Kinder Morgan (NYSE:KMI) just reported earnings. To highlight a few of the numbers: The company cut its 2016 spending program by $900M to $3.3B. It also decreased its project backlog by $3.1B from $21.3B in Q3 2015. The company guides to full year 2016 distributable cash flow of $4.7 billion only a small part of which is paid out through a dividend, which was cut in December by 75%. The earnings call was chock full of interesting commentary from the management team. I want to discuss some of the absolute best pieces (emphasis mine):
...KMI's underlying business remains strong even in this challenging environment...
...The fundamentals don't seem to matter in this Chicken Little-The Sky is Falling market, but they should prone to long-term investors.
...We are a generator of a tremendous amount of free cash flow about $5 billion per year and that's after we've paid all of our operating cost, our interest expense and our sustaining CapEx. Now, there are several ways we can utilize that cash flow…
Of course none other than CEO/Chairman Rich Kinder himself could put it like this. The company generates tons of free cash flow and the market is full of chicken little's who can't see beyond next quarter's earnings or so I take it. He owns 243 million shares or thereabouts so his interests are well aligned with those of minority shareholders and he has his money where his mouth his.
We can de-lever the balance sheet and totally fund our growth capital needs and/or return cash to our shareholders through either increasing the dividend and/or buying back shares (??). We have significantly reduced our anticipated capital expansion expenditures for 2016. You'll hear more details on that from Steve today and at our investor conference. And that's a trend you can expect to continue as we high-grade our capital investments and selectively joint venture projects where appropriate.
Talk about increasing the dividend and returning capital to shareholders seems a little bit premature at this point in time after just having slashed the dividend in December? Or is this all part of a genius plan to cut the dividend, drop the share price and then de-accelerate CapEx and accelerate buybacks at the expense of all the Chicken Little's in the market?
There is an important section that you should read in full because as a pipeline company Kinder Morgan lives by the payments of E&P and other companies. If these are dropping like flies, counterparty risk (i.e. will their fees for transport be paid in full) becomes a real risk. Management explains it has only 20 customers who account for 1% of revenue and a great majority of customers are of investment grade quality debtors. The biggest of all its customers represents 5% of revenue and its credit rating equals AA- which is very high. A paragraph about counterparty risk that actually worried/confused me a little bit was the following:
We estimate that our top 25 customers constitute about 44% of our revenue and just over 80% of the revenue from that top 25 is coming from an investment grade rated entities.
Which implies only about 35.2% of revenue appears to come from investment grade customers AND top 25 customers. With the great majority of customers solidly investment grade many smaller customers must be investment grade or higher as well. Kinder Morgan will be providing more detail on the counterparty risk next week and I think that's good because you can easily misread this information.
We high graded our backlog to focus on the highest return opportunities. We're aiming to reduce spend, improve returns and selectively joint venture projects where appropriate. We've reduced our 2016 spend that we initially announced to you by an additional $900 million, that's off to $4.2 billion we said in December and we've reduced our backlog by $3.1 billion from the third quarter of 2015 and that was just under $1 billion worth of projects placed in service during the quarter.
That action along with retaining cash above our $0.50 annual dividend aviates the need for us to access the capital markets, [shores] up our investment grade debt metrics and both of those things adds stability to our outlook in difficult times while enable us to continue to grow our value over time.
I think this part of the earnings call provided a lot of relief to the market. Especially the reassurance about needing to tap capital markets (which are not super conducive right now). But the company reducing its CapEx spend is also taken as a great way to return price stability to the company's shares. I continue to think the talk of returning capital in the introduction is somewhat at odds with this but we'll see how that plays out.
The Q&A part of the call is one of the richest and most interesting parts with Kinder answering several questions seemingly genuinely and in depth:
I think as far as overall market is concerned, I said in the opening remarks it seems like a chicken little disguise following market. There seems to be no discrimination among based on quality or based on virtually anything it's just if oil prices go down, sell everything in the energy sector. I think that's a very wrong headed short-term view, but the market is what the market is. And obviously we believe we're tremendously underpriced.
If you look he is a company that's going to have close to $5 billion of free cash flow in the total market capital, but this level is $27 billion, $28 billion. I'm afraid to even compete that it upsets me so much. But that's my feeling on it, probably more than you wanted to hear. But as a larger shareholder I can tell you its very frustrating.
After KMI jumped it now has a market cap of $33 billion but still, a ~6x free cash flow multiple is definitely low, especially considering the quality and stability of earnings of a pipeline operator of the scale and size of KMI. I think its interesting that Richard Kinder, in a very simple way, does the valuation for us here.
After being prodded further by a significant long term shareholder Rich Kinder volunteers more interesting information:
What we've tried to say is that we're going to have a lot of cash flow - just let me finish please, you can take what we have today which is roughly $5 billion of free cash flow. You can look at our backlog, we can give you an idea of what the expected return on that is and then you can take that number and let's say that's a dollar, whatever it is, per share, you can take that and add it to our present number and buildup what you think the cash flow will be in 2020 or 2021 but I want to again caution you that we have not been in this business 35 years, this is the most - more head win, side wins, anything that I have ever seen and to sit here and give you a number in 2020 would be insulting to you and to everybody else.
Kinder is again putting in no uncertain terms, the company is very much undervalued and he believes whatever way the coin comes up shareholders will win in the long term.
And what we're trying to tell you is, we've got a lot of cash flow, we're going to do that, we're going to use that in a way that makes the most sense for the company and its shareholders. And if that involves buying back shares or increasing the dividends to a level, that's what we're going to do.
I'm always a little bit wary of CEO's promising growth in cash flows but I'm quite convinced Kinder, with over 200 million shares, means it when he says he thinks the shares are greatly undervalued and the free cash flow is going to grow over time. Painful as it is I believe he may be doing the right thing, cutting the dividend and spending free cash flow elsewhere. I understand the outcry among shareholders but it may be in their best long term interest.
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.