Forecasting the direction in which oil might head is a dangerous game. Not surprisingly then, so is investing in the energy sector.
The oil slump, which began in 2014 and persisted until 2016, prompted many investors to look to other sectors in order to find value. This general apathy towards oil companies kept their share prices depressed and forced many top players to restructure, cut costs and become more efficient.
Now that the sluggish phase is over, following a sharp recovery in oil prices since April, the timing is opportune to look for bargains in this beaten-down sector. Indeed, valuations of some top energy companies look very compelling.
One smart way to benefit, yet not become fully exposed to volatile energy markets, is to invest in energy infrastructure companies, such as gas and power utilities and pipeline operators. Pipelines, for example, work like energy toll roads. Producers pay a fee to the operator every time they use them to transport energy products. Their unique position in this energy value chain makes them more stable than their upstream counterparts.
Good Company, Smart Revenue Model, Slumping Stock
Within this category, I have started to like Kinder Morgan (NYSE:KMI).
Headquartered in Houston, Texas, Kinder Morgan is one of the largest energy infrastructure companies in North America. Its portfolio consists of approximately 85,000 miles of natural gas, refined petroleum products, crude oil, and carbon dioxide pipelines.
The company moves 40% of the natural gas consumed in the US, and 2.1 million barrels of petroleum products per day, making it the largest private fuel transporter in the country. Its revenue model is built on fee-based transportation, with 66% of 2018 EBDA (earnings before depreciation and amortization) expected to come from take-or-pay contracts.
Despite its impressive profile, Kinder Morgan has been a terrible investment. During the past five years, its shares have lost more than 50% of their value, following the company’s decision in late 2015 to slash its dividend by 75%, a way to counter one of the oil market's worst slumps.
Cash Is Back
But three years down the road, Kinder Morgan's situation looks quite promising. In April, the company’s board of directors approved a 60% hike in the quarterly cash dividend, to $0.20 per share, helped by the company's strong cash generation.
This year, management expects the business to generate adjusted EBITDA of $7.49 billion, with distributable cash flow (DCF) of $2.05 a share. With its current annual dividend of $0.80 a share, the pipeline operator will have a lot of room to grow its payouts going forward. As per its guidance, Kinder Morgan plans to increase its payout to $1.00 a share in 2019 and $1.25 a share in 2020, a robust growth rate of 25% annually.
Its most recent earnings report shows that the company is well on track to achieve that goal. In the quarter that ended on March 31, KMI achieved distributable cash flow (DCF) of $0.56 per share, representing 4% growth over the first quarter of 2017, producing $804 million in excess DCF above its dividend.
“Even with the substantial dividend increase, we still expect to internally fund all of our growth capital with some excess remaining,” said Richard Kinder, the Executive Chairman of the company. “For the foreseeable future, we expect to continue funding all growth capital through operating cash flows with no need to access capital markets for growth capital.”
This optimism from the company’s top executive was bolstered by Canada’s Liberal government deciding to buy the Trans Mountain pipeline and its expansion project for C$4.5 billion ($3.5 billion) last month, taking the contentious asset off Kinder Morgan’s hands amid strong opposition from environmental groups and the province of British Columbia.
This cash windfall is huge for Kinder Morgan, injecting about $2 billion onto the company’s balance sheet in after tax proceeds from its Canadian subsidiary. Kinder Morgan could use the cash to pay off debt or return cash to shareholders if it doesn’t decide to make an acquisition.
Some investors, however, are concerned that after the sale of Trans Mountain, Kinder Morgan will not have a project backlog big enough to fuel growth in its cash flows.
The Bottom Line
Trading at $16.72 as of yesterday's close, and with an annual dividend yield of 5%, Kinder Morgan stock is down more than 7% this year. However, compared to other large pipeline operators such as Enbridge (NYSE:ENB) which fell more than 20%, this is a notable performance.
Given the company’s cheap valuation, its growing dividend and an improved outlook in the energy markets, Kinder Morgan is a good value for oil bulls who want to buy a cheap stock with promising upside potential and growing payouts. We think this stock is ripe for a meaningful recovery.