Valuentum Exclusive Analysis for the Discerning Investor

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Question: Valuentum's latest note on Kinder Morgan (KMI) hinted the company's situation is improving, even though its ratings are weaker than Enterprise Products Partners' (EPD). Would you please compare these companies? Is Valuentum saying Kinder Morgan is a better bet than Enterprise Products Partners because Kinder Morgan is a corporation and not an master limited partnership?

By Brian Nelson, CFA

Answer: Thanks for the note and your question. It's often difficult for us to compare and contrast two companies that are very net debt heavy as we tend to be very debt averse in the first place.

That said, there are a few things that we look at with respect to Kinder Morgan versus Energy Products Partners, for example. First, we think both are effectively fairly valued on the basis of our fair value estimate range at the time of this writing, perhaps each may be a nudge undervalued (but still within the fair value range). Both register relatively low ratings on the Valuentum Buying Index of 3. These would be the first two items we'd look at. Are shares undervalued? And then -- are shares timely for consideration?

Your question may be referring to the Dividend Cushion ratio, and it comes up a lot. Master limited partnerships (MLP), in our view, are beholden to new debt and equity issuance, in our view, meaning that generally speaking their traditional free cash flow (cash flow from operations less all capital spending) is less than the cash distributions they pay. This poor FCF-to-distributions paid relationship is what we often refer to with respect to MLPs.

In Kinder Morgan's case, while there is still long-term risk to the dividend (even at current depressed levels) given its massive net debt position, traditional free cash flow generation relative to dividends paid is better than that at Enterprise Products Partners. Through the six months of 2017, Enterprise Products Partners generated $2.3 billion in net cash from operations and spent $1.1 billion in capex, good for ~$1.2 billion in free cash flow. Over the same time, Enterprise Products Partners paid out $1.8 billion in cash distributions, amounting to paying out more than it generated in free cash flow. Kinder Morgan, on the other hand, did not pay out more in dividends than free cash flow during the same time period.

EPD source, page 5 here. 

But why the seemingly counter-intuitive Dividend Cushion ratios between the two? Why is Enterprise Products Partners' higher than Kinder Morgan's, all else equal. Well, from our standpoint, the market (somehow -- rightly or wrongly) seems to be comfortable continuing to fund MLPs with new equity and debt capital, despite the poor FCF-to-dividends paid relationship. To consider the ongoing market dynamics, whether we think reasonable or not, is why we tend to use two different Dividend Cushion ratios, one unadjusted ratio (as used for corporates) and one adjusted ratio that we use for REITs and MLPs (which gives these entities credit, fair or not, for future equity capital issuances--in the numerator). Said differently, we like Kinder Morgan's free-cash-flow-to-dividends-paid relationship better than Enterprise Products Partners', but Enterprise Products Partners' ability to continue to raise new capital to fund free-cash-flow shortfalls is captured in its adjusted Dividend Cushion ratio. Kinder Morgan's Dividend Cushion ratio is unadjusted because it is a corporate (so no external capital assistance is captured in our methodology), while Enterprise Products Partners' ratio is adjusted on the basis of our methodology--because it is an MLP.

Given MLPs' generally poor FCF-to-distributions paid relationships, we think a lot of the MLPs, despite possessing fantastic assets, as well as their payouts to unitholders continue to be supported by external capital. Once credit tightens, things may turn for the worse. In times of good credit, like today, we may point to the more favorable adjusted Dividend Cushion ratio for MLPs, while in times of poor credit, we may point to the less favorable unadjusted Dividend Cushion ratio for MLPs. That's our sentiment with respect to MLPs -- their financial health (and arguably the resilience of their equity prices) largely depends on their access to the capital markets. As you can probably tell, we're not fans of MLPs or debt-heavy companies at all, and the analytics behind them become more and more art (in estimating whether they will have capital access) than science because of their poor FCF-to-distributions paid relationships.

Here is more information on the adjusted and unadjusted Dividend Cushions and why we use them:

Q&A: https://www.valuentum.com/articles/20151113_1

Podcast: https://www.valuentum.com/articles/20161026

Please let us know if we can elaborate further, and please always contact your personal financial advisor to determine if any idea may be right for you. Valuentum is a publishing company. Many thanks for your membership!

Read more about the Valuentum Buying Index rating system, "Value and Momentum Within Stocks, Too."

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