This past summer, Richard Kinder stunned the financial world when it was announced his Kinder Morgan (NYSE:KMI) was acquiring its MLPs, Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipeline Partners (NYSE:EPB). Details on the transaction can be found here. Now over the past year, EPB shares are down 5.7%. That drop comes despite a 9% rally since the transaction was announced. Even with the merger, buying EPB a year ago has not proven to be the greatest trade, and that is because of fundamental problems at the partnership. In fact after reviewing its most recent quarter, it is increasingly clear EPB holders should be thanking their lucky stars Kinder decided to acquire EPB and join its struggling operations with KMP's well-performing ones.
In the past quarter (financial and operating data available here), EPB generated DCF (distributable cash flow) of $150 million or $0.65 per share, just enough to cover its distribution. EPB was only able to meet its distribution because it recently acquired KMI's 50% stake in the Ruby Pipeline, which helped to make up for problems at its own operations. Revenue in the quarter fell to $352 million from $369 million a year ago. However, the company was able to generate to $150 million in DCF thanks to cost cutting (operations and maintenance expense fell 10%) and earnings from its stake in Ruby. At some point though, expenses get cut as much as they can be.
EPB is likely getting to that point with sustaining cap-ex (which is subtracted from operating cash flow to get DCF) coming in at only $12 million, which is less than an annualized 1% of property, plant, and equipment. Additionally while EPB was able to meet the same $0.65 distribution that it declared in each of the past four quarters, debt is up $570 million from a year ago. EPB has had to add debt to acquire new assets, and its distribution is still stuck at $0.65. This is because of problems at EPB's core assets.
In particular, its operations in Wyoming have been under strain for the past year thanks to a lower re-contracting rate. Simply put, EPB gets paid less for each unit of natural gas that moves through its pipelines than it used to. In fact over the past year, transportation volumes are up nearly 10% to 8,798 BBtu/d. However, revenue is lower by around 4.6%. Lower rates at Wyoming have squeezed margins in that region, directly putting pressure on distributable cash flow.
This has left EPB in a bind, and it had begun to acquire assets to make up for stagnant operations, and the Ruby Pipeline deal has helped to stem the bleeding, though it has led to an increased debt burden. Its low equity price and high dividend yield (it was higher than 8% prior to the merger announcement) also made equity funding of acquisitions extremely expensive. In short as a stand-alone entity, EPB would have struggled to accretively grow earnings in the next few years without making debt funded acquisitions that would risk the firm's balance sheet.
Now though, EPB will receive KMI shares and a bit of cash. Instead of owning a stake in a struggling and small pipeline MLP, they will have a piece of a larger, more diversified energy transport firm with $17 billion in growth projects lined up, driven by growth in Canada and the Northeast. KMI can also work to restructure EPB's existing asset base to eventually deliver some growth. EPB will also be less than 20% of the consolidated entity, making its problems in Wyoming in particular less meaningful on a consolidated basis. Rather than owning an MLP with a stagnant distribution, KMI should be able to deliver 10% dividend growth while gradually deleveraging its balance sheet. Conversely, EPB would have been forced to lever its balance sheet further if it were to generate any distribution growth.
With lower revenue and costs cut as harshly as they could, it has become clear $0.65 is about as high of a distribution as EPB can afford, thanks primarily to weakness in Wyoming where lower transport rates have squeezed margins. Sometime before the fourth quarter ends, EPB should be part of KMI, and this deal is great for EPB investors as they can trade their units in a struggling MLP for stock in stronger company and received a premium too. These weak third quarter numbers give EPB holders yet another reason to thank Richard Kinder for buying them out.
Disclosure: The author is long KMI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.