In a recent article on Kinder Morgan Inc. (NYSE:KMI), found here, I discussed broadly the difficulties in valuing KMI now that it has changed its method for funding growth CAPEX but I came to the conclusion that Distributable Cash Flow (DCF) was still the best metric for determining its value, rather than GAAP earnings. I described how the company is undervalued from a historical perspective but the analysis behind the legitimacy of DCF deserves further discussion which is the focus of this article.
As an accountant I believe strongly in GAAP earnings. The net income number provides a true reflection of the results of a business and increases in shareholder value in terms of retained earnings. Expenses match up with revenue generated and a valuation can be determined from a multiple of those earnings, reflecting the present value of future expected earnings.
If you were to purchase a company completely, you would want your investment to be repaid to you over a certain number of years and then start making a profit. The more stable and reliable the business is, the longer the number of years a typical investor is willing to wait to earn back their investment, i.e. the longer the payback period is they're willing to accept. Small businesses (<$30 million market cap) may have EBITDA or earnings (depending on type of business) multiples of 3 or 4 compared to the S&P 500 which has a 15-20 P/E multiple on a historical earnings basis.
For long-term investors, buying shares in a public company is the same as taking an ownership position in that company with an expectation of being repaid your investment over the long-term, either by way of dividends (cash distributions) or increases in the value of the company by way of increased retained earnings which financial theory says we investors should be indifferent between the two.
Cash is King
Though financial theory says investors should be indifferent to where a company's cash flow is directed as long as it is increasing the value of the company, investor psychology and preferences are not homogeneous. Dividend growth investors, for example, like companies that pay steady, increasing dividends that can be reinvested. Income investors want a portfolio that will generate steady income for them to live on without having to sell shares. Dividends are also an easily understood metric for valuing a company because the return to shareholders, i.e. the dividend yield, is simple to compare to other income generating assets. The zero interest rate policy (ZIRP) environment we have been in since the 2008 financial crisis has boosted the relative valuation of dividend stocks because comparatively safe government bonds have low yields.
Investors' search for yield in the ZIRP environment led them to KMI. The company offers a large infrastructure asset base generating stable and reliable cash flow that can be distributed to shareholders in excess of GAAP earnings because GAAP earnings includes many non-cash expenses. That is, the company generates significant cash in excess of its actual profit, because its assets are being depreciated. KMI promised to distribute all that extra cash to shareholders, and fund growth with capital infusions.
KMI had weak GAAP earnings due to non-cash expenses and weak free cash flow due to high growth expenditures but was able to pay out large distributions because capital markets funded the growth, making it an attractive income investment. Conversely, a company may have great GAAP earnings but poor cash flow if the cash is going towards working capital, capital expenditures, debt repayment etc. In that situation the earnings actually available to shareholders in the form of cash is significantly less, making those earnings less valuable to shareholders focused on income.
Free Cash Flow (NYSE:FCF) vs. Distributable Cash Flow (DCF)
Investors focused on cash flow for valuing a company will generally rely on the Free Cash Flow metric, being cash from operations less capital expenditures. The idea is that regardless of what GAAP earnings are, cash flow is what matters and the cash generated from operations can be used to reinvest in the company (capital expenditures) and/or distributed to shareholders. If a company consistently needs to invest capital to maintain earnings then free cash flow reflects a reasonable net cash from the business that can be distributed to shareholders and becomes the basis for valuing the company.
The weakness in this measure is that companies don't necessarily have static levels of capital expenditures or the capital expenditures they are incurring are growing earnings rather than maintaining them. For other companies with heavy investment periods, shareholders are required to accept the short term cash crunch as the cost of growing future earnings. It's no different with KMI except that KMI gives more information to shareholders by going one step further and differentiating capital expenditures between sustaining CAPEX and growth CAPEX. Sustaining CAPEX is the capital expenditure required to maintain existing asset throughput/volume while growth CAPEX is, as it sounds, capital expenditures that create new capacity. Sustaining CAPEX won't necessarily sustain earnings but because contracts are long-term and often fixed by regulatory process, sustaining CAPEX can be reasonably expected to maintain existing earnings rather than grow new earnings. By differentiating between growth and sustaining CAPEX, KMI could give shareholders the opportunity to fund new growth specifically, via capital infusions. This allowed for greater distribution of cash flow from existing operations and is the model that broke down at the end of 2015.
DCF therefore is FCF plus growth CAPEX and is a superior metric for valuing the company because it provides more information to shareholders regarding the company's investments. If sustaining and growth CAPEX were lumped together, it would be far more difficult to measure the returns shareholders are getting from the existing vs. new infrastructure assets.
Accordingly, we can focus on DCF as a measure of the cash generated by existing assets adjusted for the CAPEX required to maintain their useful lives. GAAP earnings include depreciation charges on the assets based on an estimated useful life as at the balance sheet date and exclusive of sustaining CAPEX. However, the company incurs sustaining CAPEX to maintain the useful lives of the assets. Pipelines, the bulk of assets depreciated, have an effective indefinite useful life if properly maintained. Thus the sustaining CAPEX figure provides a more useful metric for assessing the cash outlay required to maintain existing capacity, rather than the historical-based depreciation charges.
One weakness with DCF is that investors are required to place reliance on KMI management's determination of a non-GAAP measure, being sustaining vs. growth CAPEX. To some extent shareholders need to trust management. PricewaterhouseCoopers audited the information provided and deemed them to be a fair representation of the activity that occurred. KMI also has significant insider ownership which provides a compensating control that 'shareholders' are not being misled by this measure. KMI management has also publicly supported and defended DCF accuracy on several occasions. The risk that DCF is misstated or a misrepresentation of the nature of the transactions that have occurred is acceptably low.
Though the 'distributable' description of KMI's primary cash flow metric is now a misnomer, Distributable Cash Flow is still an appropriate and useful basis for valuing the company.
Disclosure: I am/we are long KMI.
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.