Reduced dividend growth outlook from management has hit shares hard providing another buying opportunity.
New equity financing vehicle will reduce pressure on stock price.
Dividend yield is out of sync with fundamentals which can lead to price appreciation as it normalizes.
Future growth prospects for KMI are still positive.
On Oct. 21, Kinder Morgan (NYSE:KMI) released its Q3 earnings, which included revised dividend growth guidance for 2016 of 6-10% from a previous guidance of 8-10%. Because KMI is primarily an income vehicle for investors, a possibly reduced dividend resulted in a 5.3% drop in the stock price, with as much as an 8% drop during the day. The guidance was also met negatively because it confirms KMI is susceptible to the current low-price commodity environment. As Executive Chairman and founder Rich Kinder has always said, KMI is “insulated” from commodity price changes but not “immune.” Q3 Earnings have shown some weakness for KMI operations, with about a reduction in distributable cash flow (DCF) of about 5% of EBITDA, which is nominal compared to the Energy sector as a whole.
Source: Kinder Morgan.
Previously, I have shown what future yields on KMI’s common stock would be, given 8-10% dividend growth to 2020, which can be found here. At the time of that article, KMI’s stock price was at $ 31 and as of Oct. 22 it had dropped to $ 29.75 with high volatility in between (high of $ 32.68 and a low of $ 26.16). I highly recommend investors read the Q3 earnings call transcript, which can be found here on Seeking Alpha.
Commodity Price Impacts
KMI’s stock price has been pressured with the entire energy sector as prices have dropped precipitously over the past year. KMI’s cash flow has been pressured by its CO2 business primarily and its gathering and processing business secondarily. Budgeted 2015 coverage excess was $ 650 million but has declined to $ 300 million. That $ 350 million decline was due to about $ 235 million for CO2 based on price variance forecasts and $ 100 million of other items being “lower CO2 volumes, lower midstream volumes and decline in the Canadian exchange rate...”
CO2 capital expansion has been reduced as current expansions were more productive than expected and meet current demand. There has not been a drop in CO2 demand but pricing has weakened. Pricing weakness is being offset with expected declines for operating expenses and maintenance expenditures of 25% for the year.
CO2 activity is partially hedged as follows:
- 2016 – 63% at $ 72 a barrel
- 2017 – 58% at $ 73 a barrel
- 2018 – 45% at $ 75 a barrel
- 2019 – 24% at $ 66 a barrel
In the short term, continued weakness in commodity prices will pressure DCF excess coverage but lower natural gas prices will stimulate long-term growth in the commodity’s volume.
I have discussed KMI’s capital structure in detail which can be found here. In short, the company generates significant cash flow on a consistent basis. KMI could use the cash it generates to reinvest in capital project expansion but chooses to instead finance it with a mix of debt and equity so that DCF can be distributed to shareholders.
For 2015 management estimates $ 4.7 billion of cash flow after operating expenses, maintenance capital expenditures and interest on debt. That cash could be used to pay for the $ 3.5 billion in capital expenditures for new projects (expansion) but instead it will pay $ 4.4 billion to shareholders as dividends and keep $ 300 million for excess coverage. The $ 3.5 billion in capital expenditures is funded with equity and debt issuance with a low cost of capital.
Because of KMI’s depressed common share price, the equity markets have become a higher cost of capital source of financing with recent yields near 7% which is higher than management feels is reasonable and so they will be avoiding common equity issuance accordingly.
Excess Distributable Cash Flow Coverage
As noted above, commodity price weakness has impacted KMI, eating into its excess coverage for dividends. Management gave a dividend growth range of 6-10% for 2016 to give flexibility as it is still at the beginning of the budgeting process for 2016. Rich Kinder made clear that the range is exactly that and does not preclude 10% dividend growth for 2016, though absent commodity price turnaround, it does seem unlikely since the company wants to maintain financial flexibility for growth options.
CEO Steve Kean was clear in saying KMI can and will grow at 10% a year, the question is determining how much of that can be dedicated to dividends to common shareholders. Management will do the 2016 budget and longer-term forecasts to determine to what extent the trade-off will be between dividends and excess DCF coverage and make conclusions from there.
Accordingly I offer dividend forecasts below, with the variable growth based on conservative near-term growth and larger growth in the medium term:
At 6% annual dividend growth, investors will have a 9% yield vs. 11% with 10% growth. If growth is slow for 2016 and 2017 and then picks up subsequently, you can still end up at a 10% yield assuming management doesn’t do any catch-up increases on commodity price recovery. The 2015 dividend, for example, is 15% higher than 2014.
The above forecasts indicate to me that investors will end up with a good dividend yield in 2020 even in a low growth environment. Here is a look at historical share price and dividend yields:
We can see from the above that historically dividend yields have been 4-5%, having jumped to over 7% recently. There is no evidence that KMI will cut its dividend. Worst case scenario is that it reduces its dividend growth modestly to maintain a strong balance sheet and financial flexibility. Accordingly I expect the market to begin pricing the stock at a more appropriate level and lower yield in the next 9 months and in the long term.
Here is a look at what the long-term future stock price might be if it reverts to historical dividend yields of 4-5% once investors’ fears and uncertainty ebb on the energy sector:
As we can see from above, if dividend growth continues, even at low rates, and dividend yields revert to the mean of 4-5%, there will be significant stock appreciation long-term.
In the near term we can do a similar analysis. If KMI yields 5% with its now $ 2.04 dividend, the price would be $ 40.80. Not an unreasonable price from a historical perspective or given the fixed nature of its operations.
One positive in the earnings call was that management does not expect KMI to pay any cash taxes until 2020, revised up from 2017/2018. This will provide further cash flow support for dividends.
Capital Expansion Financing
With third quarter results management announced it will not be accessing equity markets for common share issuance until at least mid-2016 because of the stressed share price. The company has an equity vehicle in place to utilize for project expansions but management couldn’t give any details on its structure but indicated investors will know “soon enough”. This new vehicle will be at a lower cost of capital than common equity, meaning it will be at less than 6-7% and will also maintain value for existing shareholders. My expectation is that this is some sort of preferred share offering with options to purchase common shares if there is appreciation, but that is speculation.
KMI has issued common equity this year totaling $ 2.56 billion in Q2 and $ 1.27 billion in Q3. We can see from the chart below that second quarter price fluctuations were modest compared to Q3 despite much higher equity issuance. The reduction in Q3 equity issuance was also partly due to the lower equity price and thus higher cost of capital. Management has said KMI’s issuances under the AMT program have been robust and there has been no overhang in the market but the perception is there and so this new equity financing vehicle will address that issue for the next 9 months. This will likely be a positive catalyst for the stock while maintaining optimal shareholder value.
Here is another look at share price and yields in the context of the above discussion on common equity issuance in Q2 and Q3:
On the earnings call, Rich Kinder discussed the natural gas demand drivers:
Natural gas has excellent volume growth potential as electrical generation continues to shift away from coal and nuclear power. In America today, natural gas accounts for 32% of electrical generation and coal 33%; by 2030 the EIA forecasts that to shift to 39% natural gas and 18% coal with modest increases in alternative energy sources. KMI is positioned to move that gas around and benefit accordingly. For KMI, natural gas transportation volumes for the 9 months ended September 30, 2015 increased 18% from the prior year period.
Exports to Mexico
Natural gas exports to Mexico are forecast to increase 44% for 2015 compared to 2014 at an average 2.6 Bcf (billion cubic feet) per day versus 1.8 Bcf per day. Mexico is forecast to add 13.7 gigawatts of natural gas electrical generation through new additions and conversion from oil even as Mexico’s natural gas production declines. KMI will be moving that gas and taking it’s cut.
Industrial and Petro-Chemical Investment
“The American Chemistry Council now counts 243 projects with cumulative investment of $ 147 billion for the years 2010 to 2023.” In Texas alone, where KMI has a large footprint and is positioned to benefit, there are 99 projects with a $ 48 billion value.
LNG exports are starting and will increase. “By the end of the year Sabine Pass Train 1 will be in service with 650 million cf a day of capacity. By next year with Sabine Pass Trains 1 through 3 online LNG capacity will be 1.95 Bcf a day.”
KMI transports a third of America’s natural gas and 63% of its revenues are from natural gas transportation. These growth drivers all point to continued investment opportunities for KMI and mitigate risk from the low price of commodities.
KMI”s long-term growth prospects are good but its share price has been pressured offering investors an opportunity to buy and likely earn high capital appreciation as markets normalize and KMI’s dividend is properly valued.
Article Source: seekingalpha.com
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