Image Source: Kurtis Garbutt
By Brian Nelson, CFA
Skeptics: Kinder Morgan’s (KMI) fundamentals are the reason why the stock has cratered from $45 per share to under $20. Many investors that failed to pay attention to the financials continue to be in disbelief, looking for a scapegoat for their miscue. There’s never a good reason to be stubborn when it comes to investing. The very best quality any analyst can have is the ability to change one’s mind. I’ve taught this religiously for years, but why do many even seasoned investors have a difficult time admitting that they’ve been wrong? It’s only human nature.
Let me explain what’s going on with Kinder Morgan. We first have to start with what equity investors have to overcome in order for them to have any value at all. Said differently, the present value of its future enterprise free cash flows must be in excess of its net debt, which stood at $41.56 billion at the end of the first quarter of 2016, up modestly from levels in 2015. We reiterate that the midstream energy industry’s measure of distributable cash flow is a misnomer, and we pay no attention to the metric. Here’s what you need to pay attention to: operating income fell to $816 million from $1.08 billion, while income before income taxes fell to ~$470 million from $643 million in the quarter, declines of 24% and 27%, respectively. Even the company’s self-proclaimed total segment EBDA dropped materially in the period.
Kinder Morgan’s share price declined not because we surfaced the obvious in compelling format, but the company’s fundamentals have warranted such a decline, particularly in light of the company’s prudent decision to forego some dividend payments to prevent a serious adverse scenario in light of what was a growing probability of the market shutting down access to incremental capital. What many investors also came to realize was that in no way, shape or form were Kinder Morgan’s cash flows immune to commodity-price changes. The profit declines that we witnessed in the most recently-reported quarter alone speak to a firm that remains heavily tied to the vicissitudes of the commodity price cycle. That Kinder Morgan’s backlog of new projects has dwindled to $14.2 billion at the end of the first quarter 2016 from $18.2 billion at the end of the fourth quarter 2015 was only to be expected in light of collapsing energy markets.
We’re not sure what other analysts or investors were looking at, but it was certainly a frightening proposition to find out that very few investors, even seasoned ones, know how to calculate traditional free cash flow or how to think about valuation. How can this be? Personally, I was shocked, and even as recent as this week, some seem to not understand that our research is designed to be far ahead of the pack, not a repeat of what others are saying or a regurgitation of management’s investor relations slide deck. We’re actually doing our own independent research and analysis – and I believe we’re doing it at the highest level possible, if our call on Kinder Morgan is any yardstick.
Part of being a good investor is knowing that price is the primary consideration behind the investment opportunity. After we absolutely pounded the table saying Kinder Morgan was overpriced at $40 per share, we said the opposite in the following January 2016 Barron’s piece, “Is Kinder Morgan on Road to Recovery?” Frankly, we called the collapse in energy, and we’ve been participating on the rebound. Those that aren’t following along may misinterpret what we’re doing because they may only know buy and hold, and we can’t do anything about that. We can only do a fantastic job. Buy and hold is not always the answer. It is possible to pinpoint exit and entry points. We do it all the time, and Kinder Morgan is only the latest high-profile example. We continue to be well into the black with the new position in Kinder Morgan in the Best Ideas Newsletter portfolio.
Please always keep an open mind. I’ve trained hundreds of analysts across three continents. It’s often the ones that already know everything that seem to make the most mistakes. Why is that? I wonder if these are also the individuals that are still trying to find a way for us to be wrong about Kinder Morgan or the midstream MLPs. How correct does one have to be to be correct? Perhaps a read of Shakespeare might have the answer to all of human nature’s shortcomings. Aye, there’s the rub.