Kinder Morgan released its 10-Q for the second quarter of 2015 on July 24.
The Corporation’s Dividend Continues to Be Financially-Engineered
The second-quarter 10-Q revealed that, through the first six months of 2015, free cash flow of ~$630 million, which consists of $2.54 billion in cash flow from operations less $1.91 billion in total capital expenditures, came up significantly short against the company’s total cash dividend outlays of $2 billion during the same six-month period. Said differently, traditional non-GAAP free cash flow less cash dividends paid has been -$1.37 billion, negative $1.37 billion, during the first six months of the year. During the first half of 2015, the company issued $2.56 billion in new shares and floated net debt of ~$544 million. Kinder Morgan, from our perspective, continues to pay cash dividends from new debt and equity issuance, and unlike most every other dividend paying corporation, is not generating traditional free cash flow in excess of its dividend payout. We’re reiterating our opinion that Kinder Morgan’s dividend is financially-engineered.
The Corporation’s Debt Should Be Rated as Junk Status Given Dividend Obligations
In the second-quarter 10-Q, Kinder Morgan revealed $41.4 billion in total long-term debt and $3.15 billion in short-term debt for a total debt load of ~$44.55 billion, which stands against a cash balance of $0.16 billion ($163 million) at the end of the second quarter.
Every quarter, Kinder Morgan pays out more in cash dividends than it generates on a traditional free cash flow basis. The company holds a total debt load that is approaching 6 times its adjusted EBITDA with negligible cash on the books. Kinder Morgan is not retaining any cash (cash from operations less cash from investing) to deleverage its business. Yet, the company garners an investment-grade rating from the rating agencies. Should the company issue new shares to fund growth, its cash dividend obligations will only increase, as the compounding dynamics of both a higher share count and a higher per-share payout take hold.
Though credit ratings are largely subjective and certainly are not dependent on one single metric, we maintain our view that Kinder Morgan’s debt is not of investment-grade quality. A Moody’s study, released December 2007, outlines a cross section of financial ratios most indicative of the rating category for global energy companies, including pipeline operators, based on most recent fiscal year-end data. Though we map Kinder Morgan’s reported 2014 results to a group of energy entities at the height of the pre-financial crisis period, we still believe such a comparison is useful in evaluating creditworthiness. When using a multi-variate approach, Kinder Morgan registers “junk” status for the vast majority of metrics. We believe Retained Cash Flow (RCF) to Net Debt is most informative of the risk debtholders bear with respect to the company’s ultra-aggressive dividend growth policy (source: Brian Nelson).
Source: Moody’s Financial Metrics™ Key Ratios by Rating and Industry for Global Non-Financial Corporations, December 2007, Kinder Morgan regulatory filings
Understanding the Valuation Absurdity at Kinder Morgan
Kinder Morgan is a corporation, not a master limited partnership. Within the global investment universe, there are corporations that bolster fantastic operating-cash-flow profiles and have true minimal capital-investment outlays for both maintenance and growth requirements. These entities can also have significant net cash positions. Whereas in the above example we compared Kinder Morgan to other energy-related entities, including pipeline operators, in assessing credit quality, below we compare Kinder Morgan to two cash-rich, capital-light entities for illustrative purposes within the equity valuation context. We assume Microsoft’s and Priceline’s total capital expenditures represent ‘sustaining’ capital outlays in the below example.
At ~17 times forecasted distributable cash flow for fiscal 2015, Kinder Morgan fetches a market cap-to-DCF multiple roughly in-line with fast-growing Priceline.com and asset-light Microsoft, even as Kinder Morgan holds a net debt position of ~$40 billion relative to the net cash position of the two comparable companies. In the case of Microsoft and Priceline, all capital expenditures were deducted in arriving at estimated distributable cash flows, while we use the “pure” measure of distributable cash flow in Kinder Morgan’s case, which completely ignores its massive growth capital outlays that propel net income (a component of distributable cash flow) and offers significant near-term cash tax benefits, the latter a dynamic that’s unsustainable over the long haul. What this analysis reveals is that, within the valuation context, Kinder Morgan is essentially getting a “free pass” on the billions it spends in growth capital, which we’ve embedded within the DCF calculations for Microsoft and Priceline but is not included in the Kinder Morgan measure.
From where we stand, Kinder Morgan’s equity valuation continues to be propped up by a financially-engineered dividend and a valuation paradigm that is wrongly supported by distributable cash flow, which ignores growth capital outlays. Our view is that Kinder Morgan’s dividend can only be supported by continued access to the equity markets and investment-grade capital, an assessment that we do not believe is warranted with the dividend intact at the present payout. Though it remains to be seen how long the “circular flow of unsubstantiated support” will continue, our discounted cash-flow-derived fair value estimate of $29 per share is unchanged following the 10-Q release.