This Undervalued Dividend Payer Is The Best Stock For America’s Energy Revolution

Oil production in the United States increased rapidly from the turn of the 20th century until 1970. It had a lot to do with making the country the richest on Earth. But production decreased just as steadily between 1970 and 2009.

#-ad_banner-#Well, fortune is once again smiling on the U.S., and it seems America might have another chance at energy independence. The International Energy Agency (IEA) predicts the U.S. will become the world’s top oil producer by next year.

While America’s new energy future is one of my favorite themes, I am not yet ready to bet on oil prices. The price of a barrel of crude was less than $30 for nearly two decades before prices surged in 2003. Easing tensions with big producers like Iran, combined with surging global production, could mean lower prices and trouble for some upstream companies like Exxon Mobil (NYSE: XOM)

That is why I am looking at one segment in particular that benefits from the volume of energy used, rather than prices. 

Master limited partnerships (MLPs) are companies set up to manage energy infrastructure assets like pipelines, terminals and storage. These companies pay no taxes but pass their depreciation and expenses down to investors who pay taxes on distributions after deducting these costs. The accounting can get a little rough, but investors benefit from tax advantages as well.

I own shares in several MLPs, but my strongest pick of the bunch isn’t even an MLP — it’s a company that owns an MLP, providing all the benefits but none of the tax headaches.

This company could be a great core pick for an energy portfolio based on huge scale and scope of assets. It has exposure throughout multiple products, both crude and refined, as well as geographically across North America. It is poised to benefit from the increased volume through pipelines as well as the coming surge in exports. 

Best of all, management has made one of the strongest commitments I’ve seen to returning shareholder cash through the dividend and share buybacks. The fact that shares are undervalued by 13% is just the kicker to a strong yield story.

Kinder Morgan Inc. (NYSE: KMI) owns the general partner and incentive distribution rights of Kinder Morgan Energy Partners (NYSE: KMP) and El Paso Pipeline Partners (NYSE: EPB), from which it derives most of its earnings. Through the two holdings, along with other owned assets, it operates in five segments: natural gas pipelines and storage, carbon dioxide pipelines, product pipelines, liquid and bulk terminal facilities, and Canadian pipelines.

Kinder Morgan assets span the major oil and gas plays including Eagle Ford, Fayetteville and Barnett. LNG terminals at Gulf and Elba could offer upside surprises on natural gas exports in the future.

Though Kinder Morgan still owns some assets itself, it has been aggressively selling into its subsidiary MLP, and management expects to transition fully into a general partner this year. This structure is tax efficient since the profits on the limited partnerships will not be taxed and can be passed through to the general partner and investors. I like KMP as well, but by holding the umbrella company, investors can get diversification across more assets without the worry of special MLP forms during tax season.

KMI carries a 4.6% dividend yield, which has increased at a strong 14% rate since mid-2011. Distribution coverage, the number of times available cash covers the distribution payout, increased to 1.03 last year from 0.98 in 2011, which means there is little threat to the current payout.

Kinder Morgan ended 2013 with $9.8 billion in debt, down from $11.4 billion at the end of 2012, and relatively low compared with $3.8 billion in earnings before interest, taxes, depreciation and amortization (EBITDA). Kinder Morgan Energy Partners may increase its share issuance to lower its debt leverage over the next year. This usually leads to a reactionary drop in shares, which would flow through to shares of KMI but should provide a good opportunity for investors.

As part of the El Paso acquisition, 505 million warrants were issued with the right to convert at $40 per share. This has been a dilutive overhang on the stock, but management is aggressively buying back the warrants. The company has bought back 157 million warrants through its $250 million buyback authorization and intends to buy back more with another authorization.

(My colleague Nathan Slaughter is a huge fan of companies with substantial stock buyback programs, which he often says are indicative of management’s confidence in their own company. That’s not to mention the obvious benefits to shareholders, who often see the value of their shares climb as a result.) 

With the 2012 acquisition of El Paso Corp., Kinder Morgan has positioned itself to take advantage of the boom in U.S. natural gas production. There are two scenarios for natural gas that may play out over the next several years. With stateside prices for natural gas a fifth as expensive as in parts of Asia, there is a tremendous profit incentive to increase exports. Even after costs of about $6.40 for gasification and transportation, producers can still make upward of $6.80 per thousand cubic feet exported. With two terminals and liquefaction assets, Kinder Morgan is well positioned for this scenario.

If exports do not increase and drive prices higher, then the global disparity will drive U.S. demand for natural gas as a fuel source for consumers and manufacturers. The price of natural gas will still increase, but more gradually as more utilities and consumers switch to use it as fuel. This demand will drive further pipeline needs and volume transported will continue to increase.

Either way, volume demand for natural gas through pipelines and storage facilities will continue to increase for many years to come, and Kinder Morgan is poised to benefit.

Risks to Consider: The company still has some commodity price exposure through its CO2 business since demand for the gas is a function of drilling needs and oil prices. Most of this exposure is hedged by the company and should not be a problem unless oil prices collapse.

Action to Take –> Kinder Morgan is hosting an analyst day in Houston on Jan. 29. I am setting a buy-under price of $37 per share before the meeting and a $40 target price. I hesitate to set a target price because KMI really is a great long-term opportunity. Unless the price jumps well above fair value, I think investors can continue to accumulate a position and benefit from an excellent total yield every year.

Investors should consider starting a position before the analyst event next week. Management is likely to update its forecasts on production and profitability, which could prompt some analysts to raise their price targets.

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