Summary
We are initiating institutional equity research coverage of Kinder Morgan (KMI) with a fair value estimate of $29 per share and a Very Poor dividend safety rating.
Valuentum has received significant attention in recent weeks following President Brian Nelson’s articles that collectively offered 10 reasons why we expect shares of Kinder Morgan to collapse.
We believe prevailing conflicts of interests from brokerage research houses and credit rating organizations have created a debt-infused stock bubble propped up by a “circular flow of unsubstantiated support.”
In this article, we provide the backbone of our estimates in calculating Kinder Morgan’s intrinsic worth to further the discussion for investors.
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We are initiating institutional equity research coverage of Kinder Morgan with a fair value estimate of $29 per share and a Very Poor dividend safety rating. There are two reasons why we are making our institutional work on Kinder Morgan publicly available, and we think both are consistent with our service to the investor. In our opinion:
1) the incidence of incorrectly-applied valuation methodologies that use debt-infused, financially-engineered dividends as the foundation for intrinsic worth estimation have artificially propped up Kinder Morgan’s stock price. In instances where dividends are not organically-derived, we believe an enterprise free cash flow to the firm (FCFF) model is the most appropriate model to value entities.
Our view is that investors are being “misled” to believe that Kinder Morgan can cover its dividend with organically-derived free cash flow, as measured by the traditional and widely-accepted definition of free cash flow–cash flow from operations less all capital spending. By our estimates, Kinder Morgan cannot cover its dividend by this measure, and we encourage management to make clear non-GAAP disclosures to this effect.
In the case of a corporate, we believe the non-GAAP measure of free cash flow is more informative than the non-GAAP measure of distributable cash flow, which is primarily reserved for use within the master limited partnership–MLP–universe. Kinder Morgan is a corporation, not an MLP, and we believe that its “newly-consolidated” business structure has increased financial transparency where investors can now more appropriately apply traditionally-accepted valuation techniques to shares with confidence.
Investors should no longer be swayed from their very own common sense with the argument that somehow because Kinder Morgan is an energy pipeline owner/operator that long-held academic and professional valuation approaches do not apply to it. Kinder Morgan, as with any other company, is objectively a future free cash flow stream and a capital structure like any operating corporate, and it should be valued as such.
We maintain our view that all companies invest considerable growth capital into their business to grow cash flow from operations, and executive teams for most corporates in these cases still report non-GAAP free cash flow, not distributable cash flow, and determine dividend policy on a target of such non-GAAP free cash flow and/or earnings. Kinder Morgan’s maintenance capital spending is on pace to surpass $600 million in 2015, up ~20%, while total capital spending is budgeted ~$4.2 billion for the year, and that excludes ~$3.1 billion related to the Hiland acquisition.
The breakdown of Kinder Morgan’s maintenance capital, growth capital, and acquisition capital may be attractive by most measures, but its composition is not that different from other maintenance capital-light corporates, where distributable cash flow is not applied in the context of dividend policy. We acknowledge Kinder Morgan’s attractively-low maintenance capital spending, but maintain our view that all capital outlays are vitally important to the valuation context. If we assume that all growth capital for every company will be value-creative, then analysis is not being performed. The time value of money in terms of growth capex outflows coupled with cash inflows matters.
From our experience across our 1,000+ equity coverage universe, corporates do not continuously borrow or issue equity to pay a growing dividend when their growth and acquisition plans significantly and consistently exceed operating cash flow generation year-after-year…after year. In these cases, corporates do not pay a dividend at all. We posit that, if all corporates were allowed this “luxury,” there would be little need for the generation of free cash flow, or earnings, at all in paying out an outsize dividend to investors.
2) the rating methodologies that assign investment-grade marks to credits that have ~6 times reported Debt-to-EBITDA metrics, aggressive growth and acquisition capital plans, and are currently paying out more than 5 times annual traditional free cash flow, as measured by cash flow from operations less all capital spending, as dividends are not appropriately evaluating all credit risk in the context of the entity’s total cash, debt-like obligations, in our view.
We believe the need for independent corporate credit rating agencies, such as Valuentum or other providers, that are not directly paid by the issuer to rate the issuer’s very own debt has never been more evident than in this instance. We believe the rating agencies are using adjusted EBITDA that has already been effectively “claimed” by management’s aggressive and die-hard dividend growth plans. It’s an “either-or” situation. Either the debt is investment-grade or the dividend can be sustained — but not both, in our opinion.
We think there resides a clear disconnect between Kinder Morgan’s credit rating and other credits with similar leverage and cash-flow profiles, and especially with ones that have such profiles and are paying out 5 times consistent annual, documented, and fully-consolidated free cash flow generation as dividends.
We believe Kinder Morgan’s true implied financial leverage, including all cash, debt-like obligations is 19 times. Kinder Morgan has $10.5 billion in debt maturing during the next 5 years, with over $3 billion due in 2017 alone. If this implied leverage is investment grade, we encourage corporates with lower levels of implied leverage and less liquidity or refinancing needs to make a case that they be considered for investment-grade marks, too.
In our previous work, we have defined the intersection of dividend growth models that use financially-engineered dividends and credit ratings that effectively “ignore” the collective magnitude of all future cash claims on the business a “circular flow of unsubstantiated support,” creating what we describe to be a debt-infused stock bubble in Kinder Morgan’s shares.
This research piece covers only our independently-derived fair value estimate of Kinder Morgan’s shares through the lens of an enterprise free cash flow model, which we believe is the appropriate framework to evaluate shares in full financial transparency.
An enterprise free cash flow model sums the present value of future free cash flows to the firm (FCFF) and deducts total debt, net of cash, to arrive at total equity value, which is then divided by weighted average diluted shares outstanding to arrive at the entity’s equity value per share.
We encourage commenters to read President Brian Nelson’s two previous pieces on Kinder Morgan, which collectively outline 10 major concerns we have with the financial health of the entity.
Kinder Morgan’s Investment Highlights
• Kinder Morgan is the largest midstream energy company in North America, with ~80,000 miles of pipelines and 180 terminals. It recently re-consolidated its holdings in Kinder Morgan Energy Partners (formerly KMP), El Paso Pipeline Partners (formerly EPB and Kinder Morgan Management (formerly KMR). Kinder Morgan’s operations are conducted through the following business segments: natural gas pipelines, CO2, products pipelines, terminals, and Kinder Morgan Canada.
• Kinder Morgan’s business strategy is to 1) focus on stable, fee-based energy transportation/storage assets in expanding markets within North America, 2) increase utilization of its assets while controlling costs, 3) leverage scale from incremental acquisitions and expansions of assets that fit within its strategy, and 4) maximize the benefits of its financial structure. The company is doing a decent job executing upon its strategy, but its capital structure will work against its dividend growth plans, potentially creating a not-so virtuous cycle for stakeholders. The firm’s reported and implied leverage are staggering (~6 and ~19 times, respectively).
• The convoluted structure of the Kinder Morgan umbrella has changed, as KMI purchased all of its subsidiaries KMP, KMR, and EPB. Surprisingly, the combined entity receives investment-grade marks from the credit-rating agencies, and to please the dividend growth crowd, the ‘new’ KMI expects 10% annual growth in the dividend from 2015-2020. In our view, however, KMI’s debt is ‘junk’ status, and its equity and dividend are significantly vulnerable.
Business Quality
Cash Flow Analysis
(click to enlarge)
The free cash flow measure shown above is derived by taking cash flow from operations less all capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Kinder Morgan, on a fully-consolidated, restated, and audited basis, cash flow from operations increased about ~60% from levels registered two years ago, while capital expenditures expanded about ~80% over the same time period.
On the basis of our projections, we expect Kinder Morgan’s free cash flow, as measured by cash flow from operations less all capital expenditures, to be consistent with performance during the past three years in 2015. Traditional free cash flow, as defined above excludes acquisition expenditures.
Valuation Analysis
What we want you to take away from our projections in our valuation model is how generous they are, but yet how we’re still having trouble getting anywhere near Kinder Morgan’s share price, which we posit is artificially propped up by a debt-infused dividend.
We think Kinder Morgan’s shares are worth $29 each, which represents a price-to-earnings (P/E) ratio of ~32 times last year’s earnings and an implied EV/EBITDA multiple of ~14 times last year’s EBITDA. We think these implied multiples are reasonable, if not extremely generous.
Kinder Morgan’s fully-consolidated, audited reported EBITDA was $6.763 billion, $5.697 billion, and $4.006 billion in 2014, 2013, and 2012, respectively. The company’s annualized pace for 2015, as of the first quarter, is $7.35 billion, but this measure includes an “add back of (its) share of certain equity investees’ DD&A and is before certain items.”
We encourage investors to calculate these numbers from the firm’s fully-consolidated form 10-k and its most recent quarterly earnings report, respectively. We think management’s segment “EBDA” measures are not as helpful to use in valuation; instead, we think they significantly overstate profitability.
Our model reflects a compound annual revenue growth rate of ~7% during the next five years and a 5-year projected average operating margin of ~29%, which is above Kinder Morgan’s trailing 3-year average. Our average EBITDA margin is ~41.8% during the next five years (roughly in line with that of the past three years), resulting in an annual EBITDA CAGR of 8%+ over our 5-year discrete forecast period.
These forecasts result in aggregate operating cash flow generation of ~$33.2 billion during the next five years. Our forecasts for total capital spending are ~$4.2 billion, ~$4.2 billion, ~$4.1 billion, ~$3.9 billion, and ~$3.6 billion in each of the next five years and do not include any acquisition spending, collectively ~$20 billion. Importantly, as in the case today, Kinder Morgan has a knack for spending growth capital, and we don’t expect that to change.
By extension, we expect Kinder Morgan to generate ~$13.2 billion in free cash flow during the next five years, but we forecast its cash dividend obligations to shareholders over the same 5-year period to be $30+ billion, which reflects the compounding dynamics of aggressive share issuances and a 10% CAGR in the per-share dividend. This supports Kinder Morgan’s Very Poor dividend safety rating. Currently, Kinder Morgan has ~2.14 billion weighted average shares outstanding.
We calculate Kinder Morgan will generate ~$28.2 billion in earnings before interest before taxes, in aggregate, during the next five years. Please note that we are assuming in our valuation model that Kinder Morgan will not pay any cash taxes at all over the next five years due to tax benefits from the re-consolidation. The traditional measure is earnings before interest, after taxes. We assume net new investment, or the net of total capital spending and depreciation, to be ~$7.5 billion during the next five years.
By extension, we assume that aggregate enterprise free cash flows over the next five years will be ~$20.7 billion. We then tax-effect earnings before interest in years 5-20 at a ~21% rate (its average effective tax rate during the past three years) and fade Kinder Morgan’s free-cash-flow-to-the-firm growth rate from 7.5% to ~3% over the corresponding 15-year period (~5.3% average). In the event of using Kinder Morgan’s internally-applied tax shield of ~36%, our fair value estimate would be lower. Free cash flow to the firm in Year 6 is $5.2 billion and in Year 20 is $10.5 billion. We use a standard perpetuity function for free cash flow to the firm at a 3% growth rate in Year 20.
One of the primary areas of concern that we have with the traditional discount methods applied to reaching Kinder Morgan’s intrinsic worth, whether it be through a dividend discount model or other, is the potential application of a ~3.3% discount rate, as management outlined in its presentation slide deck in May (page 26). To put this bluntly, a rate this low is absurd. Valuations using a 3%-5% discount rate are not reasonable. The implications on intrinsic worth as the discount rate approaches zero are amplified, significantly reducing the integrity of any value estimate (especially if any growth, even modest, is assumed in the perp).
This is worth repeating. We think a ~3% discount rate makes little sense in terms of an investor hurdle rate, and we posit a high-single-digit discount rate is much more appropriate given both the corporate’s existing leverage and non-existent cash cushion to pay out dividends organically. The discount rate should match the average expected rate over the duration of the cash flows of its assets, or into the perp, not that of today. Kinder Morgan may have unlevered project returns of 8%-12%, but that’s very close to its cost of capital in our opinion. The company’s ~3.3% ‘Analyst Day Hurdle Rate’ assumption is “fantasy” when it comes to long-term intrinsic value estimation.
We assign Kinder Morgan the lowest cost of equity measure in our coverage universe at ~8.9% and assume a 6.6% long-term after-tax cost of debt, which we think is reasonable in light of evaluating long-term intrinsic worth. We discount future enterprise free cash flows at ~8%, our estimate of the company’s true cost of capital. We disclose the value breakdown, by phase, from our valuation model below.
Of note, we value over 1,000 equities, and Kinder Morgan is a significant anomaly in our valuation process, which is why we’re issuing ongoing warnings to investors. We view this a necessary duty. Please see the footnote for how we account for the firm’s tax holiday.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $29 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example).
After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Kinder Morgan.
We think the firm is attractive below $23 per share (the green line), but quite expensive above $35 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Kinder Morgan’s fair value at this point in time to be about $29 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm’s current share price with the path of Kinder Morgan’s expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm’s future cash flow potential change.
The expected fair value of $33 per share in Year 3 represents our existing fair value per share of $29 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
We see little justification for Kinder Morgan’s existing share price of ~$40 per share, let alone the price targets out there north of $50 per share! According to a recent tally, nearly 77% of ‘tracked’ analysts view shares as a ‘Buy’ and ~18% a hold.
All three of the major credit rating agencies rate this company investment-grade, with at least one “hiding” behind terminology such as a “weak” investment-grade. With Kinder Morgan expected to issue boatloads of equity and debt in coming years, we’d be surprised to see anything different. The conflicts of interests at work that are perpetuating this “circular flow of unsubstantiated support” couldn’t be more evident, in our view. The company’s Valuentum Buying Index rating is a 1, the worst on our scale.
We trust you find our independent opinion and valuation informative, if not surprising. Thank you for reading!