"Cut" is the new word at Kinder Morgan (NYSE:KMI). The company is aggressively cutting its costs while it waits for the two catalysts that can bring the company back to its glory days: higher oil prices and the completion of its $7B trans mountain pipeline. The word "cut" has been liberally applied to KMI's employees and dividends.
As we know, earnings drive stock price. The major risk in investing in KMI is that earnings continue to fall. Over the past year, KMI's EPS has fallen by one-third, and the company's rolling average EPS has dropped from one to nearly zero:
When looking at the current EPS, investors should understand that this EPS has been bolstered by cost cuts that work in the short-term but are harmful in the long-run. The job cuts lead to reduced productivity. This can result in a negative feedback loop, in which the reduced productivity spurs more cost-cutting efforts, leading to even lower EPS.
KMI's status in the oil industry is linked to its production. It employs the second highest number of workers in this industry, accounting for 14% of the oil and gas pipeline workforce; a layoff of a small percentage of its workforce is actually large, numerically. Ditching employees is not free either, as the company will pay severance packages for all past employees. A company expecting a near-term recovery would want to optimize production and not engage in layoffs.
Nevertheless, increases in efficiency have had no effect on the company's EPS. Asset turnover shows zero correlation with EPS growth:
Optimism in a rebound in KMI is misplaced as the company makes its way into the zero EPS region. The price of oil is again on the decline. And even if it were on the incline, KMI is not properly positioned to be a strong rebound stock for an oil bull market.
KMI's profit margins are already at its 5-year peak. This seems like good news for KMI investors:
However, the stock remains stagnant. It continues to trade in the $17 to $19 range, as it has done for the past quarter. I've already proposed two income generation methods for KMI investors while they wait for a rebound: buying volatility and selling covered calls.
However, perhaps the opportunity cost here is too great. World oil demand is falling. This is a factor over which KMI has no control:
No matter how well the company does in its cost-cutting efforts, the market will continue to punish a company without macro environment suitable for growth, especially if that company is highly leveraged and in debt. KMI holds over $40B in debt, with a debt-to-equity ratio of 1.25. Much of the company's debt comes from acquisitions and dividend payouts - now a target of KMI's cost-cutting policy.
Oddly enough, KMI's business plan was solid: Act as the toll booth for oil transportation. Investors would get a cut of those toll payments, and the dividend should have been sustainable if it had not been so high. The debt taken on for the sake of investor happiness ended up as a ball-and-chain around the company's ankle.
A toll booth can only go bankrupt if cars stop traveling on roads. Oil is still traveling through pipelines, just at a lower rate. Profit margins typically peak before a recession, so KMI had no real excuse to spend so aggressively. This is the sign of management thinking about the now, instead of the future.
Again, take a look at the profit margin peak for KMI, which occurred in April:
At this time, the company was paying 1500% of its earnings in dividends. Only short-term investors should have liked this fact; long-term investors should have seen the disaster coming. Now that profit margins are back near the peak, KMI investors should again be wary of management movements.
Unsustainable dividend raises or new acquisitions should be seen as warning signs. What we saw in 2015 was a bubble. Now that the bubble has popped, long-term investors should not be hoping for another bubble.
KMI investors should learn from the past and be cautious holding KMI moving forward. The company has been shown to play the oil game dangerously. No one can predict when the price of oil will rebound, but we can predict that KMI's management decisions make the stock a risky hold even in an oil bull market and even in spite of the company's solid business model.
Moving forward KMI will continue to cut costs and repair its balance sheet. A company repairing its balance sheet cares little for improving earnings and therefore is not a suitable long position. Still, KMI controls perhaps the best oil assets in the US, and this fact will ensure that KMI has a clear support level, probably at $15.
If you're going to hold KMI, I suggest you also play it sideways in the short-term. A short strangle can bring you monthly income. I recommend the following short strangle:
- Sell KMI Jul 18 call
- Sell KMI Jul 17.5 put
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