The build-out of energy pipelines and infrastructure continues to be one of the most underestimated plays in the market. Companies in the oil and gas transportation industry are spending billions of dollars every year to increase storage capacity and stretch pipelines across the country.
Most of these companies are structured as tax-efficient master limited partnerships (MLPs), which are one of my favorite investment vehicles and account for nearly 15% of my personal portfolio.
However, the huge increase in capital expenditures over the past few years has limited distributions, even amid historic energy production and pipeline volume. But the build-out and spending won't last forever.
Once the infrastructure is in place, it will last for decades with regular maintenance -- and these companies could see their distributable cash flow jump. Many of these partnerships already pay yields above 5%, but one of my favorite pays a whopping 7%.
Not only does it pay a higher yield, but the market is currently mispricing shares -- and insiders are increasing their own stake in the parent company.
Short-Term Disconnect, Long-Term Gains
Kinder Morgan (NYSE: KMI) owns the general partner and incentive distribution rights of Kinder Morgan Energy Partners (NYSE: KMP) and El Paso Pipeline Partners (NYSE: EPB). Collectively, the group is the largest midstream transportation player and the fourth-largest energy company in North America, with assets in every major oil and gas play in the country.
Most of these assets generate revenue based on volume instead of commodity prices. This makes for extremely predictable cash flow, which should continue to increase as the U.S. energy revolution evolves.
Since KMI issued shares in February 2011, the two investments have traded nearly in sync, with one outperforming for a short time before the other catches up.
Shares of the parent company started to gain in April and have outperformed by more than 6% since.
For its first quarter, the energy partnership reported distributable cash flow of $1.55 per unit, beating expectations, and an increase of $1.6 billion in project backlogs, to $16.4 billion. Distributable cash flow covers the distribution by 1.1 times, and strong sales from a higher backlog could mean that the company's forecast distribution of $5.58 per unit this year may be increased.
Are Insiders On To Something?
Beyond the short-term market disconnect in pricing and strong outlook for the Kinder Morgan group of companies, insiders are also sending a persuasive signal that shares are underpriced.
Founder and CEO Richard Kinder has purchased almost 400,000 shares in the incorporated company for $12.9 million since the beginning of the year and now owns 240.8 million shares, 23.3% of the total outstanding. He also owns nearly 326,000 shares of KMP.
Director Fayez Sarofim, an early investor in the company, has also been making some strong purchases with 400,000 shares (for $13.5 million) since the beginning of the year, bringing his ownership to 22.7 million shares.
Between Kinder, Sarofim and three other insiders nearly $27.6 million of the parent company shares have been bought just since February. Insiders own a total of 35% of the parent with institutional and mutual funds controlling another 52% of the shares outstanding.
KMP officers Steven Kean and James Wuerth have bought a combined $2.1 million in KMP shares since December. Insiders own 8% of the energy partnership, with institutional and mutual funds controlling another 23% of the shares outstanding.
There are tax reasons behind insiders' preference for KMI shares, but I prefer shares of the energy partnership for my own portfolio. If you are willing to work through the extra K-1 schedule on your taxes, MLPs can offer deferred tax savings that add to the sector's draw.
In January, I put a price target of $40 on shares of KMI, and I'm setting a target of $90 on KMP, which represents 15% upside on top of the 7.1% distribution yield. This price target is based on a conservative estimate of 5% distribution growth over the next several years and 3.5% distribution growth after that.
Risks to Consider: Shares dropped in February when Boardwalk Pipeline Partners (NYSE: BWP) slashed its dividend and MLP investors worried that KMP's growth was not sustainable. KMP's first-quarter earnings put some of these fears to rest, but the company will need to invest heavily to keep growing.
Action to Take --> The build-out of infrastructure needed to move America's new energy production will be an issue at least through this decade. MLPs like KMP are poised to benefit from volume pricing and tax advantages. Shares of KMP are currently cheap relative to the parent company and pay a strong distribution. I am setting a buy-under price of $82 per share and a target of $90 over the next year.