We have received many questions in the past few weeks regarding our thoughts on Kinder Morgan's (NYSE:KMI) bonds, so we are offering our analysis and specific recommendations.
Hysteria set into the MLP space (KMI is not an MLP but is substantially similar) in early December 2015 when KMI slashed its distribution by 75% to preserve cash flow for expansion capital. The problem that KMI faced is that with its stock price depressed and the bond market, especially for anything energy related, in a major slump, the capital markets were difficult to access. KMI was forced to raise $1.6 billion in capital a few weeks earlier with an expensive convertible preferred stock issue (KMI-A). On December 1, 2015, Moody's changed KMI's credit rating outlook to negative after the company announced that it was going to assume another $1.5 billion in debt as part of its acquisition of shares in Natural Gas Pipeline Company of America. Moody's basically stated that this extra notch of leverage was just too much and would likely lead to a credit rating reduction from "investment grade" down to Ba1. The consequences of a drop to "junk" status was significant, as it would lead to higher borrowing costs and other ripple effects. One week later, after KMI announced the distribution cut, Moody's quickly restored the Baa3 rating to "stable", citing the fact that distributions would now be cut by $3.3 billion.
That first week in December saw KMI's stock plunge by 30% and bring out talk of the "broken" MLP model, KMI's "death spiral" and even questions regarding KMI's solvency. Many KMI bonds, which were trading around par in the spring of 2015, suddenly plunged into the high-70s. We will offer our view of the current situation and our opinion regarding the bonds.
The problem KMI faced was too many demands on its cash flow. These demands included: (1) debt service, (2) growth capital expenditures, and (3) distributions to shareholders. KMI's 2015 EBITDA came to $7.5 billion - but the demands on this cash flow were $2.1 billion in interest expense, $3.9 billion in capital expenditures and $4.2 billion of dividends - or $10.2 billion total (this does not include an additional $2.1 billion for acquisitions). The shortfall in 2015 was made up through issuances of more common shares and the convertible preferred stock, totaling $5.4 billion. In 2013 and 2014, the shortfalls were made up mostly with $8 billion of additional borrowings over these two years. The point is that KMI's business model, which included paying healthy distributions to shareholders, relied upon open and low-cost capital markets, which resulted in over $13 billion of newly raised capital from 2013 to 2015.
As long as EBITDA was growing and the capital was available, this model was reasonably sustainable. However, the last time KMI saw EBITDA growth was in 2013 - since then EBITDA has been mostly flat, at $7.4 billion in both 2014 and 2015. Growth has stalled along with the energy industry as production declines. KMI, like the entire midstream sector, is facing flat to down results as its client base cuts back. Continuing to spend heavily on cap-ex and pay large distributions with no cash flow growth does not make sense.
For these reasons, the decline in KMI's stock price in 2015 was warranted. At its peak in 2015, KMI was trading at approximately a 17x-18x EBITDA multiple which is very high. These types of multiples can only be supported with consistent double-digit EBITDA growth. Flat EBITDA growth typically means valuation multiples of below 10x EBITDA, and often in the mid-single digits. KMI is a market leader with a huge asset base critical to the energy infrastructure of the U.S. The current stock price implies a multiple of 11x, still robust in our view. Unless there are clear signs of growth ahead, it is difficult to see how KMI should be worth more than the current value. If there are signs that energy industry volumes will resume their growth, then KMI stock (along with the entire midstream sector) will likely rise again.
Now moving on to KMI from a credit perspective. At no time did we consider KMI to be a weak credit; despite the plunge in the stock price, the bonds were always a solid investment. Talk of a "broken" MLP model, KMI's incredible "debt burden," and inability to access the capital markets were exaggerated. We also saw comments that KMI's absolute number of $41.5 billion itself was a problem, as if so many billions of debt automatically meant a crisis - in reality, the absolute amount of debt is irrelevant, it can only be assessed in the context of the total value of the company and in relation to EBITDA and cash flow. In this case, $41.5 billion of debt results in about 5.6x net leverage - which is exactly the same leverage as in 2012 and 2014 when there were no concerns about KMI. $41.5 billion of debt compares to an $84 billion enterprise value, or about a 50/50 debt-to-equity ratio.
We consider KMI to be a strong credit, befitting of an investment grade credit rating (and always has been), for the following reasons:
- KMI owns the largest natural gas pipeline network in the U.S. with 69,000 miles of pipeline and is a market leader in several other areas of the energy infrastructure business. These pipelines are an irreplaceable hard asset, critical to this nation. Natural gas usage is only growing, continuing to replace coal. A recent article in the New York Times starkly documents the shrinking of the coal industry. This dynamic favors KMI's infrastructure.
- Over 90% of KMI's revenues are fee-based as clients pay KMI based primarily on volume, not on commodity prices. It is likely that over the next year, as energy producers shrink or go bankrupt, there will be pressure on transportation fees and renegotiations are likely. Recent lawsuits (e.g. Sabine Oil (OTCPK:SOGCQ) and Quicksilver (NYSE:KWK)) have put into question the pipeline contracts and it seems clear that this will force renegotiation of prices - putting pressure on midstream cash flows. We view this risk as more of an issue for equity valuations, not debt service.
- Despite all the "noise" in 2015, KMI's EBITDA has held steady, at $7.4 billion in each of 2014 and 2015, with growth expected in 2016. The stability of KMI's cash flows remain proven even with the 70% plunge in oil prices.
- Leverage of 5.6x is high, but reasonable for a company of this scale, with hard assets and consistent cash flows. This leverage level has remained flat for years, and management projects similar 5.5x leverage in 2016.
- Interest coverage remains comfortable at 3.5x, and expected to remain steady in 2016. $7.4 billion of EBITDA easily covers $2.1 billion of interest expense. This bill always gets paid first - before dividends to shareholders and before growth cap-ex. So there is $5.3 billion of excess EBITDA cushion to cover interest expense.
- With the cut to its distribution, KMI has committed itself to operating within its cash flows in 2016, with no requirement to access the capital markets. $7.4 billion of EBITDA can now cover $6.5 billion of headline uses ($2.1 billion of interest, $3.3 billion in growth cap-ex, and $1.1 billion of dividends). The $3 billion dividend cut did the trick, a strong show of support to bondholders.
- Management has made it clear that it is committed to preserving its investment grade credit rating. The dividend cut was a major signal that the Company understands that it needs to take care of its bondholders before it can distribute cash to stockholders. We expect that any further pressures on the credit rating will be taken care of as necessary - from cutting the entire distribution, to asset sales.
- KMI's size and scale gives it tremendous options to handle adverse situations. From asset sales to convertible preferred stock raises, KMI has the ability to weather other storms that come its way.
The key risk we see is continued weakness in energy prices which would lead to further reductions in the oil and gas industry. Lower volumes and declining pipeline transmission prices could erode KMI's revenue and cash flows. A downside case scenario for KMI could see a 10%-20% drop in EBITDA, down to $6.0-$6.5 billion. This would result in total leverage of 6.6x, with still strong interest coverage of 3x. In this scenario, we would expect a total cut to the distribution and deferrals of growth cap-ex. While the stock price will decline in this scenario (a 10x EBITDA multiple on $6.25 billion of EBITDA implies a $9-$10 stock price), the bonds will be serviced in full. While we don't believe this downside scenario is likely (especially with recent signs that oil prices have bottomed), it is neither far-fetched. It will be interesting to see how the Chesapeake Energy (NYSE:CHK), Linn Energy (LINE), etc., stories play out and how they will ultimately affect the midstream industry - no one really knows yet. Investors in the midstream sector are hardly "out of the woods" and we would advise caution on the stocks, but see good value in many of the bonds.
Which Kinder Morgan bonds do we like? The company has a wide range of bonds available with various maturities from 2017 through the 2040s. With the recent rebound in bond markets and energy, KMI bond pricing has generally rebounded back to Fall 2015 levels and are hardly the bargains they were just a few weeks ago. The chart below shows offer pricing for various KMI bonds maturing from 2017 to 2025 (slightly better pricing and yields can be found at other platforms, such as Interactive Brokers).
The best choice in the near term are the 9% of 2/1/2019 yielding nearly 4%. The premium price often scares away investors, but there is really no reason to avoid premium priced bonds. The 9% interest rate "makes up" for the higher purchase price over time and results in a yield-to-maturity significantly higher than the 2.65% bonds maturing on the same date but trading at a discount (tax differences can be a consideration). Next I would look at the 3.95% of 9/1/2022 which is yielding 4.7%. But our favorite KMI bond is shown below.
Sometimes simply typing in the name of the issuer won't show all the bonds of a company. KMI has made many acquisitions over the years, assuming the bonds of the acquired companies, and in several cases, these bonds can only be found under their original name. All these bonds are "pari passu" which means of equal ranking in the capital structure. As Moody's points out in its credit rating report: "As part of the November 2014 re-organization of KMI, a cross-guarantee was executed by most of its domestic, wholly-owned subsidiaries, leading to the Baa3 rating for all of the included entities." Investors in KMI bonds should therefore also search for bonds under "El Paso," "Tennessee Gas Pipeline" and "Copano Energy." It is these Copano Energy bonds where we find the best value.
The 2021 Copano bonds, which were originally a $1 billion issue but now only $332 million outstanding (see page 108 of KMI's 2015 10-K for detail), seem to have fallen off the radar of KMI bond buyers and offer a 5.8% yield-to-worst (they have traded up only in the last few days from 101-102 levels; they may yet trade down a bit), by far the best yield for any KMI bond maturing through 2025. KMI bond prices have rebounded strongly in the last few weeks eliminating recent bargains. However, KMI remains a solid choice as part of a diversified portfolio of individual bonds.
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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.
Additional disclosure: DIA holds positions in KMI bonds in both personal and client accounts.