This article was originally published on valuentum.com/.
“…the credit rating agencies have a lot to think about. Kinder Morgan’s investment-grade credit rating is in part supported by the firm’s ability to access the equity markets to sell its own stock. But its share price is artificially propped up by the incorrect application of dividend discount models that are using financially-engineered dividends, which themselves are in part supported by the debt raised from an investment-grade credit rating, which is then used to keep raising debt and growing the dividend…and so on.”
5 More Reasons Why We Think Kinder Morgan’s Shares Will Collapse
It may feel like something’s different at our independent equity research firm, but nothing has changed in the past few weeks. In fact, we’ll keep doing spot-on analysis on Kinder Morgan and across our entire coverage universe. It’s business as usual at Valuentum. Here are 5 more reasons why we think shares of Kinder Morgan will collapse.
6) Kinder Morgan’s dividend is in part organic, in part financially-engineered.
7) The traditional “blind” use of the dividend discount model does not apply to Kinder Morgan.
8) The company’s implied leverage is 19 times after considering all cash, debt-like commitments, at least in the eyes of shareholders.
9) Bondholders will start to care. Equity holders will start to care. They will – and then it all unravels.
10) Highly-publicized insider purchases are not a sign of support, in the case of Kinder Morgan, but an admission of vulnerability.
Kinder Morgan (KMI) is now a corporation (not an MLP), and tax implications aside, that means it should be valued like any other corporate: on the internally-generated (organic) future free cash flows it generates for its shareholders discounted back to today. The following analysis on KMI is separate and distinct from previously-publicized analyses from Barron’s and Hedgeye on Kinder Morgan Energy Partners, formerly trading under the ticker symbol, KMP. Our previous article on the topic was originally published here.
In business analysis, the most prevalent form of discounted cash-flow valuation analysis is the application of an enterprise free cash flow model, the framework we use at Valuentum to value all companies in our coverage universe. In all cases for non-financial operating companies, we calculate the present value of future free cash flows to the firm (FCFF) and then deduct the book value of a company’s debt, net of cash, from that sum to arrive at a firm’s equity value. We then divide equity value by weighted average diluted shares outstanding to calculate an intrinsic value estimate of a company’s shares.
In this widely-accepted process in both the academic and professional worlds, dividends are a symptom, an output, of the enterprise free cash flows that a company generates for all of its stakeholders–debt, equity and preferred, where applicable. Dividends are not a driver behind the valuation equation of a business for one very important reason: a company can artificially and unsustainably prop up a dividend via external financing activities, as in the case of raising debt or issuing equity, to achieve a payout that is completely detached from what its internal operations can feasibly support.
An enterprise free cash flow model values the operating assets of a business, not a company’s ability to engage in financial engineering to create a valuation construct around its dividend that is unrelated to its ongoing, underlying operational performance.
It is clear that Kinder Morgan cannot internally support its dividend, let alone increase it year after year. This is not a question, but a matter of reality at the company. The boards of most every corporation like Kinder Morgan, not MLPs, set their respective dividend policies on the basis of either a payout ratio of earnings and/or a target of free cash flow, as measured by cash flow from operations less capital expenditures. This makes sense because free cash flow is what’s left over to allocate to dividends, buybacks and/or acquisitions. In Kinder Morgan’s case, the company’s internally generated free cash flow was $850 million, $753 million, and $786 million in 2014, 2013, and 2012, respectively.
Is Kinder Morgan’s organic free cash flow stable? Yes. Is Kinder Morgan’s organic free cash flow consistently positive? Yes. Does Kinder Morgan have a great business model? Yes. But to the point: Is Kinder Morgan’s organic free cash flow insufficient? Absolutely 100% yes.
Based on the 2.159 billion weighted average shares outstanding at the end of the first quarter of 2015 and the company’s current $1.92 per share annualized dividend, Kinder Morgan will pay over $4.1 billion to shareholders in dividends this year alone. That’s more than 5 times what the company generated in internal free cash flow in each of the past three years from its own operations.
In being presented with such data, most management teams would come away with the view that perhaps they should ratchet back dividend “spending” and de-risk their cash-flow profile, but Kinder Morgan is instead plowing ahead with dividend increases! Management says it’s on track to meet its full-year dividend target of $2 per share, up from today’s levels, and even expects strong year-over-year growth for years after that.
Kinder Morgan seems to not care about its earnings, free cash flow, or leverage in setting dividend policy, unlike most every other operating company. And with “unlimited” access to capital whenever it wants it, or so it seems at the moment, and with arguably brazen confidence, management believes it can do just about anything it wants with its dividend growth plans, regardless of its actual consolidated financial statements.
But how long before the chickens come home to roost?
Before proceeding, we think it makes sense to address the ‘maintenance and growth capital’ question. To many, this is old news. To us and to shareholders, both matter. Both maintenance and growth capital spending are shareholder money that is used to support future cash flow from operations. In this regard, Kinder Morgan is no different than any other corporate: every company uses large amounts of capital each year to grow its cash-generating capabilities not just to replace their cash-generating capabilities. Every single company.
But we have to put to numbers this dynamic for each and every one of them. We cannot ignore growth capital for Kinder Morgan in its valuation equation. Not only is growth capital spending a cash outlay in the calculation of economic value estimation, a vital component of the investment merits of Kinder Morgan at an appropriate price, but the timing of such outlays are absolutely critical in estimating intrinsic value. A dollar spent today is worth significantly more than a dollar earned 20 years from now. The time value of money matters.
As is traditionally the case with corporates, the most a company can organically pay to shareholders as dividends each year is a function of its long-term free cash flow generation, not its long-term operating cash flow generation. The distinction between these two cash-flow measures is extremely important. For example, in looking through the lens of a dividend discount model within the context of business valuation, only organically-supported dividend payments should be used in the valuation process. A range of $750-$850 million of dividends each year, or an approximate of the amount of annual free cash flow generated during the previous three years, is a much more reasonable dividend input to ascribe to Kinder Morgan than its current pace of annual dividends of ~$4.1 billion. The difference between the ~$4.1 billion and the $750-$850 million range is textbook financial engineering, completely unrelated to the value of Kinder Morgan, itself.
If, for example, a brokerage house has a price target of ~$50 per share on shares and uses a dividend discount model to support the valuation, approximately 20% of the value, give or take, behind that price target ($850 million/$4.1 billion) corresponds to Kinder Morgan’s organic business, while the balance of the value behind the price target is supported via external financing activities. The dividend discount model should not be used to value businesses where earnings and free cash flow are completely and undeniably disconnected to the dividend payment. Kinder Morgan, a corporation (not an MLP), is expected to earn ~$0.90 per share this year and ~$1 per share next year, while paying ~$2 per share in annual dividends going forward. A large portion of Kinder Morgan’s equity value defended by a dividend discount model is fictitious.
We can understand why supporting and growing the dividend at all costs is everything to management when Wall Street is using dividend discount models to value its company. That doesn’t change the fact, however, that applying a dividend discount model on financially-engineered dividend payments is a mirage–which brings us to the next tangible point.
One of the dual and perhaps lesser-known benefits of the dividend discount model is that it seconds as a calculation of the present value of future cash dividend obligations. For example, the higher the “perceived” equity value that is supported by the dividend discount model, the more the present value of cash obligations the company has to shareholders, and by extension, the lower implicit credit quality of the organization, assuming a company continues to pay and increase its dividend irrespective of what the credit rating agencies say.
In any case, what matters most is not the absolute level of the debt on Kinder Morgan’s books, which is striking by itself, but whether Kinder Morgan can service all of its debt-like, cash obligations with its own organically-generated EBITDA, which pays no mind to capital spending in any form. Kinder Morgan currently has $42.8 billion in debt, net of cash, on the balance sheet, and implicitly, on the basis of the price targets of some brokerage houses that employ a dividend discount model, it has another ~$100 billion in “mandatory” obligations to shareholders in the form of dividends (though if you ask a shareholder, the dividend payment is as contractual as it gets).
We think that, as the credit rating agencies evaluate the firm’s die-hard commitment to shareholders and its unwavering backing of an explosive future dividend growth plan, the implied leverage of cash, debt-like commitments at Kinder Morgan should approach $140 billion. The company’s reported Debt-to-EBITDA is 5.8 times, already a consideration for junk-rated credit status, but its implied Debt-to-EBITDA is closer to 19 times ($140 billion/$7.35 billion) after factoring in all cash, debt-like commitments! The company is buried under cash, debt-like obligations.
No matter how much one likes Kinder Morgan’s reliable, toll-road-like business model, $140 billion in present-value, cash debt-like commitments is a lot to service with only $7.35 billion in annual adjusted EBITDA, a measure that ignores all forms of capital spending, as most would prefer to look at its business model. If we use the high-water-mark of free cash flow that Kinder Morgan generated during the past three years, it would take 50 years to pay off its tangible debt load on the books today, and that’s if it doesn’t pay one penny of free cash flow to shareholders as a dividend.
Bond holders should take note of the existing tangible leverage on the books and Kinder Morgan’s commitment to paying out more than 5 times its internally-generated free cash flow as dividends to shareholders, as it has done the past three years, coupled with management’s commitment to keep growing its cash dividend obligations to shareholders in coming years. Kinder Morgan’s track record may matter, but if it can’t cover all of its cash, debt-like obligations, it can’t. At the end of the first quarter of 2015, Kinder Morgan had just $259 million of cash on its books.
At an implied leverage of 19 times all cash, debt-like commitments, the credit rating agencies have a lot to think about. Kinder Morgan’s investment-grade credit rating is in part supported by the firm’s ability to access the equity markets to sell its own stock. But its share price is artificially propped up by the incorrect application of dividend discount models that are using financially-engineered dividends, which themselves are in part supported by the debt raised from an investment-grade credit rating, which is then used to keep raising debt and growing the dividend…and so on.
We don’t care much what you call it, “A Debt-Infused Stock Bubble” or some other name, but the situation isn’t sustainable in its current form. The “circular flow of unsubstantiated support” will last as long as the credit rating agencies and sell-side analyst community allow it to, and from implied levels of leverage to understanding the pitfalls of dividend discount models, the story will take some time to evolve and for others to figure out.
But does Kinder Morgan have a way out?
The first option for consideration would be for the board to scrap its dividend growth plans to reduce its level of implied leverage. But this may not matter. In cutting the dividend, the board would just reduce its firm value in the context of wrongly-applied dividend discount models, and this would then further reduce its attractiveness as a credit because the price in which it can raise equity to support its capital position would then be substantially reduced. In this event, the credit rating would likely face pressure anyway…thereby starting the spiral lower.
The above scenario also helps to reiterate the fragility and irrelevancy of the dividend discount modeling framework in Kinder Morgan’s case. In the above scenario, there would be no actual change to Kinder Morgan’s business operations at all, but the firm’s equity value, as measured by the dividend discount model, would plummet.
The second option for consideration would be for Kinder Morgan to start paying down its abnormally high levels of leverage with excess free cash flow, but then the company wouldn’t have any organically-derived free cash flow to allocate as dividends to shareholders at all. In this light, the financial engineering would become even more obvious, and the move in turn, would then force a decision on the company to cut its own dividend, which would then yet again hurt its “perceived” value in the eyes of those using a dividend discount model, thereby starting the spiral lower anyway.
From our perspective, management’s best option may be to raise as much equity capital as it can while the times are good. The company knows how important its equity price is to the “circular flow of unsubstantiated support” better than anyone, and from our perspective, that’s the predominant reason why insiders are buying back stock at present levels. From our vantage point, we don’t view the highly-publicized insider repurchases as a sign of confidence at all, but recognition that the company’s shares are incredibly vulnerable.
A fresh, unbiased voice is saying: “Your stock is trading at ~100 times the trailing 3-year average of free cash flow, ~40+ times forward earnings, the company has implied leverage of 19 times after considering all of your cash, debt-like commitments, and it has negligible cash on the books. Yet ‘everybody’ loves both your equity and your debt?” Clearly, something is wrong.
The credit rating agencies can keep giving Kinder Morgan investment-grade marks and the brokerage houses can keep valuing the company on financially-engineered dividends. But we’re certainly not sticking around! Frankly, we’re sleeping better at night knowing the company is no longer in the Dividend Growth portfolio. The low end of our enterprise free cash flow derived fair value estimate is $29 per share.
You can access our stock landing page on Kinder Morgan at the following link >> I can be reached at brian@valuentum.com, if you’d like to look at our enterprise discounted cash-flow model.
Image Sources: Roy Luck, Simon Cunningham, Images Money, Trading View. No alteration has been performed on the pictures.