After the close on October 16th, Kinder Morgan Energy Partners (KMP) reported quarterly results (these result pertain to its sister company Kinder Morgan Management (KMR). Frankly, there is no way to classify these results as anything but disappointing. To be clear, I am not a KMP bear and certainly do not subscribe to the overly-zealous Hedgeye bear thesis. In fact, I have written an article here disputing their thesis. Moreover, I am a long term investor in KMP, but to be a successful investor, one cannot look at investments with rose-colored glasses. Great companies will from time to time report disappointing results. Often, pullbacks from these missteps can present great entry points. Other times, they can be harbingers of things to come and present early warning signs to exit the position. While I remain a long term optimist on KMP because I believe in the shale gas revolution in the United States which will increase the demand for pipelines, this quarter gives me serious caution about near term prospects for the company. I would like to explain some of my concerns and how I would position going forward.
At first glance, KMP's quarter looked strong. Here is the headline of the press release (available here): "Kinder Morgan Energy Partners Increases Quarterly Distribution to $1.35 Per Unit, Up 7%. Third Quarter DCF 22 Percent Higher Than Q3 2012." As MLP investors are well aware, distributions and distributable cash flow are the lifeblood of these stocks. Therefore, it would seem that this growth portends strength, but that would be an over simplification. A major reason why DCF (distributable cash flow) has grown is that KMP has continued to acquire pipelines to expand its breadth. As a result, little of this growth is organic. To fund acquisitions, KMP issues debt and equity. As such, its unit count has expanded from 356 million to 435 million annually.
This 22.2% growth in units has slightly outpaced gains in cash flow, as such DCF per share actually declined year over year from $1.28 to $1.27. Unitholders are far more interested in their piece of cash flows than total cash flows. If a company doubles profits but triples its share count, your shares would lose one-third of their value. Growth for the sake of growth is not positive for investors; we seek acquisitions that provide accretive growth. Seen this way, KMP's DCF is actually disappointing despite 22% headline growth.
Further in the long run, MLPs can only distribute the cash flow they generate. Every so often, there is a quarter where they distribute slightly more than they generate. They do this by issuing some debt to cover the shortfall. As debt eventually matures, the company is essentially borrowing from future distributions to pay current ones. If there is an extraordinary event that leads to a coverage ratio of less than 100%, that is permissible, but if it is a recurring trend, that is a sign the distribution must be cut. Unfortunately, this is becoming a recurring trend for KMP.
With DCF per unit declining year over year, I am unsure why KMP would increase the distribution again to $1.35, dropping its coverage ratio to 94%. Further, in its press release, the company said it now expects to distribute $5.33 per unit in 2013, suggesting a fourth quarter payout of $1.36. KMP is promising another quarterly increase even as it over-paid in the third quarter. This action does not feel responsible to me. Importantly, the company is not increasing its distribution to meet expectations. At the beginning of 2013, the company budgeted for a $5.28 annual payout. With lagging performances at its operations, I am unsure why the company is determined to pay more than it had promised unitholders. KMP should be paying no more than $1.30 a quarter (still a great 6.5% yield).
Management is clearly focused on increasing payouts to unitholders, perhaps to dispel unfounded reports of financial weakness and impropriety, but I believe shareholders would be better served by keeping distributions in-line with DCF and previous forecasts, rather than raising it beyond the means of the company's performance. I believe management has been comfortable paying beyond its means because it is more financially secure than it has been in years and is capable in adding debt to its capital structure. At the beginning of the year, KMP had a leverage ratio of 2.76x; it now stands at 2.47x, and from 2009-2012, the company ran a leverage ratio of approximately 3.00x. With less reliance on debt, KMP is clearly willing to add some debt to goose distributions.
However, investors need to be aware that this $1.35 distribution is a debt fueled one with a sustainable distribution of $1.25-$1.28. Importantly, pipeline volumes, which are the drivers of distributions in the long run, were pretty weak this quarter with natural gas volumes actually falling 5% year over year. Given increased U.S. production of natural gas, this decline in KMP's transportation volume is especially troubling. Further, operating expenses as a percentage of revenue grew from 52% to 57.5%, which was disappointing to see. Clearly, KMP was unable to fully utilize its network with falling volumes while incurring higher expenses, which leads to weaker distributions for unitholders.
Investors in KMP also must recognize that the general partner, Kinder Morgan (KMI) continues to take a big portion of earnings as a fee for operating the pipeline. Despite weaker year over year performance, GP payout rate (GP payment/DCF for unitholders) held steady at 78%. As a KMP unitholder, it is certainly frustrating to see the general partner make out as well despite weaker performance but that is essentially how the contract is structured, making weak results disproportionately harsh on KMP investors.
Acquisitions this year have yet to prove accretive to KMP holders, and the increased distribution is a false sign of strength as the increase is funded by debt with the coverage ratio dropping to 94%. The company is essentially borrowing from future distribution hikes to pay a higher one now. While the company can afford to take out debt given its improved balance sheet, I believe it is bad practice and would prefer KMP to keep its powder dry so that it can acquire other pipelines that are attractively priced. Falling volumes and higher expenses were clearly disappointing, and this quarter was clearly not KMP's finest. Nonetheless, I believe US oil and gas production will continue to increase, which will benefit the pipelines. Given its reach and high quality assets, I do believe KMP is a long-term winner that should return to moderate growth in 2014. However with lower DCF/unit, KMP should not rally in the near term and is fairly valued at $80. If it were to fall $75, I will consider adding to my position. Given this quarter, KMP should trade sideways for a bit, but I plan on riding out near term volatility given my long term optimism.