The $38 billion acquisition of El Paso Corp. (EP) by Kinder Morgan, Inc. (KMI) is scheduled to close today, May 24, 2012. The EP acquisition will significantly impact the two underlying Kinder Morgan master limited partnerships ("MLPs"), Kinder Morgan Energy Partners LP (KMP) and Kinder Morgan Management, LLC (KMR).
KMP's numbers will change significantly once the drop-downs from KMI and the asset divestitures demanded by the Federal Trade Commission ("FTC") take place. KMP agreed to divest certain of its assets in order for KMI to receive regulatory approval for the EP acquisition. Specifically, KMP will sell: (i) Kinder Morgan Interstate Gas Transmission natural gas pipeline system; (ii) Trailblazer natural gas pipeline system; ( iii ) Casper and Douglas natural gas processing operations; and (iv) 50% equity investment in the Rockies Express natural gas pipeline system. KMP now refers to these assets as the FTC Natural Gas Pipelines disposal group and accounts for them as a business held for sale. KMI expect the sale of these assets to be completed in 3Q 2012, expects drop-downs from KMI will include all of the Tennessee Gas Pipeline system and a portion of the El Paso Natural Gas pipeline system, and expects the combination of drop-downs and divestitures to be neutral to distribution per unit in 2012 and positive thereafter.
Notwithstanding these major changes, I think it is still instructive to review KMP's performance as of 1Q 2012. Overall, revenues in 1Q 2012 decreased 7.8% vs. the prior quarter and 7.3% vs. 1Q 2011 (by comparison, revenues in 1Q 2011 increased 3.4% vs. 4Q 2010 and decreased 6.4% vs. 1Q 2010). However, segment earnings increased significantly - up 17% over the prior year period (and up 4.1% vs. the prior quarter). The drivers of KMP's segment earnings over the past 5 quarters are summarized in Table 1 below:
3 months ending:
Natural Gas Pipelines
Kinder Morgan Canada Total
Segment earnings before DD&A and amort. of excess investments
Table1: Figures in $ Millions
For the purpose of analyzing changes in reported and sustainable distributable cash flows, it makes sense to review trailing 12 months ("TTM") numbers rather than quarterly numbers given quarterly fluctuations in revenues, working capital needs and other items.
In an article titled Distributable Cash Flow ("DCF)" I present the definition of DCF used by Kinder Morgan Energy Partners LP and provide a comparison to definitions used by other master limited partnerships ("MLPs"). KMP's definition and method of deriving of DCF (what KMP refers to as "DCF before certain items") is complex and differs considerably from other MLPs I have covered. Using KMP's definition, DCF per unit for the TTM ending 3/31/12 was $4.85, up from $4.46 the TTM ending 3/31/11. How do these figures compare with what I call sustainable DCF for these periods?
The generic reasons why DCF as reported by an MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to KMP' results with respect to sustainable cash flowing to the LPs generates the comparison outlined in Table 2 below:
12 months ending:
Net cash provided by operating activities
Less: Maintenance capital expenditures
Less: Working capital (generated)
Less: net income attributable to GP
Less: Net income attributable to noncontrolling interests
Add: Net income attributable to noncontrolling interests
Working capital used
Risk management activities
Proceeds from sale of assets / disposal of liabilities
DCF as reported
Table 2: Figures in $ Millions
The principal differences of between sustainable and reported DCF numbers in the two TTM periods are attributable to risk management activities and a host of other items grouped under "Other". Risk management activities present a complex issue. I do not generally consider cash generated by risk management activities to be sustainable, although I recognize that one could reasonable argue that bona fide hedging of commodity price risks should be included. In this case, the KMP risk management activities items reflect proceeds from termination of interest rate swap agreements rather than commodity hedging and I therefore exclude them.
Items in the "Other" category include numerous adjustments as detailed in Table 3 below:
12 months ending:
Asset impairment and reserve adjustments
Other (no information provided)
Table 3: Figures in $ Millions
These adjustments further illustrate the complexity and subjectivity surrounding DCF calculations. They also highlight the difficulty of comparing MLPs based on their reported DCF numbers, which is another reason why I exclude them from my definition of sustainable DCF.
Distributions, reported DCF, sustainable DCF and the resultant coverage ratios are as follows:
12 months ending:
Distributions excluding GP distributions ($ millions)
Weighted average units outstanding (millions)
DCF as reported ($ millions)
Sustainable DCF ($ millions)
Coverage ratio based on reported DCF
Coverage ratio based on sustainable DCF
These are solid coverage ratios. However, Table 2 clearly demonstrates the extraordinarily high proportion of cash generated by this partnership that is claimed by KMI, KMP's general partner. I would therefore also like to evaluate the sustainability of cash flows from the perspective of all partners (i.e., LPs and GP). This requires a closer look at net cash provided by operating activities:
12 months ending:
Depreciation & amortization
Decrease (increase) in working capital
Net cash from operating activities
Less non-sustainable cash items within "Other":
Termination of interest rate swap agreements
Write downs and reserve adjustments
Earnings in excess of distributions from equity investments
Income from equity funds used during construction
Sale of PP&E
Other (no explanation provided)
Adjusted net cash from operating activities
Distributions to LPs, GP & non-controlling interests
Table 5: Figures in $ Millions
Table 5 shows that, after my adjustments, in the TTM ending 3/31/12 net cash from operating activities did not quite cover distributions to KMP's limited partners, to KMI and to non-controlling interests (the latter account for insignificant amounts). Of course, one could argue I am being too harsh in deducting these items, especially write downs and reserve adjustments which non-recurring. But totally ignoring them isn't right either (especially when they appear several times over the course of 2-3 years). In certain instances, these items also impact cash flows and provide some insights as to management's judgments, so I believe looking at them is worth the effort. One of the first warning signs referred to in my recent article on Buckeye Partners, L.P. (BPL) was in connection with such items. Of the $723 million in write-downs and reserve adjustments for the TTM ending 3/31/12, $322 million are write-downs made in 1Q 2012 to mark down assets in the FTC Natural Gas Pipelines disposal group.
As always, I also generate 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 in the last two years.
Here is what I see for KMP:
Simplified Sources and Uses of Funds
12 months ending:
Capital expenditures ex maintenance, net of proceeds from sale of PP&E
Acquisitions, investments (net of sale proceeds)
Other CF from financing activities, net
Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions
Cash contributions/distributions related to affiliates & noncontrolling interests
Debt incurred (repaid)
Partnership units issued
Other CF from investing activities, net
Net change in cash
Table 6: Figures in $ Millions
Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $527 million in the TTM ending 3/31/12 and by $371 million in the comparable prior year period. Thus, KMP is not using cash raised from issuance of debt and equity to fund distributions. However, KMP investors face some major unknowns in the form of uncertainty regarding the prices at which KMI will sell (drop-down) assets to KMP and the amounts KMP can generate from the assets it is divesting. At this time, I would stay on the sideline.