Valuentum Exclusive Analysis for the Discerning Investor

Symbol Keyword

Let’s cover the quarterly reports from a few industry bellwethers.

By Brian Nelson, CFA

Kinder Morgan (KMI) Plans for Dividend Hikes

Kinder Morgan appears to be back on track, something that it set the stage for in early 2016 when Barron’s wrote about Valuentum’s take, “Is Kinder Morgan on the Road to Recovery (January 2016).” The pipeline operator continues to trade near our fair value estimate of $20, so it’s hard to make the case that there is a tremendous valuation opportunity in shares, though its prospects for a return to dividend growth have improved.

On July 19, Kinder Morgan announced that it expects to raise its dividend by 60% in 2018 and advance the payout at a 25% yearly rate through 2020. The company also authorized a $2 billion share buyback program, a good sign in that the capital markets remain open to the company, though we’re less thrilled with any entity, for example, buying back its own stock near or at fair value. We generally prefer companies buy back their stock at a meaningful discount to intrinsic value.

All in, we liked the news at Kinder Morgan, especially that backlog inched higher on a sequential basis, but we maintain our view that fundamentals remain inextricably tied to energy-resource pricing, and while the company expects to end 2017 at a 5.2 times net debt-to-adjusted EBITDA ratio, that’s still high for any corporate with a large dividend payout (especially one buying back stock). Kinder Morgan is no longer included in the Best Ideas Newsletter portfolio.

Union Pacific’s (UNP) Strong Second-Quarter Performance

The railroad industry continues to attract investor interest as M&A talk continues, even as we posit the likelihood of any combination would be met with rigorous antitrust review. Railroad operators heavily tied to the East Coast markets may see the greatest benefit from a potential rebound in fossil fuel sentiment, punctuated by President Trump’s agenda that has reportedly “ended the war on coal.” Though CSX (CSX) and Norfolk Southern (NSC) fit that theme nicely and Canadian Pacific (CP) may be one of the best in the group on the basis of its financial make-up, we continue to view Union Pacific as one of our favorite railroad operators.

Our thesis on Union Pacific continues to be one focused on the railroad operator’s trajectory of improvement. The company’s second-quarter report, released July 20, for example, revealed a lot of the things we like to hear. For starters, Union Pacific’s operating revenue increased 10%, operating income leapt 21%, diluted earnings per share advanced 24%, and its operating ratio improved 3.4 percentage points, to 61.8%, all measures compared to the same period a year ago. Carload volumes increased in four of its six commodity groups, and improvements in core pricing and productivity directly translated to profitability improvements. Coal revenue advanced 25% in the quarter thanks to a 17% increase in volume and the balance coming from improvement in average revenue per car.

Union Pacific’s free cash flow generation, as defined by cash flow from operations less all capital spending, during the first six months of the year was $1.87 billion compared to cash dividends paid of $980 million over the same time period, revealing significant dividend coverage with traditional measures of free cash flow. We’ll be monitoring the impact that energy and intermodal pricing pressures may have on profits in coming periods (and some caution with respect to the current sales trend of auto sales may be warranted), but we continue to like this railroad operator quite a bit, and we’re not worried too much about difficult year-over-year comparisons in the back half of 2017. Union Pacific currently yields ~2.3%, and shares are up more than 40% since being added to the Best Ideas Newsletter portfolio July 2013.

Colgate-Palmolive (CL) Trades at Premium

Colgate-Palmolive reported second-quarter results July 21. The company’s reported net sales fell 0.5% on a year-over-year basis, while organic sales were roughly even versus the year-ago period. Excluding a number of charges and one-time items, operating profit fell 1% while net income increased 1% in the quarter as the company failed to leverage meaningful earnings expansion on relatively flat sales performance. Through the first six months of 2017, net cash provided by operations fell to $1.3 billion from $1.32 billion over the same period last year. Management noted that the “second quarter was another challenging one,” blaming “softness in North America and challenges in Asia Pacific.”

Colgate-Palmolive is a fantastic company, and its share in the global toothpaste market (~43.6%) and global toothbrush market (~32.8%) is impressive, but we think its performance is reflective of much of what we are seeing with respect to how the market may be too-richly pricing consumer staples (XLP) entities. On lower revenue and hardly any earnings growth in the second quarter, shares of Colgate-Palmolive are trading at 23 times expected 2018 earnings numbers ($3.14), and such forecasts are based on advancing revenue. Our fair value estimate of $60 sets the high bound of our fair value range about where shares are exchanging hands at the time of this writing. They are not cheap.