In a sharp reversal from just a few days ago when Kinder Morgan (KMI) said it would generate sufficient “distributable cash flow” to fund dividend growth of 6%-10% in 2016, the executive team opted to cut its dividend December 8 by 75%, to $0.50 per share annually, a move that despite our best efforts has still managed to surprise the market, as evidenced by shares indicated down in after-hours trading. Though we plan to tweak our valuation model to account for the impact of recent acquisitive activity and the slide in energy resource pricing on Kinder Morgan’s intrinsic value, we’re reiterating the low end of our fair value estimate range at this time. We plan to update our 16-page valuation and dividend report on Kinder Morgan by 8am CST tomorrow.
There are a few lessons to take away from the recent dividend cut. First, entities that are capital-market dependent, meaning that they need access to both the equity and debt markets, have substantially higher risks to their dividend profile than other companies that have cash-rich balance sheets (sufficiently more cash and short-term investments than long- and short-term debt) and generate an excess in free cash flow, as measured by cash flow from operations less capital spending, above their expected cash dividends paid. Second, it is imperative to emphasize that with the recent craze of dividend growth investing across many corners of the web, executive teams have been using the dividend as a way to please investors like no time before in the history of the equity markets, in our view. In this light, it’s important to note that boards can do what they want with the dividend, until simply they can’t. Hard to believe today, but Kinder Morgan raised its dividend 16% as recently as October 21 – that’s less than two months ago.
We like to use the Dividend Cushion ratio, a forward-looking cash-flow-based liquidity and leverage metric, to ascertain a company’s dividend health and the degree of a company’s capital-market dependence. Such a financial metric helps add perspective around management’s plans for the dividend, as in most cases, investors may be flying blind, hanging on every word of the executive team for their income needs, instead of digging deep into the financial statements. The risk of putting too much emphasis on a historical track record is evident in Kinder Morgan’s case as it has been in every other case like it. Only by looking intensely at the future expected financials can investors truly gauge the capacity for dividend increases. Eventually, stretching too far to please income investors catches up with the executive team when conditions deteriorate. Be sure to read about the Dividend Cushion ratio here.
We’re maintaining our view that, while Kinder Morgan is not a master limited partnership, many across the MLP universe could face a similar fate. We believe Plains All American (PAA) is next in line to cut its distribution among the more heavily-followed midstream equities, and we would expect the credit rating agencies to eventually begin demanding more prudent and debt-friendly actions across several MLPs, particularly as crude oil price decks are updated and financial flexibility is reduced. On the basis of net debt to annualized adjusted EBITDA, we believe Energy Transfer Equity/Energy Transfer Partners (ETE/ETP) will likely see a credit downgrade deeper into junk before this cycle is over, but a dividend/distribution cut is equally likely.
In our piece, “3 Anomalies Across Pipeline Entities,” released August 11, the free cash flow shortfall relative to dividends/distributions paid for Energy Transfer Equity/Energy Transfer Partners was nearly 4 times greater than that of Kinder Morgan (-$4.7 billion versus -$1.38 billion). We find it somewhat puzzling that in late September Moody’s raised Energy Transfer Equity’s credit-rating Ba2 outlook to positive following its deal with Williams Companies (WMB), which in our view, was in as worse a shape as Kinder Morgan in terms of its free cash flow shortfall relative to cash dividends paid through the first half of the year. In light of the meager, yet meaningful, direct commodity exposure of Energy Transfer Equity’s collection of MLPs, their capital spending plans, and massive dividend obligations, bondholders at Energy Transfer Equity should be looking for more prudent capital allocation now rather than later. A dividend cut would provide that option.
Kinder Morgan is not the first midstream equity to cut its dividend, and it won’t be the last.