Kinder Morgan (NYSE:KMI) faced a rough year, dropping from more than $40 to just above $10. Kinder Morgan's shares have recovered over the last weeks, but still trade well below their highs seen a year ago. The reasons are the company's high leverage and huge debt load, which I will look at in this article.
Kinder Morgan's long-term debt stood at $43 billion at the end of 2015, shareholder equity stands at $35 billion, and the assets Kinder Morgan carries on its balance sheet stand at $84 billion. This means that Kinder Morgan's long-term debt to equity ratio stands at 1.23, the company's debt to asset ratio stands at 0.51, showing a rather large leverage. We can also compare how Kinder Morgan compares to its peers:
In comparison to its peers Plains All American Pipeline (NYSE:PAA), Energy Transfer Equity (NYSE:ETE) and Spectra Energy (NYSE:SE), Kinder Morgan looks highly leveraged. The company's 1.29 debt to equity ratio is a lot higher than the ratios of PAA (1.23), ETE (0.95) and SE (0.77). Looking at the debt to assets ratio, we see that the differences are not very big, but Kinder Morgan is among the more highly leveraged companies as well.
Looking at Kinder Morgan's debt relative to the cash flows the company produces, we get the impression of a rather high leverage as well. The company's trailing EBITDA stands at $7.4 billion, which means the company's debt to EBITDA ratio is 5.8 right now. Rating agencies state that a leverage ratio this high usually means that a company does not deserve an investment grade rating, but Kinder Morgan is an exception. Due to the company's huge size and diversified asset base (and also a diversified customer base), Kinder Morgan is still rated with an investment grade rating (although the lowest one). The company, however, cannot increase its leverage further without harming its credit rating, several rating agencies have stated.
With the possibility of more rate hikes this year (as well as in future years), high debt levels can become a drag on the company's bottom line (and cash flows). Thus, getting rid of some of its debt wouldn't be a bad move for Kinder Morgan. Kinder Morgan produced $4.7 billion in distributable cash flows last year (i.e. operating cash flows adjusted for maintenance capital expenditures), and Kinder Morgan guides for $4.7 billion in distributable cash flows for the current year. With planned growth capex of $3.3 billion in 2016, this means that the company has $1.4 billion left for other purposes, which includes dividends, debt reductions and share repurchases.
$1.2 billion will be spent on dividends in 2016, as long as Kinder Morgan keeps the dividend at the current level. Cutting it again would make even the most benevolent shareholders shy away from the company, and increasing the dividend now does not make a lot of sense either (as long as the company's financials are as stretched as they are right now). When we thus assume that $3.3 billion will be spent on growth capex and that $1.2 billion will be spent on dividends, Kinder Morgan will be able to spend $200 million on debt reductions, which would be equal to 0.5% of the company's total long-term debt load. This is not a fast pace at all, but would be a move in the right direction.
There are two ways of reducing debt: Paying down debt notes/bonds at maturity and not taking on any new debt, or repurchasing bonds/notes that are publicly traded. In some cases, the second option makes a lot more sense, due to two reasons:
- Bonds and notes with a lot of years until maturity often trade below face value, which means by paying an amount of X dollars, a company can retire more than X dollars of debt.
- Bonds/notes with many years to maturity often have higher yields than short-term bonds (which were issued with lower interest rates in the first place), thus by repurchasing these notes, a company can save a lot on interest payments.
Let's look at Kinder Morgan's publicly traded debt notes:
We see that Kinder Morgan's debt comes with rather high interest rates, especially the notes maturing after 2030 oftentimes were issued at interest rates of more than six percent.
We also see that some of Kinder Morgan's notes trade well below face value, e.g. the 5% bonds maturing in 2043, which trade at just 81% of face value. This means that Kinder Morgan could retire $1 in debt by spending just $0.81 when the company repurchased these bonds in the open market. For every $1 billion committed to repurchase bonds at roughly 80% of face value, the company can retire $1.25 billion in debt, at the same time, this would save the company $63 million in annual interest payments (5% interest rate multiplied by $1.25 billion in face value). Interest expense reductions in turn would lead to higher net income, higher operating cash flows and higher distributable cash flows in future years, which would be highly beneficial to the company's shareholders.
Engaging in such activity (repurchasing debt that trades below face value) thus allows Kinder Morgan to cut its debt load substantially, and at the same time, this allows for growing net income and cash flows due to lower interest expenses. If Kinder Morgan chooses to engage in such activities, this will make the company financially more healthy and provide a boost to Kinder Morgan's income at the same time. I thus would not be surprised if Kinder Morgan chose to direct a growing amount of its distributable cash flows towards debt reduction, at least until the company's leverage ratios are down to healthier levels.
If, for example, the company chose to lower its growth capex spending to $2.0 billion annually and to keep its dividend stable, Kinder Morgan would be able to repurchase debt notes for $1.5 billion a year, which would lead to debt level reductions of $1.9 billion a year (assuming repurchases at 0.8 times face value), and which would, at the same time, lead to interest expense declines of roughly $100 million. In a couple of years, Kinder Morgan could thus easily reduce its total long-term debt by $10 billion, and save $600 million in interest payments each year - which would mean a substantial boost to the company's net income and DCF levels at the same time.
Kinder Morgan's debt levels and leverage ratios are high, but not too high to handle. The company still holds an investment grade rating, but it would likely be beneficial to reduce the company's debt levels over the next years, especially since further rate hikes are very likely. By repurchasing debt notes below face value, Kinder Morgan could save a lot of interest expenses and reduce debt levels substantially at the same time. Reducing growth capex and diverting a growing portion of the company's cash flows towards debt reduction could be the right move for the company.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.