Here's Why the Best Is Yet to Come for Kinder Morgan, Inc.

By Matthew DiLallo Markets Fool.com

Kinder Morgan (NYSE: KMI) has been going through a bit of a rough patch. Distributable cash flow, which peaked in 2015 at $2.14 per share, fell to $2.02 per share last year and is expected to slip again this year, to $1.99 per share. That said, the company doesn't expect its current struggles to last much longer because it is working through a series of strategic initiatives that will position it to capture growth opportunities that should emerge in the future. It's why the company firmly believes that its best days are still ahead of it.

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Getting its balance sheet back on solid ground

One of Kinder Morgan's top priorities over the past year has been to strengthen its balance sheet, with the aim to reduce its leverage ratio from a peak of 5.6 times net debt to adjusted EBITDA in 2016 down to a target of five times. The company has already made significant progress on this goal, ending last year with a leverage ratio of 5.3 times by generating free cash flow and completing several strategic partnerships and non-core asset sales. The biggest improvement came from its Southern Natural Gas Pipeline joint venture with utility Southern Company (NYSE: SO). That transaction not only brought in $1.47 billion of cash that Kinder Morgan used for debt reduction but Southern Company assumed half of the system's debt and will fund half of the growth capital spending going forward.

That said, Kinder Morgan expects to take a slight step back this year, projecting that the leverage ratio will rise to 5.4 times. However, leverage should head back down in 2018 as it completes some of its current growth projects and other initiatives. By solidifying its balance sheet, the company will have more flexibility to allocate capital toward other opportunities.

Image source: Kinder Morgan Inc.

A more sustainable financial model

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Another of Kinder Morgan's goals has been to secure new funding sources for growth projects. Before the oil market downturn, it had no problem issuing cheap debt and equity to finance expansion projects. However, the company's cost of capital rose along with its leverage ratio, which no longer made those sources palpable options. As a result, Kinder Morgan has been funding capital projects with internally generated cash flow while it searched for a new way forward.

That new path has started to materialize over the past several months, with the company increasingly turning toward private equity funds to partner with it on some of its larger growth projects. The reason it has chosen this path is that these partners pay it an up-front fee that reimburses capital expenses on the project to date as well as an additional amount to recognize the value created on the project thus far. Furthermore, the partners agree to finance a portion of future capex. As a result, Kinder Morgan now has a repeatable process that it can use to fund growth projects in the future.

A focus on quality of quantity

Aside from the impact of low oil prices, another weight on Kinder Morgan over the past couple of years has been its declining investment returns due to its focus on growth above all else:

Data source: Kinder Morgan. Chart byauthor.

However, the company is working to reverse this trend by high grading its backlog. The outcome of that process was the decision to partner several large projects and cancel others with returns that did not meet its higher hurdle rate. This process resulted in Kinder Morgan's capex-to-EBITDA multiple improving from 7.5 times at the beginning of last year to 6.7 times at the start of 2017.

Overall, it currently has $10.6 billion of projects remaining in its backlog,excluding thosein itscarbon dioxide segment. These projects shoulddeliver an incremental $1.6 billion of adjusted EBITDA on an annual basis by 2021, representing a nearly 20% increase in earnings for the company, which would push them to a new all-time high. While those figures assume no additional joint venture agreements or new growth projects, it shows that it already has the projects in the pipeline that it needs to drive its results well above the prior peak.

Why this means the best is yet to come

That said, Kinder Morgan sees even more opportunities than those currently in its backlog, which is why it has worked so hard to improve its financial position. Fueling that optimism is the fact that oil and gas remain vital sources of energy. In fact, the U.S. Energy Information Administration sees demand for oil and gas in the U.S. increasing 30% and 50%, respectively, by 2040. That rising demand suggests that the country will continue to need reliable energy infrastructure in the future.

That forecast is good news for Kinder Morgan for two reasons. First, it suggests that more volumes should flow through the company's system in the years ahead, increasing the value of its current assets. It also implies that it should have ample opportunities to invest in high-return infrastructure projects in the coming years. These forces should combine to fuel earnings growth for years to come.

Add it all up and it appears that the company's best days do still lie ahead.

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Matt DiLallo owns shares of Kinder Morgan and has the following options: short January 2018 $30 puts on Kinder Morgan and long January 2018 $30 calls on Kinder Morgan. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool has a disclosure policy.