On January 20, Kinder Morgan (KMI) reported fourth-quarter results, and absent 1) a large goodwill impairment charge related to its core midstream natural gas assets, 2) a reduction to its estimate for backlog of future potential business, and 3) warning that further goodwill impairments are around the corner if energy resource pricing remains depressed, quarterly performance wasn’t all that bad (or at least not as bad as some had been expecting). Kinder Morgan had previously announced a 75% dividend cut and a very costly preferred equity issuance just a few weeks ago as it continues to work to get its financial house in order. Our $20 per share fair value estimate is unchanged at this time.
We’re starting to like what we’re hearing from management, and we again applaud the executive team because we think they understand the issues and are working toward a solution. On the conference call, the team made it very clear to investors that the dividend is not a driver behind the intrinsic valuation of equities, but that it is an output of the free cash flow generating capacity of the entity, or at least it should be. CFO Kim Dang: “I think there is very good financial theory that says whether a company pays a dividend or does not pay a dividend does not impact the value of the firm.” If financial advisors and individual investors learn anything from Kinder Morgan’s fourth-quarter report, it should be this very important observation. We continue to value Kinder Morgan in the context of an enterprise free cash flow model, which we believe is the best lens through which to evaluate equity value.
Importantly, organically-derived dividends, or those sourced from traditional free cash flow generation, or cash flow from operations less all capital spending and/or earnings, are a symptom of a strong company, not a driver behind it. You wouldn’t say, for example, that Apple (AAPL) has been one of the best performers in history because it initiated a dividend a few years ago, would you? Many may not remember that Apple had cut its dividend in 1995… Unlike organically-derived payouts that you would find at Apple or Microsoft (MSFT), for example, dividends that are financed in part from external capital, or from the financing section of the cash flow statement, have little bearing on the underlying valuation of the operating assets of the company, and therefore, should not be used within the valuation context. The dividend discount model is obsolete because it neither considers the net cash on the balance sheet, nor does it consider future enterprise free cash flow generation going forward.
That said, we continue to emphasize that there is a significant difference between traditional free cash flow generation and the industry’s definition of “cash flow.” These terms are not interchangeable. We define non-GAAP free cash flow as cash flow from operations less all capital spending, and we maintain our view that the industry’s definition of “cash flow” is severely imbalanced as it ignores the very growth capital spending that is used to propel net income, which itself is included in the industry’s “cash flow” definition. Within any valuation context, the timing of cash inflows and outflows matters, and large growth capital outlays in the near term weigh on intrinsic worth (while rising interest rates challenge the NPV equation in long duration cash flow streams). Under valuation approaches that incorporate the industry’s definition of “cash flow” or a financially-engineered dividend, not only are growth capital outlays ignored, but the timing of such capital outlays aren’t even a consideration of the analysis. Growth capital is shareholder capital, and it should be factored into the analysis appropriately within the valuation context.
We continue to await the release of Kinder Morgan’s 10-Q, which includes critical and additional information than the data included in the press release, not the least of which is GAAP cash flow from operations. We’ll make due with what we have for now. Using net income plus DD&A as a proxy for cash flow from operations, absent working capital shifts during the period, cash flow from operations came in at ~$4.3 billion for the year, based on our estimates. Management noted that growth capital spending in 2015 came in at ~$3.4 billion, and when added to the ~$565 million in sustaining capital spending, gets to ~$3.9 billion in all organic capital spending (excluding acquisitions) for the full year. Until we receive the 10-Q, our estimate is that Kinder Morgan pulled in roughly $400 million in traditional free cash flow during the year, as measured by cash flow from operations (~$4.3 billion) less all capital spending ($3.9 billion). This compares to ~$1.2 billion in future annual dividend obligations on the basis of its $0.50 per share payout on 2.236 billion shares, still implying an organic shortfall, to the tune of ~$800 million.
We posit that this shortfall is why management opted to cut future capital spending by $900 million to help close the gap for 2016 and provide some free-cash-flow cushion for the year. We applaud the executive team for a much more conservative and balanced approach to capital management, and we believe that, absent any exogenous shocks in the energy markets (key customer bankruptcies, ongoing collapse in energy resource pricing, etc), traditional free cash flow generation may very well be sufficient to cover the company’s substantially reduced payout during 2016, suggesting that revolving-door trips to the equity and debt markets may be temporarily on hold. Though this is great, management is not leaving much, if any at all, for debt repayment. Backing out impairment “charges” and losses on goodwill “impairments,” nearly $1.9 billion in total destroyed shareholder capital, operating income for the full-year came in at $4.5 billion, a modest bump versus last year’s mark. However, we’re awaiting more clarity about what’s included in those charges, and whether we should be completely backing them out for comparison purposes. Was the fourth-quarter the big bath?
In any case, adding the adjusted operating income of $4.5 billion to full-year DD&A of $2.3 billion, Kinder Morgan’s reported, adjusted annual EBITDA was $6.8 billion for the full-year. Bear in mind, the $6.8 billion number backs out nearly $1.9 billion of shareholder losses in the form of “charges” that we’ve analytically pulled below the line. The number differs materially from management’s annual mark of ~$7.37 billion disclosed in the press release, which we believe excludes very important and tangible costs backed out from the company’s actual, reported income statement provided in its regulatory filings. Though we encourage analysts to evaluate the 10-Q for reported debt figures when it is released, debt, net of cash, stood at $41.2 billion at the end of the year. On the basis of our estimate adjusted EBITDA directly from the income statement, that’s good for a net-debt-to-equity mark (or leverage) north of 6 times. Should a corporate, not an MLP, that may not generate any incremental free cash flow for debt repayment (after dividends) be an investment-grade entity leveraged at 6 times?
Furthermore, Kinder Morgan remains exposed to changes in commodity prices, noting key sensitivities in its press release, which may have been less than what many were expecting (perhaps the impairment charges helped out here as well?) — $7 million in earnings per a $1 change in per-barrel crude oil prices and $1.2 million in earnings per a 0.10 MMBtu change in natural gas. Management is targeting a crude oil price environment of $38 per barrel in 2016 and an average Henry Hub natural gas price of $2.50 per MMBtu. As with Energy Transfer Equity (ETE), the executive team prefers to keep its customer composition tight to the chest, and we posit that there are skeletons in its closet, though perhaps not to the tune of Chesapeake (CHK) and implications on Plains All American (PAA) and Williams Partners (WPZ); we continue to emphasize that the financial health of upstream entities remains critical to the financial health of their midstream counterparts. Kinder Morgan reduced its backlog to the tune of over $3 billion from an estimate just three short months ago and telegraphed that many future opportunities, previously of adequate return, have fallen to the wayside, implying further reductions in total backlog. The environment remains difficult.
All in, what a difference a few short quarters make. Though we don’t yet have the 10-Q in our hands, in our view, Kinder Morgan is in much better shape of covering its dividend in 2016 with traditional free cash flow, as measured by cash flow from operations less all capital spending, and the firm’s share price is no longer beholden to an artificial dividend-growth “pricing” paradigm perpetuated by the use of dividend growth models on financially-engineered payouts. We continue to expect other midstream equities to follow Kinder Morgan’s lead in more conservatively managing their capital allocation decisions, and that may mean further distribution cuts across the MLP space to come. Kinder Morgan’s shares are rallying on this news, and other executive teams are watching. Our fair value estimate for Kinder Morgan remains unchanged at $20 per share. We would expect the credit rating agencies to negatively reevaluate Kinder Morgan’s credit outlook in the event the dividend is increased or share buybacks are pursued anytime soon, especially without support from the capital markets, which may not be had unless energy resource pricing recovers materially.