- KMP is trading down 1% after hours after reporting disappointing results.
- Distribution coverage was a weak 88% as DCF/unit increased by only $0.01, less than most expected.
- With high equity issuance and 50% IDRs to KMI, KMP has limited accretive growth potential and should be sold.
Over the past 10 years master limited partnerships ("MLP") have been fantastic investments thanks to booming US energy production. To maintain their tax status, these companies have to return the vast majority of cash they generate to unitholders, which makes them ideal investment vehicles for income investors. Typically, MLP investors focus on current income and the potential for income growth. Whenever current income or the growth rate is impaired, the stock tends to perform very poorly as happened to Boardwalk Pipeline (NYSE:BWP). In its just announced quarter, Kinder Morgan Energy Partners (NYSE:KMP) reported really disappointing results that raise concerns about its growth profile. While KMP has been a fantastic investment over the past 15 years, it looks like the growth is slowing and now may be a good time to take profits and exit the name. As a side note, this analysis applies to Kinder Morgan management (NYSE:KMR), an LLC that owns KMP units and reinvests distributions.
In the quarter, KMP earned $0.43 on sales of $3.58 billion (financial and operating data available here). Analysts were looking for $0.58 on sales of $3.35 billion. While revenue was up 19% year over year, earnings were down from $1.41 a year ago. In fact excluding one-time items, EPS in this quarter was lower than it was in Q2 2006. It is unsurprising units were trading 1.2% lower after hours. Now, most MLP investors often ignore net income and focus primarily on distributable cash flow ("DCF"). DCF is a non-GAAP measure that is essentially operating cash flow less sustaining (but not growth) cap-ex. In a sense, it is sustainable free cash flow. DCF is the amount of money an MLP should sustainably be able to pay out to unitholders.
Now, KMP's business is a bit seasonal as natural gas usage is higher in the first and fourth quarters. As a consequence, it tends to distribute less than its DCF in those quarters and pays out more in the second and third with the goal of distributing 95%-100% of DCF every year. While I expect a coverage ratio of less than 100% in Q2, the DCF results were truly disappointing. KMP generated $561 million of DCF while most analysts were looking for $588 million. While DCF was up 11% year over year, KMP's unit count has increased notably (more on that below), so DCF per unit was only up $0.01 to $1.23. Annual growth per unit of 1% is unimpressive.
Despite this weak number, KMP increased its distribution by $0.01 sequentially to $1.39, giving it a coverage ratio of 88%. In the past year, DCF increased $0.01, but its quarterly payout is $0.05 higher. In quarters like this, it can seem like KMP increases the distribution just for the narrative of increasing it. An 88% coverage ratio is anemic and well below last year's 93%. This quarter was not strong enough to merit a distribution increase. By increasing the payout, KMP ate through its excess DCF from last quarter and will need to deliver stronger results in the second half of the year to maintain a full year 100% coverage ratio. With so little wiggle room, KMP could not withstand a downturn in its results without cutting the distribution.
Despite spending lots of money on cap-ex, results were unimpressive pretty much across the board. Natural gas transport volumes were up about 9% thanks to expansion efforts but sales volumes were lower by about 9% while gathering volumes were up a meager 1%. KMP is spending on outsized portion of its cap-ex budget on its CO2 unit, but production growth was muted and lower crude realizations cut into results. KMP continues to operate lucrative mainly fee driven business, but they just failed to deliver much per unit growth.
As noted above, KMP's DCF/unit barely increased because the unit count increased. In the quarter, KMP issued $413 million of equity, bringing first half issuance up to $1.069 billion. In past years, KMP's average unit count has increased from 413 million to 457 million. This is because KMP distributes all of its cash. As such when it invests in growth cap-ex, it has to sell debt and equity. Since December 31, its long-term debt position increased to $19.6 billion from $18.4 billion. This issuance makes DCF/unit growth slower than DCF growth and requires KMP to find accretive projects to justify this issuance. In coming quarters and years, I expect a similar if not higher pace of issuance as its backlog now stands at $15.4 billion.
Unfortunately, this backlog is not necessarily a positive. While KMP's general partner Kinder Morgan Inc (NYSE:KMI) doesn't put up any capital to fund these growth projects, it gets 50% of all incremental cash flow thanks to a beneficial partnership agreement. In a sense, for KMP to generate a return of 8% on a project, it needs to find one with a return potential of 16%, since KMI takes half of the cash flow thanks to its "incentive distribution right ("IDR")." This structure can benefit KMI at the expense of KMP, and there is the risk this backlog does not deliver the promised results, making it dilutive to existing investors. Additionally, we are seeing delays in its $5 billion trans-Canada project that account for a significant portion of its growth potential.
KMP's quarter was truly disappointing. Its issuance of equity and debt is seriously weighing on growth, and KMP is reaching a size where double-digit growth may be impossible. The fees to KMI also make accretive projects difficult to find. With this combination, it is unsurprising that coverage ratio fell to a paltry 88%. Because of diminishing growth prospects and the cash flows KMI takes, I sold my position in KMP several weeks ago. I encourage you to do the same.