We experienced unanticipated twists and turns over the past number of months with Kinder Morgan, Inc. (KMI). The oil and gas sector’s cyclical downturn was well underway, KMI’s cash flow remained strong, yet the share price fell with others in the sector. The negative sentiment also turned to KMI’s increased debt that was used in part to fund the previously acclaimed consolidation transaction.
KMI’s acquisition of the troubled Natural Gas Pipeline of America, LLC (NGPL) along with Brookfield Infrastructure Properties (BIP) caused Moody’s to put KMI on negative credit watch. Faced with losing its investment grade credit rating and the already increased cost of equity due to the share price decline few choices remained. The company cut the dividend 75% rather than forego attractive long term return investments. This resulted in another rush for the exits as disappointed income oriented investors sold shares.
Kinder Morgan’s stock represents our ownership share of a solid underlying business. This major midstream infrastructure company has a wide protective moat, real infrastructure assets that appreciate over time; and attractive investment characteristics. They supply essential goods and services to our society. None of this changed with the stock price decline, and the underlying business has a value that is independent of the fluctuating share price.
It is not unusual for a value investment to decline after the initial purchase, in my case it’s almost inevitable. Still, this investment is extraordinary in the number of ways it continues to test the fortitude of shareholders. There is a silver lining in the clouds. The analysis suggests we should continue holding, or even buy shares at these levels. So, let’s not convert a temporary impairment into a permanent loss by selling shares. The company is taking risk off the balance sheet, increasing cash flow and will be in position to increase the dividend (with the attendant share price appreciation).
Advancing from here:
At KMI’s January, 2016 analyst conference [Source] management explained the dividend cut, their outlook for 2016 and how they will view capital allocation. The dividend cut will eliminate the need for equity funding from the capital markets and use internally generated cash flow primarily to fund attractive mid-teen return growth projects and reduce debt. Management will decide the optimum use of cash depending on the challenges or opportunities the market offers at the time. The uses could include attractive growth projects, strengthening the balance sheet through debt reduction, increasing the dividend, and/or share buybacks should the share price remain low.
It’s hard to imagine any explanation making a 75% dividend cut more palatable to income oriented investors. In reality they didn’t have many options in this environment. In trying to explain the dividend cut they could have borrowed a quote from General Oliver Smith. General Smith, a highly decorated combat veteran, was commander of the 1st Marine Division during the Korean War. During the Battle of Chosin Reservoir his Division was encircled by the enemy. Before breaking through the encirclement and saving the Division, Smith explained; “Retreat, hell! We’re not retreating, we’re just advancing in a different direction.”
Management increased the hurdle rate of return for discretionary capital projects to a minimum after tax and unlevered return in the mid-teens compared to the previous hurdle rate of 8-12%. The company estimates this upgrade will reduce the project backlog to $18.2 Billion over the next five years. In this analysis it is assumed discretionary expenditures will realize a minimum 13% after tax unlevered return.
Crude oil prices remain at unsustainably low levels. Prices are below the marginal cost of the new oil production required to offset the natural decline in existing crude oil production. As the oil and gas industry reduces drilling budgets the natural decline rates and increases in demand will at some point bring supply and demand back into balance.
A break even price of about $70/barrel is needed for marginal new oil to become economical. Although we don’t know when this price increase will occur, we know it will. The crude oil assumption in this analysis is prices will recover gradually during over the 5 year investment horizon as illustrated in the table below.
Management also indicated the company’s leverage ratio would be reduced to a 5.5 Debt/EBITDA in 2016 and would continue in the years beyond although the future target was not quantified. To the extent the company generates excess cash flow they will: “pay down debt and/or increase dividends and/or repurchase shares; invest in high return midstream investment opportunities and/or acquisitions.”
Based on our case summarized below, KMI should be able to reduce leverage to their target of 5.0 by early 2018. It is further assumed KMI will increase the dividend $0.50 in 2018 to $1.00/share and again in 2019 dividend to $2.02/share. Management stated it was unlikely they would return to the previous 1.0 distribution coverage ratio so the dividend level in 2019 and beyond is set here to maintain a more conservative 1.3 dividend coverage ratio for this analysis.
In response to analysts’ direct questioning on the dividend, management offered no guidance on when or how much the dividend would be increased. There can be any number and quantity of dividend increases but the purpose here is to demonstrate the capacity of the company over the next number of years to:
- Fund maintenance and attractive discretionary capital projects with internally generated cash flows, debt issuance and no equity issuance.
- Reduce the leverage ratio (as measured by Debt/EBITDA) to the target ratio of 5.0 in 2018, continue to improve it, and maintain it well below the debt covenant ratio of 6.5.
- Significantly increase the dividend in 2018 and maintain a strong coverage ratio as measured by Distributable Cash Flow (DCF).
The dividend cut was a surprise to many and the company was criticized by some for choosing to advance in this different direction. However, the short term pain will lead to long term gains as the balance sheet is strengthened, leverage is reduced and significant upside potential exists for dividend increases in the future.
Maximizing Debt Reduction:
This sensitivity case is for illustration purposes only and assumes the dividend is kept at $0.50/share through the five year period. Projects are funded and debt reduction is the priority. It demonstrates the ability of the company to pay down debt and decrease the leverage ratio.
Some observations that can be made:
- The dividend coverage ratio as measured by Distributable Cash Flow (DCF) remains strong.
- Maintenance and discretionary capital projects are funded with internally generated cash flow, no equity, and a small amount of debt in 2017.
- The leverage ratio measured by Debt/EBITDA remains well below the debt covenant ratio of 6.5 and would continue to improve well beyond the target of 5.0.
The crude oil sensitivity case is also for illustration only and contains the same assumptions as the above sensitivity case except the unhedged crude oil prices. Crude oil remains at $30/Bbl. through 2017 and recovers to $60/Bbl. In 2020. Project funding and debt reduction remain the priority.
Kinder Morgan is painted with the same broad brush used for oil and gas producers much more sensitive to commodity prices. The facts are; 97% of KMI’s cash flow is fee based or hedged for 2016, and will not be significantly impacted by commodity prices. In future years the commodity hedge book is not as strong, still the company’s cash flow remains relatively immune from commodity prices.
In 2020 the leverage ratio ends at 4.0, well below the 5.0 target and the debt covenant level of 6.5. In this more pessimistic crude oil scenario the dividend is well covered, debt is reduced and attractive projects are financed primarily with internally generated cash flow.
With the dividend reduction should KMI be valued as an income investment or otherwise? To address this, two valuation models are used; enterprise to cash flow, more specifically Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA) and the dividend yield basis.
Cash Flow Valuation:
The chart below shows the average industry EV/EBITDA over a number of years.
Source: Credit Suisse
The Dividend Resumption case discussed above generates an EBITDA of about $9600 million in 2020. Applying a range of EV/EBITDA ratios the following equity values and price per share can be determined. Add the accumulated dividends over the investment horizon and the following estimates for 2020 are made.
The Dividend Resumption case generates a dividend of $2.04/share in 2020 similar to the level before the dividend cut but with a 1.3 coverage ratio and less leverage on the balance sheet. Applying a range of potential dividend yields, a price per share can be estimated. Adding the accumulated dividends over the investment horizon, the following estimates for 2020 is made.
At today’s share price of about $17/share, both methods estimate a potential price of about $33/share and accumulated dividends of about $6.50/share. This provides an attractive total return of about 135% or 27% per year for the patient investor.
Observations and Lessons Learned:
It was thought KMI’s limited commodity price exposure in the midstream sector would provide a buffer to the cyclical downturn. Not so. The stable cash flows did not provide immunity from the negative sentiment and the share price fell. We also underestimated the depth of the oil and gas bear market and how the resultant negativity would impact midstream companies.
It seems there is a change underway in the midstream infrastructure sector. Credit standards are being tightened and the focus is changing from leveraged dividend growth to balance sheet strength. Time will tell whether this is an enduring change. Still, many bargains could appear in the midstream sector as other companies face cutting high yield dividends to strengthen their balance sheets. When they do, income oriented investors will flee, depressing share prices and providing new opportunities for value investors.
Kinder Morgan’s track record of delivering on dividend promises is a credit to management’s past commitment to returning cash to shareholders. It also reminds us of a warning we hear often; good past performance does not guarantee good future performance.
A margin of safety was used to determine a share price sufficiently below estimates of future value to justify this purchase. Since income oriented investors are more focused on dividend return than total return a dividend coverage margin of safety should also be considered with income oriented investments. The dividend yield attracted many investors just as the dividend cut sent those same investors to the exits even with enterprise cash flow strong.
We should always ask, “what did we miss” when things go wrong because the best investing lessons often come from experiences like this. Don’t misunderstand, I believe KMI will work out just fine in time, but it would have been nice to know some of this in advance. This reminds me of a story our pastor likes to tell. After preaching or speaking an older person will often say; “I wish I had heard you say that thirty years ago.” To which his standard reply is; “I hadn’t made enough mistakes thirty years ago to teach you what you heard today.”
Kinder Morgan’s is a major midstream infrastructure company with a protective moat, real assets that appreciate over time; with attractive investment characteristics; supplying essential goods and services to society. Management owns shares and are invested along with us; they have a good long term performance record; and cash flows remain stable. None of this has changed and the underlying business will weather this storm.
We have experienced a temporary impairment in this investment and the silver lining is the company is on the right path to strengthen the balance sheet, increase cash flows through attractive growth projects and will be in position to increase the dividend. Share price appreciation will follow. We need to be patient, focus on the business not the fluctuating share price so we don’t change a temporary impairment into a permanent loss of capital with a sale.
Disclosure: Long KMI
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