Kinder Morgan: Still Paying for Broken Promises

Broken promises aren’t quickly forgotten. That’s the hard lesson being learned by pipeline company managements, as the sector remains cheap yet out of favor.

Kinder Morgan (KMI) reported good earnings on October 17th. Volumes were up, and they sold their Trans Mountain Pipeline (TMX), including its expansion project, to the Canadian Federal government. TMX is Canada’s only domestic pipeline that can supply seaborne tankers. All other pipelines lead to the U.S.

Canada’s landlocked energy resources are becoming a political football. Alberta wants to get its oil and gas to export markets, but neighboring British Columbia opposes the new pipelines necessary for Albertan crude to reach the Pacific coast. Caught between the two provinces, KMI sensibly sought an exit. The transaction was well timed, closing before cost estimates for completing the expansion  were ratcheted up and a court ruled that a new environmental study was required (see Canada’s Failing Energy Strategy). Canada’s taxpayers were on the wrong end of the deal.

Nonetheless, Rich Kinder opened the earnings call lamenting KMI’s valuation. He said, “I’m puzzled and frustrated that our stock price does not reflect our progress and future outlook.” We do think KMI is cheap, but the explanation lies in recent history. Before the Shale Revolution created the need for substantial new pipeline investments, KMI’s investor presentation reminded “Promises Made, Promises Kept.”

KMI Promises Made Promises Kept

This turned out to be true only until financing new projects conflicted with paying out almost all available operating cash flow in distributions. Investors in Kinder Morgan Partners (KMP), the original vehicle, were heavily abused. They suffered two distribution cuts and a realization of prior tax deferrals timed to suit KMI, not them (see What Kinder Morgan Tells Us About MLPs). Former KMP investors, who are numerous, retain deeply bitter memories of the events and have lost all trust in Rich Kinder.

KMI was only the first of many. Distributions on Alerian’s MLP index have been falling for three years. Their eponymous ETF has cut its payout by 30%. Alerian CEO Kenny Feng, normally a reliable cheerleader for the MLP model, recently turned more critical, citing,”…significant abuses of [distribution growth] in the past…” The irony is that until late last year Alerian’s own website showed reliable distribution growth, completely at odds with what investors in their products were experiencing. They only corrected it when mounting criticism from this blog (see MLP Distributions Through the Looking Glass), @MLPGuy and others forced a humbling revision.

AMLP Makes Distribution Correction

Too few commentators acknowledge the poor treatment of MLP investors (see MLP Investors: The Great Betrayal). Pipeline stocks are attractively valued but have been that way for some time. The legacy of broken distribution promises continues to cast a pall. KMI’s objective in abandoning the MLP model was to be accessible to a far broader set of investors as a corporation. So far, it hasn’t helped their stock price.

One explanation might lie in how they present their financial results. Distributable Cash Flow (DCF) is a term widely used by MLPs and retained by KMI even after it became a corporation. MLPs calculate their distribution coverage ratio, which is the amount by which DCF exceeds distributions. It’s somewhat analogous to a dividend payout ratio, albeit based on DCF not earnings. Kenny Feng notes that generalist investors aren’t familiar with DCF or its coverage ratio. It may be why KMI’s stock is languishing.

DCF is Free Cash Flow (FCF) before growth capex. MLPs have long separated capex into (1) maintenance, required to maintain their existing infrastructure, and (2) growth, for new projects. FCF, a GAAP term, is indifferent to the two types of capex and deducts them both. DCF (not a GAAP term) treats them differently by excluding growth capex, and is always higher.

Unsurprisingly, KMI regularly promotes its 11% DCF yield, which is higher than its energy infrastructure peer group. However, FCF is the more familiar metric, and is lowered by the subtraction of growth capex. Because KMI spent over 70% of its $4.5BN DCF on new projects, the remaining $1.4BN in FCF results in just a 3.3% FCF yield. This is still higher than the energy sector and certainly better than utilities (which are often negative because of their ongoing capex requirements). But it doesn’t stand out versus other sectors, and probably causes analysts to overlook the high DCF yield.

As a corporation, KMI continues to promote a DCF valuation metric used by MLPs, Using the more common FCF yield, it isn’t compelling. However, DCF seems reasonable to us given their business model.

To see why, consider yourself owning an office building. After all cash expenses, including maintenance and setting aside money annually to replace HVAC and other equipment, it generates $1 million in cash, annually. In real estate this is called Funds From Operations (FFO). Because you’re already deducting the expenses required to keep the building operating, and it’s most likely appreciating in value, it’s reasonable to value it based on the $1million recurring cashflow. A cap rate of 5% means you’d require at least $20 million before agreeing to sell it.

Now suppose you decided to redirect $700K of your $1 million annual cashflow towards buying a second building that you also plan to rent out. You still own a $20 million asset, and reinvesting some of that annual cashflow in a new building doesn’t affect the value of what you already own.

In this example the $1million in FFO is analogous to KMI’s DCF. It’s why they believe their stock is undervalued, because 11% is a high DCF yield. Their FCF is so much lower because they’re investing most of their DCF in new assets that will generate a return.

GAAP FCF doesn’t differentiate between capex to maintain an asset and capex to acquire a new one, which is why pipeline companies don’t dwell much on FCF. Moreover, properly maintained pipeline assets generally appreciate. As climate activists slow new pipeline construction in some states, it simply raises the value of nearby infrastructure that can serve the same need.

Critics may believe that DCF doesn’t reflect all the necessary maintenance capex that’s really required, or that the underlying assets are depreciating in value even while properly maintained, although there’s little if any evidence to support either claim. So KMI remains misunderstood.

The dividend might offer a more compelling story. Yielding 4.7%, it’s below the 5.8% of the broad American Energy Independence Index. Because of history, investors are understandably cautious in buying for the yield. But today’s $0.80 annual payout is expected to jump to $1 next year and $1.25 in 2020. This 25% annual growth will push the yield to 7.4% in two years, assuming no upward adjustment in the stock price. A rising dividend might finally vanquish the unpleasant memories of prior cuts, and draw in new buyers.

In spite of its attractive valuation, MLP ETFs and mutual funds don’t own KMI, because it’s not an MLP, providing another good reason to seek broad energy infrastructure exposure that includes corporations.

We are long KMI and short AMLP.

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
1 reply
  1. emcee
    emcee says:

    Excellent article! I would argue DCF is “Owner’s Earnings” which is a Buffett-coined term. As long as we trust that management is honest in assessing maintenance CapEx.

    I owned Kinder Morgan since 2013. Still own it. While I was disappointed with the dividend cut, I trust Rich Kinder and happy to see that he kept all his shares too. Rich pointed out at the time that he suffered equally from the dividend cut because he is the single largest shareholder – and all his cash flow are tied to dividends. He doesn’t get a regular paycheck from the company.

    I like CEOs who have significant skin in the game. While I have nothing to show for my KMI holding so far, I am a patient long-term investor. Count me as an optimist!

    Reply

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.