Image Source: Benson Kua
By The Valuentum Team
Kinder Morgan is on its way to righting its debt problems, and we love it!
When the US government seemingly raises the so-called debt ceiling every few months, how can the public view towards massive leverage and effectively being unable to repay future obligations without making significant changes hold a stigma? In many ways, it has now become “okay” to be buried under mountains of debt. Is it now the norm? Each citizen in the US, for example, owns a piece of its country’s $19.3 trillion national debt, amounting to a whopping $60,000 per person, and this number is growing. That means that each new baby born in America is saddled with $60,000 in debt at the very moment life begins. It’s sad.
But even if this alone is not a big enough national crisis, most Americans have found a way to the debt punch bowl anyway, whether it be of the credit card or auto-load variety, or even the more sanguine mortgage and student-loan burden, the latter of significant political concern, “Debt, Debt and More Debt (April 2016).” How therefore can Americans point fingers at corporates or master limited partnerships (MLP) and real estate investment trusts (REITs) that are beholden to issuing more and more capital, taking on more and more debt, and then spending excessively when it comes to paying out massive cash distributions, when their own fiscal house is not in order? Excessive risk-taking and the “quick buck,” after all, have become a part of American society, at least if the housing crisis of late last decade is any indication. In this day and age, can Americans truly decipher what acceptable levels of leverage are?
Valuentum published a recent piece showing the reported net-debt-to-EBITDA figures in the energy master limited partnership arena recently, and the leverage levels continue to be striking, “Distributing Truth on MLPs (July 2016).” Kinder Morgan (KMI) and Energy Transfer Equity (ETE) ended 2015 with net debt positions of ~$43 billion and $36 billion, reflecting reported leverage of ~6+ and 7+ times, respectively. Though no single metric such as net-debt-to-EBITDA can judge credit quality by itself, generally speaking, to earn investment-grade marks in most cases across the global credit universe, an entity’s reported debt-to-EBITDA ratio is generally below 2 (that’s 2 — and generally for strong companies with solid free cash flow in excess of cash dividends paid). For most MLPs, retained cash flow measures (or the percentage of cash flow generation an MLP “retains” after paying distributions relative to its net debt position) reveal that credit quality is very poor, at best.
In this light, we maintain that the little “blip,” which most described as a “sky is falling scenario,” that we witnessed with respect to energy MLPs (AMLP) in 2014-2015 will be nothing compared to a true crisis that we believe has only been delayed, not canceled. Market participants have become so used to more and more capital, more and more debt, that they think this is a normal way of doing business — taking out massive leverage, paying out cash distributions in excess of what is generated in operating cash flow less organic maintenance and growth investment. Successful businesses aren’t walking the equivalent of financial tightropes. In many ways, it’s a crisis of understanding as much as it is a debt crisis. Can investors truly be blamed though? After all, look at what they are being fed on television, for example.
You may have heard of the American reality television series, Shark Tank, which paints entrepreneurs as “winners” when they land a “capital raise” from Mark Cuban or Kevin O’ Leary or Barbara Corcoran or any one of the other stars on the show. Entrepreneurship is not about raising a bunch of capital — or taking out a bunch of debt. In fact, there’s really nothing entrepreneurial about that at all. Trust me — anyone can give away a bigger piece of their company in an equity stake or take on more debt and/or royalty payments (future cash obligations). It’s about what you do with that capital that matters. You’ll note the capital-raise cycle is what MLPs and REITs (VNQ) specialize in–these structures issue more and more equity, diluting existing shareholders, and layer on more and more debt because they retain negligible cash flow. Even one of our favorite REITs, Public Storage (PSA) recently changed its long-standing policy of avoiding corporate debt. Everyone these days is getting drunk off the debt punch bowl!
Now that said, at least one company is starting to sober up: Kinder Morgan. After it stretched too far when it consolidated its risky MLP structure, the company took on a whopping amount of debt, which became a big factor behind its recent dividend cut. On July 10, however, Kinder Morgan announced a deal with Southern Co (SO) where it sold a 50% stake in the 7,600-mile Southern Natural Gas pipeline system, receiving proceeds of $1.47 billion, which could be used to help pay down debt, and dare we say, pave the way for the company’s dividend to return to expansion. Though Kinder Morgan and the credit rating agencies make a variety of adjustments when arriving at a representation of leverage, Kinder Morgan CFO Kimberly Dang has suggested that leverage could fall to 5.3 by the end of 2016, below the company’s previous target of 5.5. Kinder Morgan continues to work to get its financial house in order, and we love it!
On January 21, 2016, Barron’s profiled the work of Valuentum’s President Brian Nelson on Kinder Morgan and his call that the company could rally 44% higher from the mark of nearly six months ago. With shares of Kinder Morgan now at ~$20 each, Mr. Nelson’s target at the time, it looks like his upside call on Kinder Morgan has largely played out, too. If you remember, Mr. Nelson called the collapse in Kinder Morgan’s shares in June 2015 when they were exchanging hands at ~$40 each. Let’s revisit what Barron’s wrote about Valuentum’s bullish call on Kinder Morgan in January of this year (source):
Brian Nelson…who generated scorn from Kinder fans for turning bearish on the stock in a much-discussed … piece Thursday that is quite positive.
“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,” he writes. “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.”
Last June, this column generated a slew of negative reader reaction for citing a piece by Nelson, the president of Valuentum Securities, who stated the ”five reasons why we think Kinder Morgan’s shares will collapse.” …
… In June, Nelson wrote that “Kinder Morgan may turn into one of the worst-performing companies this year and into 2016,” adding that he was removing the stock from his firm’s Dividend Growth portfolio.
When Nelson slammed the stock, it was trading at $40. In the following months, it fell 70% to yesterday’s close of $12.01 following a drop in oil prices that Kinder bulls said wouldn’t seriously hurt a midstream energy player.
In December, the company did something the fans said was not going to happen; it slashed its dividend, by a whopping 75%. Barron’s followed that news with a piece that remained skeptical about the stock.
Nelson’s timing in June was impeccable, given how far the stock fell in subsequent months. One could argue that his latest piece is a little slow off the blocks, given that the stock has had a nice run already on the latest earnings results.
But the Nelson piece, which is quite detailed in its financial analysis and measured in its praise, suggests that more good news could be in store for the company and stock. He writes that the stock’s fair value, based on his analysis, is $20 a share, a full 44% higher than it is trading at now.
Coming from Nelson, a knowledgeable student of the stock and an investor who has shown a willingness to bet in both directions — and who has largely been proved correct — that carries some weight.
We continue to include shares of Kinder Morgan in the Best Ideas Newsletter portfolio. We trust you continue to enjoy our work at Valuentum. If you want more of Mr. Nelson’s thoughts every month, please consider the Nelson Exclusive here (limited availability). Thank you for reading!