Kinder Morgan Is A Blue-Light Special

| About: Kinder Morgan, (KMI)

Summary

Non-cash charges decreased earnings, but normally non-cash charges affect other periods and depreciation, amortization, and depletion all have assumptions that could be wrong.

Cash flow held up remarkably well in the first quarter, demonstrating the underlying strength on the business.

The cash flow needed to pay the old dividend rate of $2 per year is still there, but the market does not weight reinvestment of cash flow nearly as much

Expect the management, especially the major shareholders to continue to manage the company for the long term and ignore the quarterly variations. That is how the company grew successfully.

The change in capital market perceptions caused the change in dividend policy, not the strength of the underlying business. Expect the capital market perceptions to change favorably in the future.

Kinder Morgan Inc. (NYSE:KMI), showed earnings before depreciation and a few other items that were slightly higher (up 1%) than the year before in the first quarter. However, net income was $276 million ($.12 per share) vs. $429 million ($.20 per share). Natural Gas Pipelines and Product Pipelines actually had earnings ahead of the previous year before DD&A, and amortization of excess investments.

What appears to be playing out here is that the assumptions made for the allocation of fixed costs from capital projects are not quite as accurate when commodity prices collapse in the middle of the allocation period. So there may literally be too much depreciation at a time when the different product lines are literally not that profitable. 20-20 hindsight is always perfect but allocating costs into the future is a whole other matter. Some of those capital projects are not going to have quite the predicted profits and now is the time that notification shows up. Many fixed costs are allocated on some sort of straight line basis because of the lack of ability to forecast the future. Then when there is a dramatic industry change, a write-off follows in the future.

In any event the assets represent capital already spent. Depreciation is based upon historical assumptions. The money invested in existing assets are known as sunk costs and therefore do not have any relevance to the forecasting of the profitability of future expenditures. These assets were more profitable in the boom times and maybe with hindsight, more depreciation needed to be allocated during the boom times, but management is pretty much stuck with those initial allocation decisions. The investor really does not know how profitable the assets were until the day they are written off and retired so that a full review of the historical record can be accomplished. By then it is too late; the next project will have updated allocation assumptions.

Then there was a bunch of non-operating items that got dumped into the first quarter; several of those items were non-cash charges. Usually when that happens, these non-cash charges relate to previous quarters that management has finally figured out how to bring the account current. The largest was "Project Write-offs" of $170 million before taxes. Had management known about this write-off ahead of time it probably never would have started the project. As it was the entry of the amounts into assets was an act of faith in the success of the project and the write-off was the belated adjustment to new reality. Really, in hindsight, the expenditures of a failed capital project need to be expensed in previous quarters. But accounting does not go back and update previous quarters. Instead the approved method is to write-off the expenditures as soon as they are known to be worthless.

This is why it is so very important to watch cash flow. Cash flow is a little harder to manipulate and is a very good sign of the company health that the market appears to ignore frequently.

"Despite continued headwinds in our industry, we are pleased with KMI's performance for the quarter, and we are pleased to have generated $954 million of cash in excess of dividends during the quarter," said Richard D. Kinder, executive chairman. "Given our tremendous amount of cash flow, we do not need to access the capital markets to fund growth projects in 2016.

The distributable cash flow, as measured by the company actually rose to $1,272 million in the first quarter from $1,242 the year before. Those figures did not take into account the preferred stock payment of $39 million for the current year first quarter compared to none the year before. That means that had the company chosen to pay the dividend at last year's rate, there was actually more cash available to pay dividends as well as a new obligation to pay a preferred dividend. Admittedly the increase in distributable cash flow did not completely cover the preferred dividend, but that is a minor issue when compared to the growth in cash flow in the current hostile industry environment.

Since the company tends to have rather large projects, a startup period can be expected with the usual extra expenses and engineering hiccups. The cash flow will probably increase to cover the preferred dividend, but sufficient time is needed.

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Source: Kinder Morgan Presentation At The Tudor Pickering Energy Conference On June, 15, 2016

So really the decision to cut the dividend was not forced by a material decline in the business. Instead the lenders for capital expansion changed their attitude toward the industry (and this company) as commodity prices collapsed. What was an acceptable practice in the past has now changed dramatically and the company has had to adjust to the new lending atmosphere. For a multi-billion dollar company that was no small challenge.

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Source: Kinder Morgan Presentation At The Tudor Pickering Energy Conference On June, 15, 2016

As noted above the company now needs to fund its capital requirements itself to bring its ratios into line with the new lender expectations. That new responsibility may include paying down some of the debt coming due over the next few years. Evidently any money available to loan will be more expensive, so the company is looking to upgrade capital projects to higher returns (if possible), improve its key ratios, and in general meet the new expectations of the lending market so its debt costs due not increase past what management considers reasonable. Capital markets rarely, if ever shut down, but they can become prohibitively expensive, unacceptably dilutive, or lead to the market viewing the common stock unfavorably. So in some ways, management gets to "choose its poison". In this case management may have chosen the best of the unpalatable alternatives.

Just like many other industries, the lending industry is subject to group think. If some key lenders become afraid to lend or change their standards, then the whole industry moves lock-step. Usually this hostile lending environment lessens with the current commodity price rally and the coming uptick in industry profits. So down the road the company may be able to return to the practices that were acceptable in the recent past. This may show itself as a sudden increase in capital projects, or a dividend boost accompanies by more financial leverage in the future. Possibly there may be a stock buy back or a one-time special dividend. The key is that this hostile lending environment is probably not forever if handled correctly (or reasonably) by management.

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Source: Kinder Morgan Presentation At The Tudor Pickering Energy Conference On June, 15, 2016

The second slide shows progress in distributable cash flow. There may be a hiccup this year, but its not going to be that large and certainly not fatal. Evidently the net debt ratios are going to have to improve. But that does not mean that the business fell apart. Quite the contrary, there are still some very attractive capital projects in the pipeline and projected growth well into the future. The company has not tied itself to any one capital project, and has a history of making acquisitions. In fact, the right acquisition for an all stock deal could solve the company's lending problems right away. In short, the company is dealing with the changing expectations as well as it can. If a safe short-cut happens (like an all stock acquisition that is a great deal), expect management to take the short-cut. In the meantime expect management to use current cash flow to shore up the balance sheet as needed. The money, as always will be prudently invested to continue a long history of profitable growth.

Mr. Market is not focusing on the time when that cash flow will no longer be needed to shore up the balance sheet. Evidently such a time is currently beyond the horizon of Mr. Market. Much of the earnings decrease was due to non-cash charges and that fact showed itself in the cash flow. But the market is concerned with that quarterly earnings decrease and the recent dividend cut. The market has always over emphasized earnings. So there may be a general failure by the market to see a healthy company whose business will resume growing as the oil and gas industry recovers.

Management is forecasting some 3% and 4% shortfalls in some cash flow areas. However, there is still the rest of the year to make up that shortfall. Even if that shortfall remains to the end of the year, that shortfall is a very respectable showing for many in the industry. Importantly, even with the shortfall, the cash for the old dividend rate is still there because the business is not suffering and is not distressed. Again, the market places more emphasis on the shortfall (what is missing) than the ability shown by the cash flow (what is there). Management had the foresight to solve a problem before it became a crisis and the market punished the forward thinking of management.

So much for the efficient market theory. It needs to be replaced by the very durable near-sighted trading theory of investing. Long term investing is not in favor unless long term is defined as the time between breakfast and lunch. Traders can take advantage of this market mentality to make some very profitable trades. Long term investors can do their homework and decide if this company fits their risk profile for a suitable investment. The stock has been beaten up enough that it is unlikely to decline further.

A broad based approach of looking at several years of earnings, sales growth and cash flow is needed to overcome the current market pessimism. A lot of failed capital projects will affect the cash flow statements and show as a lack of sales growth over the long term. Both sales and cash flow are a lot harder to manipulate than earnings. Yet Mr. Market does not show a lot of respect for either.

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Source: Kinder Morgan Presentation At The Tudor Pickering Energy Conference On June, 15, 2016

No matter what the market may wish or claim to see at the moment, this company has some permanent long term advantages. Plus it has a very experienced founder at the helm who is also a major shareholder. That major shareholder lost a lot of income when the dividend was cut. Since that was a major source of his income from the company, investors can bet that he did not make the decision lightly. He hurt his income to the turn of eight figures (ouch!).

So while the market is moaning and groaning, the individual investor needs to focus on the business. As shown above, there is a lot of good to focus on with a lot of (probably) permanent advantages. This company should be among the first to restore its dividend and will most likely maintain an investment grade rating. Management is very proud of the history of maintaining that rating. Because of the actions taken, the rating will be maintained in the future due to the balance sheet improvements anticipated. Management has stated that the balance sheet strength is a very high priority. That is why the dividend was cut. The market reacted as though there was a continuing business problem, but so far management has not guided to any significant business challenges, only a slight slowdown in growth from historical records and in some measurements a little hiccup. The oil and gas industry has seen far worse than these little bumps.

So the $2.00 dividend is still available in the cash flow, it is just being reinvested in the business at the present time. But the market does not care unless the money is distributed. The average investor can establish a position, knowing that (based upon history), the invested money will enable the company to compound at least some of its growth rate which will grow the distributable cash flow even more. The market may be worried that reinvesting the cash flow may lower the growth rate when compared to the ability to borrow and leverage the project. But management has responded to this challenge by attempting to upgrade the current projects. So the long term investor can expect that the dividend will not only reach $2.00 in the future, it will most likely increase past that rate at some point.

The market will eventually regain its composure with respect to the company, especially after a dividend increase or two. Nothing succeeds like more money. But for the time being, with the current hostile industry environment and hostile lending environment expect management to direct the money to the proper priorities. Right now, reinvesting the cash in the business is a high priority. While the market clearly does not like the decision, with the history this management has growing the company, the individual investor should be applauding the decision. Most likely the dividend reduction will work out better than anyone expected because of the superior management of the company and the old valuation views will be restored. This stock looks like an excellent bargain at the current price.

Blue light special anyone? With one of the founders at the help, expect the stock to reach its old highs and eventually surpass those highs. While it may take awhile, and the market has no patience for that view right now. The management has long taken a very successful long term view of guiding this company profitably for years. Expect that guidance to continue to succeed long term with some hiccups along the way.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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.