- KMP announces 6.9 million unit secondary, sending shares near 52 week low.
- Paying down commercial paper is negative for free cash flow.
- Issuing equity suggests management does not believe KMP is very undervalued.
- Unit sales will limit possible upside.
- KMP can be held for its distribution not for capital appreciation.
Kinder Morgan Energy Partners (NYSE:KMP) fell 2% after-hours when the company announced a large secondary offering (details available here). As the following chart shows, KMP has had a rough year, and this deal will price within 2.5% of the 52 week low. As an existing holder, it is always disappointing to see a company issue equity near the lows. On the last earnings call, CEO Richard Kinder also famously said, "you sell, I'll buy (transcript available here)." While Mr. Kinder is not selling, the company continues to sell units at what he has seemingly argued to be a great price. While I will explain the rationale and ramifications of the secondary below, the offering is frustrating nonetheless. As a side note, this analysis also fully applies to Kinder Morgan Management (NYSE:KMR), a company that solely owns units of KMP and automatically reinvests dividends.
(Chart from Google Finance)
First, let's examine the details of the secondary. KMP plans on selling 6.9 million units, which will increase the total unit count by approximately 1.6%. If the offering is over-subscribed, underwrites can sell another 1.035 million units. Assuming the over-allotment is not filled, KMP will sell about $550 million in equity before paying fees. There are two stated purposes for this offering.
KMP will be using some of the proceeds to pay down its commercial paper debt. KMP currently has $2.75 billion in commercial paper outstanding, and this debt has an average yield of 0.2758%. For comparison, KMP currently yields 6.8%. Any commercial paper that is paid down with the proceeds of this offering is negative for cash flow. Let's say KMP paid down $100 million in CP. That CP currently costs $275,800 per year. The dividend payments will cost $6,810,000. As a consequence, existing KMP holders have lower cash flow than they would otherwise. Frankly, the decision to sell equity near a 52 week low to pay down near term debt makes little financial sense. If they wanted to pay down debt, I would prefer to see them focus on longer-term floating rate bonds rather than commercial paper.
If KMP wants to de-lever its balance sheet, that is a defensible goal. However, KMP is replacing inexpensive debt with expensive equity. As a consequence of this decision, future distribution growth will be slower. As of the end of last quarter, debt to equity stands at 1.19x compared to 1.26x a year ago thanks to $1 billion in debt reduction. KMP's balance sheet is not overly risky, and its financial situation is growing healthier. Unless there are concerns about being unable to roll over the CP (which is unlikely given relatively liquid market conditions for investment grade CP), this decision is troubling.
The remaining cash will be used for general partnership purposes. This is typical offering language as management does not wish to pigeon hole its use of the cash. It could be used to fund any new projects or working capital. Currently, KMP has a project backlog of about $14 billion, so some of this cash will almost certainly be used to fund growth projects. This is one of the problems with KMP's structure. With a handful of exceptions like Enterprise Product Partners (NYSE:EPD), master limited partnerships ("MLP") pay out virtually all of their available cash. As a consequence, KMP has to sell equity to fund new projects.
KMP argues that its project backlog will generate a higher ROI than the cost of equity. As a consequence, while the unit count is always rising, the firm can continue to increase the distribution. Still, a secondary is far less accretive to the distribution at $80 than it is to $90. Projects have to be more profitable to still be accretive with units near a 52 week low. KMP has not timed this offering well. Moreover if units are appreciably undervalued, should a firm sell equity? It might be better to wait on some growth projects until units are trading at a more appropriate level.
In the past, I have dismissed the bear case laid forth by Hedgeye's Kevin Kaiser and argued that KMP could be worth over $100 in a previous article. Further, I have explained how issuing equity is not necessarily dilutive to cash flow. Still, the size of this offering at such a low price is disappointing. With units so low, I would rather see the company turn to debt markets to fund growth rather than sell equity to pay down debt or consider slowing its cap-ex spending. By selling so many units, KMP management is acting in a way that suggests it doesn't feel the price is too low. If you believe an asset is worth $100, you wouldn't sell it an $80 unless doing so is absolutely necessary, which is not the case for KMP.
Based on this action, KMP cannot believe fair value is all that far from $80. Units sport a solid 6.8%, and KMP should be able to incrementally increase the payout. For the past six weeks, I had been considering adding to my KMP position. However, I am uncomfortable buying equity when the company is selling increasingly more equity. I don't plan on selling my position as the valuation seems reasonable, but I won't be adding as significant capital appreciation seems unlikely. An ever increasing unit count will slow the pace of distribution growth. Selling equity near a 52 week low shows a lack of discipline. Investors can own KMP for the yield but should not expect much appreciation with KMP continuing to sell equity.