There’s one thing for sure about Valuentum: as a member, you get the truth, the whole truth, and nothing but the truth. That’s why our members love us! We’re completely independent and completely tied to your best financial interests. You know we’ve never been shy about outlining the risks related to MLPs – for one, you don’t have to look far to see this warning (source) on the front page of every one of their 16-page reports (at the bottom):
Firms in the oil and gas pipeline industry own or operate thousands of miles of pipelines and terminals—assets that are nearly impossible/uneconomical to replicate. Most companies act as a toll road and receive a fee for transporting natural gas, crude oil and other refined products (and generally avoid commodity price risk). Though there is much to like, most constituents operate as master limited partnerships and pay out hefty distributions that can stretch their balance sheets. Additional unit issuance (dilution) has become common, and capital-market dependence is a key risk. We’re neutral on the group.
The view that MLPs are inherently risky enterprises is not based on their operations, but instead is grounded on the riskiness of their business structure, which is always reliant on new capital. Bulls will say that this is just how MLPs operate (and they’re special entities to be evaluated differently), and some will even refuse to accept this view. But the reality is that the inherent riskiness and capital-market dependence of an MLP is a fact: the entity is dependent on new, incremental money for growth spending. This has always been the case, and the SEC and accounting boards have signed off on it. And since we (at Valuentum) lump maintenance and growth capital spending together in our discounted cash-flow process, we simply say that MLPs are dependent on the capital markets for their operations and survival. We don’t like the MLP structure any more than the next person, but we accept the abnormal risks related to it in the form of a significantly larger distribution payout than otherwise could be had under a general operating structure (as in a corporation).
In including any MLP in the Dividend Growth portfolio, we’re making a side bet that a company is not engaging in fraudulent activity (with the assumptions they make) and the MLP structure itself won’t be torn down by allegations that it is a Ponzi scheme – if it is, the SEC has approved a Ponzi scheme. Many have presented the case of Ponzi-scheme-like characteristics, but accountants (see here) and the SEC via Linn Energy (LINE) (see here) have reviewed the business model time and time again, and it has come up with no wrongdoing. So it comes down to this: as long as the market and the parent support an MLP’s distribution, it will be sustained. Accountants and the SEC have signed off on this structure, and our analysis has been forced to adapt to it. If the market flinches, a scenario such as that which happened to Boardwalk Pipeline (BWP) is within the range of probable outcomes. It is a risk that is inescapable for investors beholden to the large distributions of MLPs. It is also important to note that this isn’t an opinion of their respective business models; it is a fact. It is also NOT a new fact.
On the weekend of February 22-23, Barron’s ran an article titled: “Kinder Morgan: Trouble in the Pipelines?” We took a read of it, and it highlighted a large number of risks that many have been highlighting for some time. We don’t think these are new risks at all, and we have a difficult time grasping whether the market just did not know about these risks in the first place or just failed to accept them. We think the latter is the most likely case, as shares of Kinder Morgan Energy Partners (KMP) have been under significant pressure as of late.
Barron’s, in our opinion, with its article, is accusing the entity of fraudulent activity (making false sustaining capital expenditure assumptions). The SEC has simply not launched an investigation, and therefore, we have a hard time saying that anything has changed with respect to the entity. Linn Energy just went through this debacle of a public relations nightmare (see here). The Barron’s article has illustrated what we believe is supposedly commonly-known about an MLP’s business model: it is based on management assumptions and new, incremental capital – something we’ve been saying for a very long time.
Here’s some of the key components of the Barron’s piece (source).
A key issue is the way it calculates its distribution. Calculating payouts based on distributable cash flow is where the sausage-making occurs. The MLP’s calculation of DCF uses some aggressive assumptions about how much it takes to sustain some of the company’s businesses, particularly its oil-production division, which generates almost 20% of annual cash flow. Use more conservative assumptions, and DCF would be lower, and so likely would the distribution and the price of the MLP units.
To be clear, Barron’s isn’t questioning Kinder Morgan’s financial reporting based on generally accepted accounting principles. Distributable cash flow, however, is a non-GAAP measure that is calculated based on the MLP’s own financial assumptions.
Kinder Morgan MLP incurs significant capital expenditures to maintain and expand its energy infrastructure, spending a total of $3.3 billion last year and a projected $3.5 billion in 2014. Those expenditures fall into two buckets: sustaining, or maintenance, capital, and expansion, or growth, capital. The key difference between the two is that sustaining capital reduces distributable cash flow, while expansion capital does not.
Kinder Morgan’s expansion capital is almost entirely financed with new debt and equity from the MLP, making it vulnerable to higher interest rates and dislocations in the capital markets. Reflecting its ongoing needs, the Kinder Morgan MLP sold $540 million of equity at $78.32 last week.
One danger of the MLP industry: It’s valued primarily based on yield. When Boardwalk Pipeline Partners…recently slashed its distribution by 80% due to setbacks in its natural-gas-pipeline business, its shares collapsed by 46%.
MLPS TYPICALLY CALCULATE distributable cash flow by taking net income, adding depreciation, and then subtracting sustaining capital expenditures. What constitutes sustaining versus expansion capex is based on a “good faith” determination by the general partner, in this case Kinder Morgan Inc. That distinction, however, can create an incentive to minimize sustaining capital expenditures, which in turn maximizes DCF and results in a higher distribution to MLP investors and a higher annual incentive payment made to Kinder Morgan Inc.
Last year, the Kinder Morgan MLP’s sustaining capital expenditures of $327 million were just 10% of total capital expenditure of $3.3 billion. The sustaining capex in Kinder Morgan’s CO2 division, which is dominated by an oil-production operation that uses CO2 to extract crude from mature wells, was just $14 million last year; growth capex in that division was $676 million. But despite the heavy expansion capex in recent years, Kinder Morgan’s oil production is little changed since 2009. Last year’s modest production gain reflected an acquisition and a big boost in capital spending, which is expected to rise about 60% this year.
It’s difficult for us to make the case that management is purposely misleading investors with its maintenance capital expenditure assumptions in order to bolster the distribution. From our perspective, there could be a whole host of reasons why oil production did not increase in its CO2 division. Kinder Morgan explains that all of its estimates are squeaky-clean right here. The key point is management’s estimation of maintenance capital expenditures – firms raise growth capital and make poor growth decisions with it all the time. Barron’s has accused Kinder Morgan of fraud on the basis of it having excess growth capital spending – not on the basis that it has mis-estimated maintenance capital spending, which is the core of its own argument. Kinder Morgan’s management just raised its distribution (see here) and noted a favorable outlook for distribution growth in 2014 (targeting $5.58 per unit). During 2013, Kinder Morgan’s sustaining capital expenditures jumped 14.7%, to $327 million (as outlined in the Barron’s piece), and the entity revealed $22 million in excess distribution coverage for the year. We have no basis whatsoever to say that management is making up these numbers.
Absent fraud accusations (which, in our view, cannot be substantiated), the Barron’s article is nothing more than a re-hashing of the inherent risks related to MLP’s that we all know very well. However, if Kinder Morgan does come under attack and its unitholders suffer as a result, the SEC and the accounting firms are to blame, and the company and its unitholders should not suffer. We’ve made adjustments to our process to accept this business model and its inherent dependency on management assumptions and new capital. We’ve embraced the concept of an MLP, despite all of its shortcomings, and we don’t want unitholders to suffer because of them. If accounting firms and the SEC then change the game after we have reluctantly accepted the MLP structure in our valuation analysis and distribution forecasts, we’re going to cry foul. MLPs, if converted to corporations, would demand SIGNIFICANTLY lower valuations. We uncovered this on Day 1 of our initiation on the group.
Valuentum’s Take
We’re monitoring the MLP situation very closely. MLPs themselves don’t fit all that well into a discounted cash-flow valuation model (and we’ve made adjustments), and we’re starting to get a sense that the group may in some ways be exposed to the risks of a run-on-the bank mentality if new capital becomes cost-prohibitive in light of recent “news” (the recent Barron’s article). For example, it may not matter if Kinder Morgan is actually estimating maintenance capital expenditures correctly or not if the market doesn’t want to keep feeding the entity new capital. Kinder Morgan simply needs new capital to survive. The situation to us is more psychological than analytical, and from our standpoint, nothing has changed. However, perception is a dangerous thing, especially as it relates to companies that need constant injections of liquidity. We don’t have to look further than the Great Recession to understand the implications of a liquidity crisis.
We’ll reiterate our opinion: nothing has changed with respect to Kinder Morgan. However, if the capital markets deny the firm new capital (as in the case of a run-on-the-bank situation) or if the parent does (as in the case of Boardwalk), there could be a relatively nasty situation brewing. However, in order for this to happen, Kinder Morgan would have to be accused of accounting fraud by the SEC (misleading investors) and the MLP structure itself would have to come under attack by accounting firms and/or the SEC. We’re not sure that the likelihood of these events can even be estimated at this point.
If Kinder Morgan and its unitholders suffer, the accounting firms and the SEC are at fault for setting up a structure that is so dependent on management’s assumptions and incremental, new capital– not Kinder Morgan and its unitholders. We reiterate the importance of focusing on the fair value estimate ranges of any MLP in our coverage – not the fair value estimate itself. We expect to update our reports on firms in the ‘Oil and Gas’ pipeline industry very soon.
<< Read Kinder Morgan’s full response to Barron’s
* The Valuentum Dividend Cushion for master limited partnerships (MLPs) incorporates the cash proceeds of future equity issuance in the numerator of the calculation. This is unlike traditional operating firms, where capital market activity is excluded.
Related Firms: KMR, KMI, EPB