Kinder Shows The MLP Model is Changing

This week Kinder Morgan (KMI) did the right thing, after doing the wrong thing last year. By slashing their dividend they finally acknowledged that the MLP model of returning most free cashflow to investors and issuing new equity to finance growth doesn’t work in the C-corp structure they adopted in 2014. The square peg jammed in the round hole. Typical corporations pay out around a third of their profits in dividends and fund most growth with internally generated cashflow. KMI is conforming. Their mistake was committed last year (see Kinder’s Blunder), as was ours in not recognizing it sooner.

KMI isn’t an MLP, but they were once and most MLP investors also hold KMI. In many cases this is because they used to hold MLPs Kinder Morgan Partners or El Paso before they were rolled up into KMI last year. We reduced our KMI position in recent months in favor of more attractively valued names, but KMI affects investor sentiment so much that we’re all invested in KMI whether we own it directly or not. The MLP model isn’t broken. It retains its advantage in holding energy infrastructure assets since its freedom from corporate income tax gives it a lower cost of capital. MLP distributions continue to be tax-advantaged to investors. The MLP GP still looks like a hedge fund manager (see Energy Transfer’s Kelcy Warren Thinks Like a Hedge Fund Manager). KMI abandoned all this for the C-corp structure but kept operating like an MLP.

KMI’s operating performance in 2015 hasn’t been much different than expected a year ago. They budgeted $4.8BN of Distributable Cash Flow and are coming in at $4.6BN; EBITDA of $8BN, coming in at $7.5BN. Down 5-6%, because they’re not immune to crude oil prices, but no matter. Like their MLP cousins their stock price has sunk as investors look ahead to substantially worse operating performance next year. It may turn out that way but you won’t find much support for that view from recent financial reports or company guidance. Plains All America (PAA) expects rising EBITDA next year and in 2017, at which time they plan to resume annual distribution increases. They are considering numerous alternatives including a potential consolidation with their MLP and a distribution cut at PAA or PAGP is not off the table. We don’t expect it but can no longer rule it out. Meanwhile, Plains GP Holdings (PAGP) yields 10.0% based on its October 2015 dividend (which was +21% on a year ago). Energy Transfer Equity’s (ETE) CFO Jamie Welch was on CNBC noting their 7.5% yield with 1.2x coverage (based on their last dividend, +37% on a year ago) and predicting continued (albeit slower) growth.

But MLP stocks have collapsed this year so something must be badly wrong. Certainly the volatility of their securities has jumped, and investors will tread more warily for some time as a result. Most fundamental analysis and company guidance are severely at odds with market prices. The two will eventually reconcile.

An alternative interpretation is that the market is rejecting the industry’s plans to finance its growth through issuing new equity and debt. KMI’s problem is not unique, they’re just bigger, more leveraged and have a more extensive list of growth projects than others. They tried to solve it by becoming a C-corp and thereby accessing a bigger pool of investors. Their dividend cut was the traumatic acknowledgment of the problem.

It’s easy to dismiss today’s sellers as mistakenly expecting deteriorating operating performance next year. What’s more interesting though is to ask where are the new investors who ought to find current values compelling. Their absence, which has allowed yields to drive higher, may signal that MLP investors don’t want to provide the financing that’s needed. The pool of traditional, K-1 tolerant investors isn’t big enough to provide the new capital. An industry with decent operating performance and substantial growth plans ought to be funding more of that growth internally. Examining operating performance and distribution coverage is clearly not the solution to establishing the security of a payout. A company’s growth plans and its commitment to them is just as important. KMI may not be the last company to accept this reality. Continued high yields on MLPs reflect a diminished appetite from traditional MLP investors to finance growth and make the use of equity financing increasingly uneconomic.

Many MLP management teams and investors (including us) believed MLP investors would willingly accommodate this growing appetite for capital. Smaller, retail investors were tapped via ETFs, mutual funds and other products that avoided K-1s (albeit in many cases inefficiently). But this class can sometimes be flighty, momentum investors and they have been leaving. The MLP structure is the cheaper legal entity through which to finance energy infrastructure, but the market is coming up short of enough interested capital.

We may be transitioning to a different type of security, with lower payouts that grow faster and more internally financed growth. It’s not what original MLP investors signed up for. The shift is painful.

Casualties so far include investors who interpreted the shocking price collapse as portending something worse and sold as a result. We’re most certainly not in that category, but our reputation as market timers has not emerged unblemished, and maintaining MLP exposure throughout 2015 hasn’t been fun. It may not get any better for some time. Nonetheless, from where we sit last week looks like the low for the year in the sector. Of course, we’ve put in the year’s low numerous times already, and I for one possess the tire tracks across my back as evidence. Humility can be expensively learned. While the industry’s prospects are good, the financing model may be shifting to one of lower payouts, less reliance on external finance and greater use of internally generated cashflow.

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