Valuentum’s President Brian Nelson’s concerns regarding the master limited partnership business model became mainstream in June of this year. In his piece, “5 Reasons Why We Think Kinder Morgan’s Shares Will Collapse,” an article that itself may go down in history as one of the most timely pieces of research ever written–in light of Kinder Morgan’s (KMI) eventual collapse–Mr. Nelson said of the MLP space at that time:
Most, if not all, MLPs report distributable cash flow (DCF), which does not in the calculation consider growth capex, an important driver behind the generation of increased cash flow from operations in the future. When MLPs report distribution coverage ratios, this particular calculation also backs out growth capex from the equation, instead using only ‘sustaining capital expenditures.’
There are a number of contractual reasons why the data is presented in such a way, but from a valuation standpoint, we’ve always taken an issue with the MLP universe being implicitly valued on a future distributable cash flow stream that “covers” the distribution than on future free operating cash flow, which is a better measure of the free operating cash flow that a business generates.
The reason why free operating cash flow is more informative is quite straightforward. Distributable cash flow does not deduct the investment associated with driving future growth in an MLP’s cash flow from operations. Said differently, it’s like getting a free pass on all of the future growth spending that is required to drive incremental cash flow from operations, a severe imbalance in the valuation equation.
In valuing MLPs, we’ve circumvented the valuation imbalance by making the universal assumption that MLPs will continue to have access to the capital markets and that they will be able to issue equity and/or debt in such a way that is not value-destructive. Said differently, in our valuation models, we give MLPs credit for the future growth in cash flow from operations without deducting the growth capex that is required to drive it. We disclose this dynamic in every one of our 16-page reports within the MLP space.
Though Valuentum has long warned about the significant risks related to the master limited partnership model, we recently reiterated our views that the risks to the downside for most MLPs were considerable, especially as their cost of capital is ratcheted higher and as credit quality deteriorates. In particular, Valuentum outlined the following dynamic in its early November piece, “Update: A 10% Cost of Capital for Midstream Equities Is Reality:”
That the recent convertible preferred issue (which will turn into equity) was priced at $49, below the $50 face value, suggests the marginal cost of capital for Kinder Morgan (or the effective yield) is close to ~12% {[9.75% + (1/50)] = 11.75%}. We’re not sure how a near-12% cost of capital float was more appealing than the cost of equity capital today, but if it is, the very thought that the marginal costs of borrowing debt or floating pure equity are greater than 12% for midstream equities is near frightening.
…we think the implications on the master limited partnership arena are even more dire. As we had outlined in this chart here, we believe investors continue to “price” equity in the MLP space (AMLP) on the basis of a “mid- to- high-single-digit” yield-equivalent on their distributions, a function of the industry’s definition of “distributable cash flow,” which we have noted our objections to in the past. We think all midstream corporates should disclose non-GAAP free cash flow, as defined as cash flow from operations less all capital spending.
In the event, however, that MLP distributions are “valued” on a 10%+ discount rate, unit prices on MLP equities would tumble. There’s more downside risk to the prices of units across the MLP space, in our view, but we’ve been rather surprised by the magnitude of the bounce in recent weeks.
Perhaps equally important, in early November, Valuentum outlined that the MLP business model itself is being shunned by industry insiders and listed several examples, supporting the view that the business model itself may not make it to the other side of this energy downdraft:
On a fundamental basis, executive teams and investors alike continue to cast a cautious eye on the MLP business model. Kinder Morgan’s August 2014 actions to reconsolidate its master limited partnership (AMLP) structure under one umbrella may have marked the beginning of a trend that could proliferate in coming years. In May 2015, Williams Co (WMB) announced plans to buy up its master limited partnership Williams Partners (WPZ), and more recently Williams Co and Energy Transfer Equity (ETE) released plans to combine. Just today, there were two more significant events: Targa Resources (TRGP) announced that it would scoop up MLP Targa Resources Partners (NGLS), and Sempra Energy (SRE) announced that it won’t form a master-limited-partnership as the market sours on the business model.
…concerns by executive teams that they won’t be able to synthetically create equity market capitalization (not value) through the formation of standalone, publicly-traded yield-sensitive vehicles to take advantage of an ultra-low-interest rate environment may continue for the foreseeable future, in our view. The threat of rising interest rates on the “pricing” of MLPs, for one, lessens the attractiveness of these vehicles for investors “pricing” them on a yield basis versus other alternatives. The threat of rising interest rates on the “valuation” of MLPs offers a higher cost of capital used within any intrinsic value estimation framework, even multiple analyses. In the former scenario, the “risky” yields of MLPs (any asset that is not riskless is risky) become less attractive to the yields on “risk-free” assets (such as Treasury bills) as interest rates rise, while long duration cash flows are worth less in a rising interest rate environment under the latter valuation scenario.
Valuentum has frequently warned about the fragility of the ‘valuation’ framework supporting MLPs and how theoretically any company with the backing of a strong credit rating could synthetically and artificially create market capitalization, but not generate any real tangible value in doing so. Here’s what we said in “Understanding Your MLP’s Financially-Engineered Equity Value” several months ago:
The primary goal of this piece…is to reveal how warped the financial engineering has become with respect to MLPs, especially in the context of the “valuations” placed on them. When one sees how easily other corporates such as Apple (AAPL), Microsoft (MSFT), Cisco (CSCO), or Qualcomm (QCOM) or any other entity with excess cash and a strong credit rating can create a shell conduit that is priced on a contractual pass-through to shareholders, or the substance of the distribution pass-through to unitholders of an MLP, for example, either one of two things may happen: 1) every capable company will or should create cash-flow-backed shell companies to artificially generate value at the parent, consequences unknown or 2) the MLP business model will be restrained, or dissolved in time.
In the example to follow, we’ll show how an investment-grade company, with essentially no investment or ongoing commitment at all, can generate $120 billion in incremental equity value, to the tune of the equivalent of the entire enterprise value of Kinder Morgan, at the time the example was originally developed. To keep reading this breakthrough piece >>
Barron’s reiterated Mr. Nelson’s work, “Why the MLP Business Model May Be a Goner,” just a few short months ago. We believe the master limited partnership model is still at significant risk.
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