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December 11, 2015 – Comments (3) | RELATED TICKERS: BIP , KMI

Board: SAS: Kinder Morgan

Author: TMFTortoise

Hi everyone,

This is the text of the article that has been published today. I just checked and it was published about 2:15 pm today. My plan had always been to post it here, as well, where many of you most interested in the company are sharing information.

If you have any questions, I'll be happy to answer them to the best of my ability.

Cheers,
Jim


As you all know, pipeline operator Kinder Morgan’s (NYSE: KMI) had a very bad time of it last week, falling 29.5%, ending at $16.82 per share. Earlier this week, it continued downward, closing Tuesday night at $15.72 (making the seven-day drop total 34.1%) before rebounding by 6.9% on Wednesday.

Last Friday saw the biggest single-day drop in that period, with shares falling from $19.26 to $16.82, a drop of 12.7%. Unfortunately, the 10% Promise article did not appear until Monday due to an unfortunate timing issue. The speed of the drop and the explosion of activity on the Kinder Morgan discussion board also caught me by surprise and, as I wrote here, I didn’t realize what had happened until much of it had happened. I apologize for this.

This article has several parts. First, I’ll present my view of the company and its operating prospects. Second, I’ll discuss the factors contributing to the drop in the share price. Third, I’ll review the company’s decision to cut the dividend by 75% and how that relates to the company’s future options. Finally, I’ll discuss how the rapid drop in price appears to have affected you, our members, and what can be done about that.

This is a long article, so grab a drink and relax as you read on.

Kinder Morgan and Operations

The company has over 69,000 miles of natural gas pipeline and transports roughly 1/3 of all natural gas moved around the U.S. It is also involved in transporting carbon dioxide which is used for enhanced oil recovery (basically pumping CO2 into the well to push more oil out). In addition, it produces some oil and gas itself and, finally, is involved in the storage of various commodities such as natural gas, oil, and coal. It’s primary business, however, is the movement of natural gas.

I do not believe that the business itself is in danger, for a couple of reasons.

First, natural gas demand is climbing. According to the U.S. Energy Information Administration, total natural gas consumption has increased from 71.66 billion cubic feet per day in 2013 to 76.49 Bcf/d this year, an increase of 6.7% in just two years. The largest part of that increase has come from the energy sector, specifically electricity generation. Since 1997, natural gas used in electricity generation has more than doubled, from 4.06 Bcf to 8.15 Bcf last year, and the upward trend has continued this year.

Beyond just the increasing level of use in the U.S., export of natural gas is expected to climb. According to market researcher Wood Mackenzie, net exports of natural gas to Mexico are expected to increase by 1.7 Bcf/d and of liquefied natural gas by 7.9 Bcf/d.

Second, the majority of the company’s cash flows are from either take-or-pay contracts (64% of 2015’s expected budget) or from fee-based contracts (22% of budget). While the former is a fixed rate contract where the customer must pay whether the pipeline is used or not, the latter is based on volume used. However, the company says that these are for stable volumes, stable end-user demand, and critical infrastructure between major supply hubs. In other words, these, too, should be quite stable in their cash flows to Kinder Morgan.

Tying into both of the above, over the last two years, the company has obtained contracts for an additional 9.1 Bcf/d of natural gas transportation, which is about 12% of the estimated total 2015 U.S. demand. No, what it does is still very much in demand and it’s highly unlikely, in my opinion, to go bankrupt.

The company grows by building or buying pipelines, as well as expanding the capacity of existing pipelines. For this, it uses funds raised from issuing equity (shares) or issuing debt. I recall (and another Fool analyst also recalls reading this) that the company uses the expected cash flows of the new or expected pipelines to secure the debt funding, but could find no confirmation at this time. One item of its policy I like is that it doesn’t add a project to its backlog until it either has a contract or is in an advanced stage of negotiations for a contract. In other words, it doesn’t build something unless it has a user all lined up.

There has been concern expressed about what happens if the customers in those contracts go bankrupt. This is a risk called out in the annual 10-K. I do not know how great a risk this poses as I don’t know who all of its customers are nor their financial health. However, a couple of items found by me and others leads me to believe that bankruptcy of a customer is not an all or nothing proposition for Kinder Morgan. There’s one non-binding legal opinion I read that the bankrupt company would be required to continue payments while it was undergoing reorganization. In addition, I found a Fifth Circuit Court of Appeals ruling from 12/31/2013 on a case in Texas that leads me to believe that it would not be particularly easy to break one of the contracts should a customer going through bankruptcy try. However, this is a risk.

While the company is not directly tied to the price of oil and gas (it has stated “We believe the market has not adequately distinguished between us and other energy companies”), it does have some exposure, largely through its CO2 business. Specifically, the distributable cash flow (DCF) from which it pays the dividend goes down by $10 million for every dollar drop in the price of crude oil and down by $3 million for every 10-cent drop in the price of natural gas. When the company set its 2015 budget for expected DCF, it used $70/bbl WTI crude as the price of oil and $3.80/MMBtu Henry Hub as the price of natural gas.

What’s Been Driving the Share Price Down?

The concern that outside analysts and investors (I’ll lump these together as “the market”) have had, however, is that there are four competing uses of the cash flow the company generates. First, it pays a dividend which, prior to Tuesday evening’s announcement, had used the vast majority of the company’s cash flow. Second, it needs to pay for the construction of the projects in its backlog in order to fulfill the new contracts and to grow. In addition, it makes acquisitions and that requires cash as well. Finally, it must pay the interest on its debt and be able to roll the debt and/or pay it off as it comes due.

On top of this was the promise by founder and executive chairman Richard Kinder that after converting from an MLP structure to a C-corporation structure in Nov. 2014, that the company would be able to continue raising its dividend by “approximately 10% each year from 2015 through 2020,” as stated in the Aug. 2014 press release announcing the deal. In addition, it would have the flexibility and the power (and the stock price) to make accretive acquisitions. While ambitious, the plan was apparently to run the new corporation in the same manner as the previous organization – pay a healthy and growing dividend, issue shares and debt to acquire or build or expand cash-generating assets.

The bloom came off the rose, however, when oil prices, after having risen to $60/bbl in the spring, started falling again last summer to the under $40/bbl level they are at today. Kinder Morgan’s share price started falling at about the same time, from the $40 level it had hovered around since the MLP conversion to under $30 earlier this fall and to the $20 level by Thanksgiving.

When the company reported second quarter earnings in July, the 10% annual dividend growth rate pledge was reiterated. However, that changed when Q3 earnings were released. Here, the promise was rolled back to 6% to 10% dividend growth for 2016. The markets did not take that well. When investors are told that an expected dividend policy is changing for the worse (from their point of view), the thought that the company itself is in trouble rears its ugly head and the share price starts to drop as everyone begins to suspect the worst.

Then, at the end of November, the company announced that it and Brookfield Infrastructure Partners(NYSE: BIP) would divide up the 53% of Natural Gas Pipeline Company of America that they did not already own so that each ended up owning half. Kinder Morgan’s share would increase from 20% to 50%. The very next day, the credit rating agency Moody’s (NYSE: MCO) changed its outlook on the company’s debt from stable to negative. That spooked the markets even further.

The reason is that all three agencies, Moody’s, Standard & Poor’s, and Fitch, already rated the company’s debt at the lowest level of investment grade at BBB- or the equivalent. Any downgrade would move it to “high yield” – a euphemism for “junk” as in “junk bonds.” While having the status changed to negative doesn’t mean a downgrade is necessarily coming, it does mean that the ratings agency’s attention has been captured, and not in a good way. As this Forbes article explains (thanks to member ecaldwel for providing a link on the discussion board), when you’re at the border, “there is no room for error.”

The last piece was the drop in the amount of excessive coverage of DCF compared to the dividend. This is the amount of DCF generated above what is needed to pay the dividend and can be put to other uses. Here’s how that’s evolved this year:

     • In Q1’s report, management said that excess coverage is expected to be $654 million.
     • In Q2’s report, management said that excess coverage would be below that expected amount.
     • In Q3’s report, management said that it had year-to-date excess coverage of $228 million.

That works out to a run rate of just $304 million for the full year, less than half of what management originally expected. And that fed into the question of whether Kinder Morgan was paying too much in dividends. Something had to give. Either Kinder Morgan would have to cut its dividend or stop expanding. It could not issue equity with the share price this low, it could not issue more debt without triggering a downgrade to junk status, and the amount of cash it could devote to growth projects was drying up.

The drop in the share price was intensified, I believe, by more and more media coverage of the situation. This led to more fear in the market, which led to selling pressure pushing the share price down, which attracted more media attention, and round and round (and down) we went.

Something Gave

Tuesday evening, Kinder Morgan told the market how it was going to resolve that problem. It announced that it was cutting the quarterly dividend from $0.51 to $0.125 per share and use the cash elsewhere. The markets didn’t exactly cheer, but the share price moved up nearly 7% in response, ending a nine-day slide that started the week of Thanksgiving. Moody’s also moved the outlook back up to stable.
Management was very clear that the company itself wasn’t in trouble. I agree. Generating nearly $5 billion in DCF this year means it’s doing well as a business and, once the board decided the best way forward was to slash the dividend, gives the company lots of flexibility. In the conference call Wednesday morning, CEO Steven Kean detailed how it’s going to use that flexibility. Of the over $5 billion in DCF expected next year, here’s the plan:

     • It will pay $150 million to pay the preferred dividend,
     • $1.1 billion to pay the $0.50 common dividend for the year, and
     • $3.8 billion to pay the majority of the $4.2 billion in expansion capital expenditures for the year, including potential acquisitions.

Under more normal circumstances, that $4.2 billion would have been funded by both issued equity and debt. Now, however, 90% of it will be paid from cash flow, with the remainder probably funded from its credit facility in which there is plenty of leeway. This reduces, as both Rich Kinder and CFO Kimberly Dang said, the company’s reliance upon the debt markets.

As DCF grows in the future and it exceeds capital expenditure requirements, the company plans to use that to deleverage the balance sheet a bit, and reward shareholders through an increased dividend and/or share repurchases.

As an investor in Kinder Morgan (I own shares and warrants and also have a synthetic long option position as well as a short put for income), I am, of course, disappointed that the dividend has been cut so much. However, as a part owner of the company – the Foolish view – I am quite pleased with the decision and the obvious focus of management and the board on the health of the company and the accrual of increased benefits to shareholders into the future.

The company had continued to be run as if it were still a MLP, raising cash through debt and equity to invest in more projects and sending nearly all the cash brought in right back out the door to shareholders. In a partnership structure, that’s what’s expected. But it’s not the best way to run a “normal” company. By cutting back on the dividend, the company has opened up all kinds of flexibility for itself without running afoul of angry (or at least upset) credit holders, ratings agencies, or shareholders. I think both Kinder and Kean learned a valuable lesson from this and I believe that the board made the right decision.

Shareholder and Member Responses

As I caught up on the large volume of posts on the Kinder Morgan discussion boards, I ran across several different responses among you, our members.

The primary one was concern about the share price drop. Seeing shares fall so sharply in such a short period of time is very troubling and it generated a great deal of concern. I’m sorry that I did not respond sooner, being the analyst on the Stock Advisor team who usually follows the company. As I wrote earlier, the speed caught me by surprise and I hadn’t been paying close attention, concentrating on my other duties here at the company. As I wrote above, however, the underlying business is and was not in trouble. When that’s the situation, share price movement is not a reason to start worrying. As I’ve written elsewhere, share prices move up and down, a lot. With what is believed to be a solid underlying business, such is not a major concern.

Another concern is the large debt load the company has, and will continue to have. According to S&P Capital IQ, it has $44.3 billion in net debt with maturities spreading out many years (the Forbes article linked above has a nice graphic showing the maturity schedule). This is the nature of MLPs which, until quite recently, Kinder Morgan has been. The difference between then and today, however, is that instead of the various individual underlying companies that made up the overall structure having their own levels of debt, all that debt now belongs to a single company.

As of the end of Q3, the debt-to-capital ratio stood at 55.5%, meaning slightly more than half of its assets had been paid for by debt. This is actually the lowest it’s been over the past eight-plus years. The ratings agencies appear to be satisfied with this level, though I will note that if it comes down from any deleveraging the company manages to do the agencies could actually bump up its credit rating, which would lower some of the pressure of staying on the right side of the investment grade / junk line.

The third major concern has been what would happen to the dividend. Many people had been investing in this because of the generous dividend and, as the share price fell, the dividend yield rose. In general, it’s not a good idea to go chasing after a dividend. The structures of MLPs and REITs are designed to pay healthy distributions (technically not dividends, but they act the same way). Regular corporations are not. As we found out this week, Kinder and his crew finally acknowledged that.

When Stock Advisor recommended the company in 2012, it was paying a respectable 4% yield, and we expected it to grow. And it did, up 46% on a quarterly basis since we recommended it. However, we would never want it to grow to the point that paying the dividend would put the company in danger. I, for one, am exceedingly pleased that the company recognized when it had reached that point and acted accordingly, rather than stubbornly clinging to a promise made when circumstances were markedly different.

So, when share prices drop markedly again in the future, what can the Foolish investor do? First, stop paying attention to the news. As we saw with this company and we’ve seen with others, the financial media tends to jump onto a situation like this and the speculation and guessing of what’s going on or likely to happen can trigger all kinds of fear-based responses in us. Pay attention enough to note what has happened, and then turn off the TV or shut down the app.

Second, take a deep breath and calm down. You are in this for the long-term and that should be measured in years, not weeks or months. Yes, it hurts. Acknowledge that, and then move past it as well as you can. If you’ve diversified your portfolio (we recommend holding at least 15 positions) and you’re using money you won’t need for the next several years (even if you’re retired), you should not be wiped out.

Third, once you’ve slowed down a bit, think about investor psychology and how we’re often whipsawed by our biases. You’re old enough to have lived through a fair amount of life and realize that the one constant is change. The situation today should not be projected out into the future as if it will never change (a tendency we have, called recency bias). As we saw just this week with Kinder Morgan, the situation changed and all of a sudden, it’s no longer so dire.

Fourth, if you can, go back to the actual data and start looking. Read the recent press releases from the company, especially the last couple of earnings releases. These are available on the company’s website. If you can, read through the transcript of the conference call. The site Seeking Alpha has been doing a good job of putting these forth for many companies.

Finally, take advantage of the biggest benefit of your membership and talk with others going through the same thing. Visit the discussion board for the company (Kinder Morgan’s is here) and start reading and/or posting. Ask questions, answer questions, and share concerns. You’re not the only one going through this. Avoid writing emotion-laden posts (you’ve followed steps two and three above, right?) and see how others are handling the same situation. Some are buying, some are selling, some are holding tight or sitting back and watching. If someone with a “CMF” or “TMF” designation at the start of their username is posting, read what they have to write. These people are long-time Fools and are either formal analysts or members who have agreed to follow the companies more closely. If a particular analyst from Stock Advisor hasn’t shown up, ask one of these people to reach out to that person. It’s quite possible that that person just isn’t aware of the most recent situation (as incredible as that may sound for something that’s in the forefront of your attention). I, for one, don’t check the share prices in my portfolio daily, so sudden moves don’t always register with me.

Final Thoughts

If you’ve made it this far, thank you. I just looked at the word count and realized that it turned out to be even longer than I had expected. I hope you don’t begrudge the length, however, and that I’ve managed to provide some information and perspective to this situation. I’ll see you on the discussion boards.

Jim Mueller, CFA (TMFTortoise)

3 Comments – Post Your Own

#1) On December 11, 2015 at 2:40 PM, SimplyDividends (< 20) wrote:

Jim,

Thank you for your thoughtful analysis. What did you make of the stock rising after the dividend cut was annouced? Perhaps a sign that KMI's credit risk was reduced?

Also - would you be so kind as to invite me to be able to post / blog? I would love to get more involved with the community.

Thank you!

Simply Safe Dividends 

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#2) On December 13, 2015 at 7:58 AM, nahag (< 20) wrote:

Nothing happens in a vacuum! Someone or some group trashed KMI on purpose. All you need is the media against you and everything else follows suit. Someone shorted this company and made a whole lot of money. I wonder if they are above the SEC crime detectors. I see oil moving up to $100 bbl in 2016 because non OPEC producers are dying economically. IRAN, V and RUSSIA. Why do you think RUSSIA is spending millions of dollars a day in Syria? To get hold of the oil wells. 

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#3) On December 13, 2015 at 5:44 PM, LiveFool (< 20) wrote:

All I see is a normal market reaction to a dividend cut plus a generally weak market mostly driven by oil prices creating a buying opportunity.

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