- Kinder Morgan confirms its 2014 and three year guidance.
- The secondary is in-keeping with its capital allocation strategy.
- Issuing equity near the lows is frustrating, and the cost of equity is high.
- KMP is an attractive income investment, but units are unlikely to rally in the immediate term.
On Tuesday afternoon, Kinder Morgan Energy Partners (KMP) announced it was offering 6.9 million units in a secondary offering (details available here). As a unitholder, I expressed my frustration over the secondary in this article. While I recognize the need for an MLP (master limited partnership) like KMP to issue equity to fund growth projects since they distribute all available cash, I was frustrated by the size of the offering as units are trading within 2% of a 52 week low. After my article was published, Miguel Garcia from Kinder Morgan's investor relations reached out to me to address some of my concerns. Here is the message followed by some of my thoughts as a KMP investor:
We appreciate your support as a KMP unitholder and share your frustration in the recent performance of our unit price. We would also like to address a few of your concerns voiced in your Seeking Alpha article.
First, we have accounted for this equity offering as part of our 2014 forecast. Therefore, the incremental distribution payments for these issued units have been taken in to account relative to our 2014 distribution/unit target of $5.58/unit.
Second, a key reason we are conducting this offering is to fund the equity portion of the American Petroleum Tankers acquisition. This transaction is accretive to KMP even when taking in to account these equity funding needs. In other words, the incremental cash flow generated by these tankers more than offsets the debt and equity costs to fund the transaction.
Third, we fund our capital needs in a disciplined, responsible way that is designed to maintain a strong balance sheet, preserve our investment grade credit ratings, and promote healthy liquidity. Generally, this translates in our funding expansion and acquisition capital with 50% equity and 50% debt.
Lastly, we would like to remind you that we have publicly announced a three-year distribution/unit growth target of 5%. We announced this at the end of January during our annual Analyst Day investor conference. With the close to $14 billion of organic growth projects at KMP (excluding the backlog at EPB), KMP has real visibility in to highly attractive growth prospects. We are enthusiastic about the future and are hopeful our investors share that enthusiasm.
There are several important points I believe most KMP bulls and bears can learn from this response. First, we got more clarity on the purpose of the secondary. In the prospectus, the stated purposes of the funds were repaying commercial paper and undisclosed partnership needs. Given KMP's $14 billion backlog, it was reasonably assumed growth projects would be funded with this cash. We now know the impending tanker acquisition was a reason for the offering. While we can debate whether KMP should get involved in the tanker business, the deal will be accretive in the immediate term.
Importantly, KMP is also maintaining its guidance for 5% annual distribution growth over three years and a payout of $5.58 this year. While it is always nice to get reconfirmation, I never doubted this guidance. When issuing that guidance, KMP did budget for $1.1 billion in secondary and ATM (where KMP sells some units unannounced during each session) equity sales. This offering totals about $525 million or nearly half of its annual plan. In other words, investors should not take this secondary as a sign KMP will issue more equity than planned, thereby endangering the distribution.
Given its history of issuing equity within budgeted parameters, I did not see this secondary as a sign KMP would be issuing more equity than planned. Rather, I continue to feel frustrated about the manner in which KMP issued the units. Obviously, issuing equity at $89 is preferable to issue equity at $79. As a consequence, the timing of the equity offering is frustrating. No one likes to sell at the lows, and unless there is a liquidity crunch or other extenuating circumstances, I don't think companies should. Below $80, I have argued KMP is trading at a steep discount to fair value, and I would prefer the company to issue less equity at this price and wait for units to rebound before selling equity at a more attractive price.
In fact, units currently yield 7%, and KMP will continue to grow that distribution by 5%. At the moment, equity is very expensive, with a five year cost of equity of over 8%. In that environment, issuing equity is costly and frustrating to existing holders, which is why I would have preferred KMP to fund growth with more debt than equity given the low cost of debt with still low interest rates. Now as stated in the response, KMP is very disciplined with its capital allocation with a 50/50 split of debt and equity to fund projects.
Being capital disciplined is important. During the financial crisis, we all saw what happens when firms rely too heavily on debt markets to meet their capital needs. I respect management's decision to maintain this ratio. Overall, I think extremely highly of management. If I didn't, I would not own any KMP. However, given the current unit price, I wish KMP would tilt its funding more towards debt, perhaps a 65/35 split on new projects. At the same time, should units rally hard, I would be fine with the firm issuing more equity than debt to fund projects. In other words, maintain a long term 50/50 debt and equity split, but allow it to fluctuate year to year based on market conditions.
I was impressed KMP reached out to me, and I think the response is valuable for all investors interested in KMP. Equity issuance is a fact of life for MLP investors. Investors who don't like this should invest in traditional corporations, which retain cash and distribute less. While equity issuance is inevitable, investors can validly criticize or praise the manner in which the partnership sells units. More than anything, I am frustrated at the timing of the offering given how low the price is and would have preferred a higher near term focus on debt. Management ensures a financially secure future for KMP with its 50/50 capital allocation strategy, though it causes some near term heartburn given the cost of equity.
With its asset base, distribution growth, and fantastic yield, KMP is a great income play and investment in growing U.S. energy production. Still, investors must be realistic and accept that units will not be rallying significantly in the immediate term given sentiment and increased supply. This secondary provides a reason to be frustrated but not a reason to sell as the long-term growth story is intact thanks to that $14 billion backlog. I continue to hold KMP for the distribution, but am not expecting capital appreciation in the immediate term.