kinder morgan (nyse: kmi) – long...*projected 2014 operating margin kmi industry average cogs/...

M c I n t i r e I n v e s t m e n t I n s t i t u t e 1

MCINTIRE INVESTMENT INSTITUTE AT THE UNIVERSITY OF VIRGINIA

Kinder Morgan (NYSE: KMI) – Long

Shreyas Hariharan | Adam Rathgaber | Naveed Mostaghimi | Nick Galdos | 10/28/2014

M c I n t i r e I n v e s t m e n t I n s t i t u t e

AGENDA

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Business Overview

Misperception Thesis Points Macro Tailwinds

Comps & Valuation

Risks & Catalyst


BUSINESS OVERVIEW

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“We’re a company run by shareholders for shareholders. ” -Richard Kinder Founder, Kinder Morgan

•  Kinder Morgan Inc. is the largest midstream and 3rd largest energy company in North America.

•  Owns and operates 80,000 miles of pipelines that transport natural gas, gasoline, crude oil, carbon dioxide and other products

•  Over 180 terminals that store petroleum products and chemicals

KMI has exceeded dividend target in each of the last 3 years.


STOCK PERFORMANCE

•  Current: $38.93 •  52 week: 30.81 - 42.49 •  Market Cap: $40.21B

•  EPS: $1.20 •  DivYield: 1.76 (4.60%) •  P/E: 35.25

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MISPERCEPTION #1: OVER-LEVERAGED

REASON THE MARKET BELIEVES THIS

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Misperception: KMI has been over-aggressive in acquisitions and is over-leveraged.

KMI INDUSTRY MEDIAN

Assets to equity 5.74 3.30 Debt to equity 2.59 1.18

EVIDENCE THAT THIS MISPERCEPTION IS MANIFESTED IN THE MARKET

14.6% of float is short despite gross and operating margins way higher than industry average.

KMI INDUSTRY AVERAGE

Gross Margin 47% 43% Operating Margin 29% 13%


MISPERCEPTION #1: OVER-LEVERAGED

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WHY ARE KMI’S ACQUISITIONS ARE ACTUALLY VERY BENEFICIAL? •  Industry is going through natural phase of market consolidation. •  Small players are going to be bought out in pipeline industry because: Ø  Operating revenue doesn’t cover costs when operations are small scale Ø  Economies of scale kick in only after certain miles of pipelines are owned


MISPERCEPTION #2: NATURAL GAS AND CRUDE OIL PRICES

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Misperception: KMI’s revenue is affected by natural gas and crude oil prices.

EVIDENCE THAT THIS MISPERCEPTION IS MANIFESTED IN THE MARKET

KMI’s stock prices have fluctuated with fluctuating oil and natural gas prices, driven primarily by market sentiment about the pipeline industry.

REASON THE MARKET BELIEVES THIS Ø  Fall in natural gas prices reflect a decrease in demand for natural gas Ø  This will reduce total revenue of natural gas pipeline companies (elastic demand)


MISPERCEPTION #2: OIL AND NATURAL GAS PRICES

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WHY IS KMI RELATIVELY UNAFFECTED BY NATURAL GAS AND OIL PRICES IN THE SHORT-MEDIUM RUN?

§  KMI has long-term contracts (4-5 years) with its clients. §  These are take-or-pay contracts. §  KMI’s fee structure involves minimum payments irrespective of whether customer

chooses to use the pipelines over the period of the contract. §  Hence, demand for KMI’s pipelines is relatively inelastic in the short-medium run.

KMI INDUSTRY AVERAGE

Gross Margin

47% 43%

Operating Margin

29% 13%


MISPERCEPTION #3: RENEWABLE ENERGY

§  “Two factors that prevent investment in renewable energy in the short-medium run: 1) load factor, because we don’t have it all the time and 2) renewable energy sources are not profitable yet because net present value is still negative.”- Carlos Pascual, Special Envoy, International Energy Affairs and Former United States Ambassador to Mexico and Ukraine.

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Misperception: Renewable energy will significantly impact conventional energy market in the near future.

M c I n t i r e I n v e s t m e n t I n s t i t u t e 10


§  Natural gas is still growing §  Domestic coal consumption is switching to other sources

0

500000

1000000

1500000

2000000

2007 2009 2011

Coal and Natural Gas US Total Output (in thousand mega-watt-hours)

Coal Natural Gas Renewables

Linear (Coal) Linear (Natural Gas) Linear (Renewables)


The ability to depend on renewable energy is hindered by:

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§  Availability §  Peak demand §  High

investment costs


§  Terminal activities provided 13.4% of Kinder Morgan’s revenue in 2012

§  Terminal operating margins continue to increase

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THESIS POINT #1: COMPETITIVE ADVANTAGE

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52

54

56

58

60

62

64

2011 2012 2013 2014*

KM Terminal Operating Margins

*projected 2014 operating margin



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Continued investment into opening new terminals


Terminals give Kinder Morgan exposure to different energy sources:

§  Crude oil §  Domestic/International coal §  Chemicals

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Kinder Morgan provides a safer environment overall than its competitors:

1.54 vs 5.7 average competitor TRIR

According to the BLS, the industry-wide TRIR is 4.8

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Terminal contracts are relatively long term: §  Liquids average: 3.8 years §  Bulk average: 3.5 years

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New port terminals provide access to vital coal demand around the world

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1. High start-up costs §  Operating revenue will cover costs only when operations are large-

scale §  FC will be distributed among large units when operations are large. §  Due to over 32 acquisitions, KMI enjoys economies of scale.

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THESIS POINT #2: BARRIERS TO ENTRY

*projected 2014 operating margin

KMI INDUSTRY AVERAGE COGS/ Miles of Pipeline $0.10 $0.57 Gross Margin/ Miles of Pipeline

$0.406 $0.322

2. Regulation § Environmental and zoning restrictions make new companies building pipelines practically impossible. § In a specific region, competitors cannot build pipelines if they exist. § Regulation promotes monopoly for KMI.


3. Customer Loyalty §  Region specific customers §  Customers are likely to renew contracts with KMI after the 4-5 year

period. 4. Competitive Advantage (explained) §  Terminals §  Safer environment §  Terminals and pipelines for crude oil, coal, chemicals, natural gas.

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THESIS POINT #2: BARRIERS TO ENTRY


MACROECONOMIC TAILWINDS

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•  Continued increases in demand as natural gas consumption has risen from 22% to 27% of US energy use (mostly at the expense of oil)


MACROECONOMIC TAILWINDS

•  According to the 2015 Farmers’ Almanac , the 2014-2015 winter is expected to be severe with below-normal temperatures for three quarters of the US, resulting in an increased demand for natural gas

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REGULATION

•  KMI recently received all of the necessary regulatory approvals for its long-awaited acquisition of all three of its MLPs

•  New regulations prevent drillers from flaring in the Bakken and Three Forks formations, perpetuating the need for increased pipeline infrastructure

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RISKS & POTENTIAL CATALYSTS

RISKS §  Investors will face a significant tax burden (losing around 4% of

investment value) with Rich Kinder’s $44B consolidation plan POTENTIAL CATALYSTS •  The US lifts the ban on exporting oil and gas

o  Russia/China’s recent 30 year $400 B oil and gas supply deal could be a huge catalyst in lifting the ban

o  Increased TAM as infrastructure will be needed regardless •  Beating Earnings Call 1/15/15 •  Berlin v. Kinder Morgan Energy Partners LP lawsuit regarding

consolidation of MLPs

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RISKS AND POTENTIAL CATALYSTS

•  VAR 1: “KMI’s big already but earnings should grow around 20% over the next 5 years. Its organizational management is a little complicated and the dropdown to MLPs on pipelines is the in-vogue thing to do these days because it allows for a better valuation and is more tax-friendly.”

- Zach Pancratz (DRZ: Alternative Strategies Analyst)

•  VAR 2: “The energy sector along with the whole market has sold off huge in the past 6 weeks. Underperformance in energy can be attributed to the huge selloff in oil (peak in June at $107 to current levels of $82). The oil names got absolutely smoked and the natural gas names got indiscriminately lumped in with them since most energy names have a mix of oil and gas. With the recent selloff and colder weather on the way you’ll definitely see a bump in natural gas prices.”

•  - John Race Jr. (Iberia Capital Partners: Institutional Sales)

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VALUATION- ASSUMPTIONS

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Revenue Assumption 8%

Margin Assumption 27%

Exit Multiple 12.1

•  Revenue Growth based on analyst estimates and corporate guidance

•  Margin assumption is a conservative estimate based on historical figures

and our analysis and predictions for future operations

•  Exit multiple is a conservative figure taken to be KMI’s current EV/

EBITDA, which is below comparable company averages


VALUATION – DCF TARGET PRICE

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EV $85.725 B

Debt $36.193 B

Cash $ 598 M

Market Cap $50.13 B

# of Shares 1.028 B

Target Price $48.76


VALUATION EV/EBITDA

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Comps' Median EV/EBITDA 14.5

KMI EBITDA $5,796 B

Enterprise Value $84,042 B

Market Cap $48,447 B

Price $47.12


VALUATION – WEIGHTED TARGET PRICE

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Comps Target Price $47.12 DCF Target Price $48.76

Weight 50% Weight 50%

Final Target Price $47.94 Upside 23%

Current Price $39.03


EV PER PIPELINE MILE

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KMI Comp Median

EV/Pipeline Mile 0.94 1.68

•  One of KMI’s biggest strength is its superior size and scope

•  However, we believe that this size has not been totally factored in to its price (shown by EV/Pipeline Mile)

•  KMI has used economies of scale to decrease its costs and prices, better positioning it to expand revenue and market share


CONSOLIDATION, TAX BENEFITS

•  KMI has been consolidating its MLPs under its own corporation

•  The move will cause the company to lose the corporate-tax breaks enjoyed by MLPs

•  However, the KMI estimates that the restructuring will actually save the company $20 billion in taxes over the next 14 years by increasing its deductions due to depreciation

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COMPENSATION

•  Richard Kinder proudly states that he makes a salary of $1, as well as a 23% stake in KMI

•  Other Executives have below average salaries and above average performance bonuses

•  This provides great incentive to perform well for KMI’s very competent management team

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Richard Kinder Title: CEO, Chairman, Kinder Morgan Salary: $1 Total Pay: $1


RECOMMENDATION

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Initiate a long position on KMI at an entry price below $40.

kinder morgan (nyse: kmi) – long...*projected 2014 operating margin kmi industry average cogs/...

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