George Thoreson

About the Author George Thoreson

I'm a bottom-up value investor and invest in companies selling below their intrinsic value, often because they are out of favor, ignored or in a special situation. Searching for value leads to interesting companies that are out of favor for many possible reasons. Studying successful value investors and learning from my own mistakes the merits of value investing, over the long term, became apparent. After becoming a value investor my results improved. Sure, I still make mistakes, but on average I’ve been fortunate in getting more right than wrong. My investing approach is covered on my blog; The share price of a company often have nothing to do with the underlying value of the company the shares represent. So, I look for investments that are priced low relative to their true or intrinsic value so they provide a margin of safety. Then we must patiently wait, as an owner of the company, until the share price catches up to reflect the underlying value.

Kinder Morgan Inc: Investment Thesis Remains on Track

Kinder Morgan Inc

Last week Kinder Morgan Inc (NYSE:KMI) reported second quarter 2015 (2Q15) results. Overall it was a decent report and our investment thesis remains on track. You will recall our investment thesis’ total return centers on management’s projected dividend growth and the resultant share price appreciation resulting from the consolidation of the Kinder Morgan companies last fall.

The five business segments produced $1.827 billion in segmented earnings before depreciation, depletion, amortization and certain items up about 2% from 2Q14 driven by increases in the product pipeline and terminal segments offset by a decline in the CO2 segment. You may recall the CO2 segment does have some exposure to commodity prices although largely offset with hedges. Revenues were down significantly, by $474 million but offset by operating expense which were also down by about $475 million. Additionally Kinder Morgan’s project backlog of expansion and joint venture investments increased to $22 billion, an increase of approximately $3.7 billion from the 1Q15.

Dividend increased 14% versus the previous year

Consistent with our thesis and management guidance after the consolidation merger the Board of Directors approved an increase in the quarterly dividend to $0.49 per share. This represents a 14% increase over the 2Q14 dividend of $0.43 per share and is up sequentially from $0.48 per share for the 1Q15.

Distributable cash flow

Distributable cash flow (DCF), Kinder Morgan’s preferred measure of cash flow is a metric we follow because it is a measure of the funds available for payment of dividends to shareholders. This is key to our investment thesis which is based on KMI’s continued guidance of strong dividend increases through the end of the decade.

Distributable cash flow during the quarter was $1.095 billion up $763 million or 230% primarily the result of the consolidation transaction that occurred last fall. During the consolidation the company issued approximately 1.1 billion shares so if you look at DCF on a per share basis, taking into account both the increase in distributable cash flow and the increase in shares, distributed cash flow per share was up $0.18 or 56% from the 2Q14.

Eighty-five percent of KMI’s DCF (and current dividend) is supported by stable cash flows from long term contracts for the fees it charges on the volumes transported in its pipelines and terminals. The company estimates the remainder of their cash flow is exposed to commodity price fluctuations but a hedging strategy is used to help mitigate this exposure. KMI is in this enviable position as it enjoys the returns on the investments made in these long term infrastructure assets over the past years.

Project backlog increases

The oil and gas industry relies on midstream companies like Kinder Morgan to provide the infrastructure to transport large volumes of products. KMI is the largest midstream infrastructure company in North America with approximate 84,000 miles of pipelines and 165 terminals. For the most part Kinder Morgan enjoys a wide economic moat with inflation adjusted tariffs and some protection against reduced demand.

However, our investment thesis is based on a growing dividend and the resultant share price appreciation. That requires expansion projects that will produce additional returns and cash flows. The backlog of expansion projects and investments is a leading indicator of future returns on investment to ensure growing cash flows, and projects need to be continually added to the backlog.

The strong demand for Kinder Morgan infrastructure assets continued during the 2Q15. The current project backlog of expansion projects increased to $22 billion. Since the 1Q15, $700 million of completed projects were placed into service and approximately $600 million in projects primarily related to the CO2 segment (where oil is produced) are being delayed beyond the time horizon of the five-year backlog due to lower commodity prices. The company added approximately $5 billion in new projects including the $3.3 billion market path portion of the Northeast Energy Direct project and an incremental $630 million investment resulting from KMI’s agreement to acquire Shell Oil’s 49% equity interest in the Elba Liquefaction Company. Projects in the backlog have a high certainty of completion and drive future growth at the company across the business segments.

Share price decline

Chairman Rich Kinder, in our view, gave Kinder Morgan a new lease on life with the consolidation merger last fall by lowering the cost of capital and helping assure many more years of expansion opportunity and growing cash flows. The merger was a creative way to improve KMI’s prospects and we bought shares after the announcement of the merger.

It has been a challenging market for energy related companies since the decline in crude oil and natural gas prices starting in the middle of 2014. The midstream companies have not been immune from these headwinds. KMI missed revenue and earnings estimates for the 2Q15 as commodity prices have some impact on 6% of KMI’s cash flow. Although 94% of the current cash flow is secured with fees or commodity price hedges, in future years some of these hedges “roll off” or expire and will expose KMI to a higher percentage of energy price weakness if they stay low for an extended period of time. KMI’s long term debt to EBITDA is estimated at 5.8X as of 2Q15 higher than the budget as a result of the Highland acquisition although management estimates this should decline to 5.6X by year end.

Probably adding to KMI’s price decline was a bearish article in Barron’s magazine. The article was based on a newsletter filled with factual errors, opinions and sensationalism. We can spend a lot of time discussing why this information is inaccurate but I’d rather spend my time looking for investment opportunities. I welcome both the pros and cons of any investment I’ve made, or considering to make, to help assure my perspective stays in balance. So I read the negative articles, but I also do analysis and due diligence before making investments and then act accordingly.


Kinder Morgan’s 2Q15 results are decent, not great, but neither are the industry conditions at this time. We invested in KMI because of its prospects over the next 3-5 years. The consolidation merger is in fact paying off as Kinder Morgan’s management anticipated it would. True, debt is a little higher than had been forecasted and crude oil prices remain lower than budgeted however quarter to quarter results will always show some variability and the investment thesis remains on track. The quarter’s announced dividend increase is also management’s affirmation and belief in the projected 10% dividend growth rate through our 3 to 5 investment horizon. It attests to the advantage of Kinder Morgan’s size, resilience, growth opportunities and their “toll road” business model.

Our investment thesis is on track, Kinder Morgan offers many desirable investment characteristics for the long term investor and is still an attractive buy. We estimate it is going to be worth s$60 to $70 in our investment horizon of 3-5 years and we’ll collect an additional $6.60 to $12.20 in dividends for an attractive total return of 60-100%. If you are focused on income, at today’s price of about $35.70/share, the dividend of $3.22/share at the end of the decade will be paying you an effective yield of about 9% on today’s share cost.

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