- Reported distribution coverage includes items I do not consider sustainable and exclude outflows that would have been required but for KMR holders receiving in-kind distributions.
- Were i-units to receive cash in lieu of KMP units, coverage ratios based on sustainable DCF would be lower than reported ratios.
- Good news regarding natural gas pipeline expansion opportunities and CO2 business; but delays on Trans Mountain mega project.
- IDR payments remain a drag on cost of capital and ability to raise distributions. KMP will require KMI waivers of IDR payments to meet its 2014 distribution target.
This article supplements, and should be read in conjunction with, my preliminary review of 2Q14 results recently reported by Kinder Morgan Energy Partners LP (NYSE:KMP). I now evaluate the sustainability of KMP's Distributable Cash Flow ("DCF") and assess whether KMP is financing its distributions via issuance of new units or debt.
DCF is one of the primary measures typically used by master limited partnerships ("MLPs") to evaluate their operating results. However, each MLP may define this term differently, making comparisons difficult. In addition, MLPs typically include non-sustainable items in their definitions of DCF.
KMP's method of determining DCF is detailed in an article titled Distributable Cash Flow (DCF) that also provides a comparison to definitions used by other MLPs. Based on this method, KMP derives DCF as shown in Table 1. The adjustments made by management in deriving DCF are referred to as "certain items."
KMP's reported DCF per unit for the TTM ended 6/30/14 was $5.49 ($2,443 million in total), up from $5.31 ($2,005 million in total) for the corresponding prior year period. While net income before "certain items" increased by $421 million, limited partners' share of net income increased by only $182 million, primarily due to higher Incentive Distribution Rights ("IDR") payments made by KMP to its general partner, Kinder Morgan, Inc. (NYSE:KMI).
Management expects positive coverage ratios in the 4th and 1st quarters of each calendar year and negative ratios in the 2nd and 3rd quarters. TTM coverage ratios are therefore more meaningful than quarterly ratios. Table 1 indicates a very tight coverage ratio in the latest TTM period and highlights the large portion of net income and cash flow claimed by KMI's IDRs. KMP's ability to generate distribution growth is constrained by its IDR obligations to distribute ~48% of every additional DCF dollar to KMI. Note that in addition to the 2% general partner interest that entitles it to IDRs, KMI also owns 11.4% of KMP's limited partner units as of 6/30/14.
KMP's method of determining DCF differs from most of the non-Kinder Morgan MLPs I follow. As shown in Table 1, KMP deducts the general partner's IDRs in deriving DCF. It thus adopts a narrow definition, one that includes only that portion of DCF that is attributable to limited partners. The more common and broader definition of coverage is one whose numerator is total DCF (available to both LPs and GP) and whose denominator is the total of all distributions made to all the stakeholders, including the general partner. DCF coverage as computed by KMP is not consistently lesser or greater than it would have been had the broader definition been used. It is just different. Making an apples-to-apples comparison to other MLPs therefore requires adjusting for this factor.
The generic reasons why DCF as reported by an MLP may differ from what I call sustainable DCF are reviewed in an article titled "Estimating sustainable DCF-why and how." A comparison between KMP's reported and sustainable DCF is presented in Table 2 below:
The principal differences of between sustainable and reported DCF are attributable to working capital and to a host of items grouped under "Other."
Most of the MLPs I follow exclude working capital changes, whether positive or negative, when deriving their reported DCF numbers. I generally do not include working capital generated in the definition of sustainable DCF, but I do deduct working capital invested. Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability, the master limited partnerships should generate enough capital to cover normal working capital needs. On the other hand, cash generated from working capital is not a sustainable source and I therefore ignore it. Table 2 indicates that liquidation of working capital generated a substantial portion ($240 million) of the DCF reported in the TTM ended 6/30/13. However, DCF as reported for the TTM ended 6/30/14 was not boosted by such liquidation, so the improvement over the prior year number is both quantitative and qualitative.
The "Other" item of difference between reported and sustainable DCF incorporates many management adjustments that I ignore in deriving sustainable DCF. These include depreciation, tax deferrals, impairments, and reserve adjustments. In the case of depreciation, for example, KMP adds back its proportionate share of the joint ventures' depreciation, depletion and amortization expenses and subtracts its proportionate share of the joint ventures' sustaining capital expenditures.
Another adjustment required for sustainable DCF coverage analysis relates to the capital structure of the Kinder Morgan entities. Kinder Morgan Management, LLC (NYSE:KMR) owns approximately 28.4% of KMP in the form of i-units that receive distributions in kind, not in cash (i.e., i-unit holders receive additional KMP units in lieu of cash). In my opinion, in order to make KMP's coverage ratios comparable to other MLPs that do not have the equivalent of i-units, an adjustment is required so that i-units are deemed to have received the same distributions as common units.
Using the broad definition, and adjusting for the i-units, I calculate KMP's DCF coverage ratio as follows:
Table 3 shows that the broadly defined coverage ratios based on sustainable DCF are somewhat lower than the coverage ratios reported by KMP.
A factor not incorporated into the coverage ratios shown in Table 3, but one that must still be borne in mind, is the waiver of KMI's IDRs. But for these temporary waivers, less cash would have been available for distribution to limited partners. So far in 2014, KMI waived $58 million of IDR payments related to units issued to finance certain acquisitions (e.g., the Copano and APT acquisitions).
The method used by an MLP to determine into which bucket (expansion vs. sustaining) a capital investment should be placed can have a material impact on DCF and on coverage ratios. There does not appear to be a reliable, consistent, standard and transparent method of making this determination and MLP investors cannot really know whether management inappropriately allocated more than it should have to the expansion bucket, and thus overstated an MLP's DCF and coverage ratio. This note of caution is applicable to all MLPs, not just KMP.
Table 4 below presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:
Simplified Sources and Uses of Funds
Net cash from operations, less maintenance capital expenditures exceeded distributions by $510 million in the TTM ending 6/30/14, and by $483 million in the TTM ending 6/30/13. However, these excess amounts would have had to been reduced by ~$687 million and ~$587 million, respectively, had i-units received cash (as explained in Table 3 and the discussion preceding it). While in the periods reviewed KMP did not fund distributions by issuing units or debt, this would not have been achieved but for the impact of the i-units. Hence sustainable DCF coverage is, by my calculations, below 1x.
Table 5 below provides selected metrics comparing KMP to some of the other MLPs I follow based on the latest TTM results.
As of 07/31/14:
EV / TTM EBITDA
Buckeye Partners (NYSE:BPL)
Boardwalk Pipeline Partners (NYSE:BWP)
El Paso Pipeline Partners (NYSE:EPB)
Enterprise Products Partners (NYSE:EPD)
Energy Transfer Partners (NYSE:ETP)
Kinder Morgan Energy Partners
Magellan Midstream Partners (NYSE:MMP)
Targa Resources Partners (NYSE:NGLS)
Plains All American Pipeline (NYSE:PAA)
Regency Energy Partners (NYSE:RGP)
Suburban Propane Partners (NYSE:SPH)
Williams Partners (NYSE:WPZ)
Table 5: Enterprise Value ("EV") and TTM EBITDA figures are in $ Millions; EPB and KMP TTM numbers are as of 6/30/14; others as of 3/31/14.
It would be more meaningful to use 2014 EBITDA estimates rather than TTM numbers, but not all MLPs provide guidance for this year. Of those I follow, the ones that I have seen do so are included in the table.
KMP's 2014 capital expansion budget of ~$3.9 billion includes small acquisitions and investment contributions, but excludes asset acquisitions from KMI. A significant portion of this amount is allocated to the Natural Gas Pipelines and will position this segment to take advantage of a surge in demand for natural gas anticipated by management based on third party forecasts and anecdotal evidence. KMP increased its quarterly distribution to $1.39 per unit (from $1.38 in 1Q14 and from $1.32 in 2Q13). Management's guidance for 2014 is for distributions totaling $5.58 per unit, up 5% from $5.33 in 2013.
The outlook appears mixed. Project backlog is growing and KMP has identified significant natural gas pipeline expansion opportunities in the Northeast. The boom in Permian Basin oil production (up from a low of 850K barrels in 2007 to 1.35M barrels in 2013) benefits KMP. As a major supplier of CO2, KMP is well positioned to help enhance oil recovery/production in mature oil fields and reservoirs that require injections of steam or carbon dioxide to coax more crude out of the ground (CO2 acts as a pressurizing agent and reduces the viscosity of oil). Also, year-to-date KMP has significantly underperformed other MLPs having risen 0.5% vs. 8.1% for the Alerian MLP index. If it catches up, investors will be well rewarded.
On the other hand, one of KMP's key projects (the $5.4 billion expansion of the Trans Mountain Pipeline) is encountering delays. The plan to build a second pipeline with a 540K barrels per day capacity (and possibly a further 240K at a later stage) running from Edmonton to the Vancouver region, thus increasing capacity on the Trans Mountain system to 890K barrels per day, has faced tough questions from regulators and municipalities. It may take several years before KMP is in a position to significantly increase its distributions or generate sufficient excess cash to meaningfully reduce dependence on debt and equity financing. There has been a marked reduction in the pace of growth of KMP's Adjusted EBITDA over the last four quarters. Also, KMP's reported distribution coverage is based on cash flows that include items I do not consider sustainable, and excludes outflows that would have been required but for KMR holders receiving units in lieu of cash distributions. IDR payments by KMP to KMI claim a significant portion of KMP's cash flows and place KMP at a disadvantage from a cost of capital perspective. Finally, KMP will require assistance to meet its 2014 distribution objective in the form of $133 million IDR payments that KMI will waive. KMI will also waive $139 million of IDR payments in 2015 and $116 million in 2016, thereafter decreasing by $5 million per year.
Investors seeking more rapid distribution growth and/or concerned with KMP's distribution coverage for reasons detailed in this report should look at KMI which, at ~4.8%, yields less than KMP's 6.9% but projects 8% distribution growth in 2014 over 2013 and provides a better alignment of interests with Kinder Morgan's management.