Although Kinder Morgan continues to expand its operation

(1)

pg. 1

Recommendation: BUY Target Price until (12/31/2015): $90 1. Reasons for the Recommendation

Kinder Morgan continues to expand its operations in response to the increased energy transportation and storage demand in North America. Kinder Morgan’s growth strategy is to expand its operations through acquisitions. It acquired Tennessee Gas Pipeline, El Paso Natural Gas, and 5 Jones Act Tankers.

Tennessee Gas Pipeline transports natural gas from Louisiana and the Gulf of Mexico to the major northeastern markets of New York and Boston. Tennessee Gas Pipeline also serves producers in the major shale formations of Marcellus and Utica.¹ Production from the Marcellus and Utica shale are estimated to grow from 15 billion cubic feet per day in 2014 to 28.5 billion cubic feet per day by 2024, or a1.35 billion cubic feet per day increase per year.² El Paso Natural Gas transports natural gas from the San Juan and Permian Basins to the markets of California, Nevada, New Mexico, Oklahoma, Texas, and Northern Mexico.¹ EPNG continues to fill previously underutilized pipeline to support growing exports to Mexico and will expand the pipeline system in future years to support growing demand.² In January 2014, Kinder Morgan acquired 5 Jones Act tankers, which will provide maritime transportation service in the domestic petroleum market. The tankers have charters with major oil companies, refiners, and the U.S.

Navy. Strategically, the acquisition is consistent with Kinder Morgan’s growth strategy and its fee-based revenue focus.³In addition, KMP has $16.2 billion in future growth projects planned through 2017 and continues to sign contracts to fill existing pipeline capacity, which does not require capital expenditures.² KMP has positioned itself to serve major domestic markets and the growing oil production of North America.

Although Kinder Morgan continues to expand its operation; there are risks associated with its growth strategy, particularly interest rate risk. Kinder Morgan funds part of its growth projects through debt and part through equity issuance. Given the current economic environment and the Federal Reserve’s bond tapering talks, there is a high probability that interest rates will rise in the near future.

Higher interest rates will increase Kinder Morgan’s cost of debt, which will make its growth projects less profitable.

KMP is set up as a Master Limited Partnership, which provides the company with tax advantages.

However, the Master Limited Partnership structure requires that all of KMP’s available cash from operations be distributed to the general partner, KMI, according to the partnership agreement. The general partner distributions could be used by KMP to fund acquisitions and growth projects instead of taking on additional debt. Overall, the general partner’s management team has kept to their promises and acted in KMP shareholder’s interest in terms of meeting distribution targets, executing growth projects that support distribution growth, and on occasion, waiving incentive distributions in order to support KMP’s acquisitions.

1 Kinder Morgan. Retrieved from Kinder Morgan’s website: http://www.kindermorgan.com/ on 4/6/2014.

2 Kinder Morgan. Kinder Morgan Energy Partners Q1 2014 Results- Earnings Call Transcript. Retrieved from Website: www.seekingalpha.com.

3 Kinder Morgan. Opportunity Knocks. 2014 Analyst Conference, January 29, 2014.

(2)

pg. 2

Kinder Morgan has smaller acquisitions and growth projects planned in 2014, which will support revenue growth throughout the year. The company consistently pays unit holders a 6% to 7% dividend yield and continues to increase its distributions to unit holders. KMP’s ability to leverage economies of scale through acquisitions and growth projects and its $16.2 billion in future growth projects support the sustainability of the unit distribution growth.

KMP’s total stock return for the period 12/7/2012 through 3/17/2014 was -.45%, which is

unexceptional. I believe that Kinder Morgan’s growth plans, the high demand for energy transportation and storage capacity, the current North American shale boom, and Kinder Morgan’s actions to leverage the current state of the North American oil and gas industry, make the company a good buy opportunity.

(3)

pg. 3

2. Company Analysis

Kinder Morgan is a leader in the energy transportation and storage industry. It operates 52,000 miles of pipelines and 180 terminals throughout North America. Kinder Morgan has five business segments including Natural Gas Pipelines, CO2, Product Pipelines, Terminals, and Kinder Morgan Canada.⁴ Strengths

KMP continues to create synergies through acquisitions and growth projects. KMP has

positioned itself to meet the increasing energy transportation and storage demand of oil producers in the major shale formations of Eagle Ford, Utica, Marcellus, and Baaken. KMP has a solid reputation for being compliant and outperforms the industry in safety measures.⁵ A reputation for compliance and operating safe pipelines are integral parts of Kinder Morgan’s ability to negotiate customer contracts.

Weaknesses

KMP’s growth strategy requires access to capital. KMP is set up as a Master Limited

Partnership. The general partner, KMI, has an agreement with KMP to distribute all of its available cash from operations to KMI. The general partner distributions take capital away from KMP, which forces the company to rely on external financing to support its growth strategy. External events such as tightened capital markets and the Federal Reserve’s current reduction in bond purchases, which affects the supply of money and puts upward pressure on borrowing rates, could adversely impact KMP’s growth strategy.

If KMP is unable to finance externally, or financing becomes too expensive, then KMP’s growth strategy would be hindered.⁶

Opportunities

The Trans Mountain Pipeline transports Canadian oil sands crude from Alberta to the west coast of the United States. The Trans Mountain Pipeline is the only pipe line that transports crude oil and refined products from Canada to the U.S. west coast.⁷ KMP plans to expand the capacity of the Trans Mountain Pipeline system from 300,000 barrels per day to 890,000 barrels per day. The appropriate regulatory approvals have to be made through the Canadian government and the National Energy Board.

If the regulatory approvals are granted, then the Trans Mountain pipeline expansion will be operational by 2017.⁸ The Trans Mountain expansion project would benefit Canadian oil producers by providing greater transportation capacity of oil sands crude and petroleum products to the Pacific coast to be exported to international markets, potentially easing the discounts on Canadian oil sands crude.⁹

4 Kinder Morgan Energy Partners LP. (2014). Form 10-K 2013. Retrieved from SEC EDGAR website:

http://www.sec.gov/edgar/searchedgar/companysearch.html

5 Kinder Morgan. Fact Sheet. Retrieved from Website: http://www.kindermorgan.com/news/factsheet1 .pdf

7 Kinder Morgan. Retrieved from Kinder Morgan’s website: http://www.kindermorgan.com/ on 4/6/2014

8 Kinder Morgan. Opportunity Knocks. 2014 Analyst Conference, January 29, 2014.

9 Julie Gordon. Canadian Regulator to Hold Hearings on Trans Mountain Pipeline. Reuters, April 2, 2014.

(4)

pg. 4

Threats

KMP may face competition from other pipelines and alternative forms of transportation. If other pipelines or alternative transportation are able to offer customers more favorable transportation services through lower prices, superior location, or facilities, then re-contracting at favorable rates and retaining current customers may prove challenging.¹⁰Existing pipelines and proposed pipelines could increase competition for the supply of petroleum products. Many pipelines have access to the same supply areas as KMP and transport to areas that KMP does not.¹⁰

(5)

pg. 5

3. Industry Analysis Industry

The energy transportation and storage industry is a mature and highly regulated industry with a moderate level of competition and high entrance barriers. In order to succeed, industry participants need to establish a history of performance and compliance and negotiate long term customer and supplier contracts. Demand for energy transportation and storage has increased with the shale gas discovery, which increased industry revenues. Increased revenues were offset by large capital expenditures necessary to increase pipeline networks and storage capacity.¹¹ The three North American Industry Classifications relevant to Kinder Morgan are the Gas Pipeline Transportation, Refined Petroleum Pipeline, and Organic Chemical Pipeline industries.

The Gas Pipeline Transportation industry transports natural gas from various types of wells.

Pipelines deliver natural gas to wholesalers, distributors, and retailers who ultimately sell the product to consumers. The Refined Petroleum Pipeline industry transport refined petroleum products such as gasoline, diesel, jet fuel, and natural gas liquid. Refined petroleum products are transported through product pipelines and stored in terminals. Wholesalers, distributors, and retailers are then able to acquire and deliver the product to the end user.¹¹ CO2 and ammonia are a part of the Organic Chemical Pipeline transportation industry. CO2 is used for tertiary oil recovery, which occurs after primary and secondary recovery methods have been applied to an oil well. CO2 recovery is common in mature oil fields where it is difficult to extract oil from wells.

Competition

The Gas Pipeline Transportation industry has three major market share holders including KMP at 36.2%, Spectra Energy Corporation at 7.6%, The Williams companies Inc. at 7.1%, and Energy Transfer Equity at 4.9%. Competition is somewhat fixed because of federal regulations and shared sources of natural gas. Long term, an Increase in demand will require greater volumes of gas to flow through pipelines and encourage competition thereby necessitating new pipeline infrastructure and capacity.¹²

The leading industry participants in the Refined Petroleum Pipeline Transportation industry are Enterprise Products Partners LP with a 25.6% market share, KMP is the second largest market share holder with 20.2%, followed by Magellan Midstream Partners LP at 9.1% market share, and Buckeye Partners LP with 7.8% market share. The product pipeline industry is dominated by four companies who have consolidated some operations to increase revenues. New entrants and smaller operations have a difficult time increasing market share because of the high capital costs associated with pipeline construction and regulatory approvals.¹¹

The Organic Chemical Pipeline industry has a low market share concentration with four companies accounting for 40% of the market. Industry leaders include Kinder Morgan Energy Partners

11 David Yang, Refined Petroleum Pipeline Transportation in the US, IBIS World Industry Report 48691, August 2013.

12 Darryle Ulama, Gas Pipeline Transportation in the US, IBS World Industry Report 48621, December 2013.

(6)

pg. 6

LP with 22.9% market share, Denbury Resources LP with 5.3% market share, and Magellan Midstream Partners LP with 5.2% market share.¹³

Outlook

The energy transportation and storage industry outlook is positive. The recent shale discoveries and hydraulic fracturing have increased North American petroleum output. Energy transportation companies benefit through economies of scale when pipeline and storage capacity are utilized. Although increased petroleum output requires infrastructure expansion and large capital expenditures to meet demand, energy transportation companies were granted favorable price increases set by the Federal Energy Regulatory Commission. Entrance barriers are high because of the large capital expenditures necessary to build infrastructure, regulatory approvals, and a reputation of performance and regulatory compliance necessary to obtain customer contracts. Economic growth and the energy transportation industry normally grow in unison. Currently, the economy and the energy transportation industry are growing. Overall the industry outlook is positive and industry participants should take advantage of the favorable interest rate environment to increase capacity or make favorable acquisitions to fully leverage the industry growth potential.

13 David Yang. Organic Chemical Pipeline Transportation in the US. IBIS World Industry Report 48699. September 2013.

(7)

pg. 7

Appendix I: Inputs into valuation using multiples

* Analyst's own calculations. Source of basic data: company's 10-K; Yahoo! Finance

2009 2010 2011 2012 2013 2014 F 2015 F 2016 F

Stock Price 51.43 66.59 73.13 82.45 84.50 87 90 94

Diluted EPS 1.12 0.63 -0.34 1.55 3.53 2.05 2.10 2.11 Sales 7,003.40 7,739.00 7,889.00 8,642.00 12,530.00 14,168 16,151 18,412

P/E 45.92 105.69 N/A 53.19 23.94 42 43 45

P/S 2.18 2.72 3.12 3.56 2.99 3.01 3.04 3.09

Sales per share- diluted 23.59 24.48 23.44 23.16 28.26 29 30 31