the past five years. On the flip side, the company has also offloaded assets during that time (the net impact of which has lowered its cash generation). For now I’ll just use the depreciation expense of $2,200m as a very rough guide. On that basis, Kinder probably pumps out somewhere in the region of $2,800 in free cash flow. That just about covers the proposed dividend raise, assuming it carries on rolling over its debt.

Outlook

Kinder expects to spend around $3,000m on CapEx this year. COVID-19 and the Saudi-Russia price war aside, its underlying cash generation is somewhere in the $5,000m per annum region. On top of that, growth projects look set to add a few hundred million to that over the next couple of years. On that basis it could probably self fund a $1.25 per share annual dividend to common stockholders. At the current share price, that would amount to a circa 8.3% yield. Add a few points of growth on top, and that’s probably right about where you’d expect a midstream player to sit.

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