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Why Kinder Morgan Needs to Skip a Dividend Increase and Buy Back Stock

What a difference just a few months can make. In the case of Kinder Morgan (NYSE: KMI), it appears to be quite a lot. After touching lows of $13 this spring, having fallen some 68% from its highs of last year, Kinder Morgan has staged a rebound on the heels of several asset sales and the hint of shareholder capital returns. Specifically, on July 11, following an announcement that Kinder had sold a pipeline interest to Southern Natural Gas for $1.5 billion, CEO Steven Kean stated that Kinder was "measurably closer to being able to return dollars to our shareholders through increased dividends or buying back stock."

Image source: Getty Images.

While it's not surprising that Kean and his team are considering both options, the best possible move he could make on shareholders' behalf right now is to buy back as much stock as possible. Here's why.

How did we get here?

Few people thought things would get as bad as they did for shares of Kinder Morgan. The company held up remarkably well through the first half of last year, with shares barely budging while the broad energy sector more or less experienced an all-out depression. Eventually, though, that hard-to-define aspect of the stock market known as sentiment set in, and shares began to slide by midsummer.

The straw that really broke the camel's back, however, didn't come until last fall, when credit concerns that had plagued the industry for a year finally affected Kinder. The downdraft was swift and brutal, and it caught management completely by surprise. A seizing-up of capital markets -- at least with respect to anything even remotely related to oil and gas -- eventually forced Kinder Morgan to cut its dividend by 74% on Dec. 8.

It's important to note that the move wasn't made because of decreased profitability. As North America's largest energy infrastructure operator, Kinder Morgan has seen its operations continue to churn out billions in free cash flow year in and year out:

MetricFY 2013FY 2014FY 2015
Cash from operations $4.12 billion $4.47 billion $5.3 billion
Capital expenditures $3.38 billion $3.77 billion $3.98 billion
Free cash flow $740 million $700 million $1.32 billion

What has changed, however, is how the market values Kinder Morgan. And that's exactly why shares are a screaming buy.

Early this year, Kinder shares traded for the lowest valuation they've seen in a long time, perhaps ever. And not because the business was suffering. Rather, Wall Street was worried that Kinder wouldn't be able to roll over its debt. Granted, Kinder does have a huge balance sheet, with $48.7 billion in liabilities as of March 31, and that requires rolling over $10 billion in short- and long-term liabilities each and every year.

Could Kinder have had a problem managing its balance sheet and maintaining its dividend? Maybe. But does that mean the equity is worth a fraction of what it once was within the capital structure? Debatable.

MetricFY 2011FY 2012FY 2013FY 2014FY 2015Current
Average price-to-book 16.72 5.2 2.82 2.92 2.21 1.1
Average enterprise value-to-LTM EBITDA 14.96 18.83 16.53 14.39 17.37 11.45
EOY total debt-to-assets 66.8% 58.8% 56.2% 55.5% 55% 55.2%

Data source: S&P Global Market Intelligence. LTM = last 12 months. EOY = end of year.

That cash flow will always be there, but the low valuation won't

With Kinder Morgan we have a classic case of a great business being tripped up by short-term problems. For long-term investors, this is the best type of short-term problem to have -- one that's financial markets-related. Kinder's pipelines aren't going anywhere, revenue and cash flow have stayed flat, and the markets' concerns have been allayed by slashing the dividend (for now) in favor of continued capital expenditures.

All of this points to one inevitable conclusion: The opportunity to increase Kinder's dividend back to what it once was will always be there, but the ability to buy back shares at an astronomical discount to its historic valuations or any reasonable measure of its intrinsic value will not. Long-term shareholders will own an even bigger piece of the pie and will be the richer for it. Let's hope management makes the right decision.

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Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.