The market reacted unfavorably to Kinder Morgan's (NYSE:KMI) second quarter earnings. Shares were down as much as 5% after-hours, but they have since rebounded to $21.33, ending the day with a loss of 3%. EPS was in line with the expectation of $0.15, but revenue missed analysts' forecast of $3.45 billion by 9%, coming in at $3.14 billion.
It's difficult to say how much of the after-hours decline was the result of the miss, since revenue doesn't play a big role in Kinder Morgan's valuation in my opinion. I believe that the following negatives are far more important than that small disappointment.
Debt Reduction Is Not Going Smoothly
The management is now aiming to decrease debt/EBITDA to 5.3x by year end, a more ambitious undertaking than the original goal of 5.5x. I would've expected that this new goal was established due to a major improvement in debt/EBITDA ratio in Q2, but that was not the case. The ratio has stayed at Q1 and Q4 2015's level of 5.6x. Keep in mind that this occurred despite the fact that various projects would have come online between the end of 2015 and now. I'm quite perplexed that the lack of results made the management more confident about the company's ability to de-lever.
Both debt and EBITDA have remained constant since FYE 2015. So with half of the year now over, how will the management reach this new 5.3x goal? The management already admitted that the upcoming SNG transaction will be dilutive in the medium term, so the $1.47 billion cash injection won't help (read Impact Of SNG Transaction). What could help is the sale of 50% of Utopia to Riverstone. The expected proceed should be at least $250 million based on the estimated capital cost. Since Utopia won't be completed until 2018, it is not currently generating EBITDA. This means that debt will decrease, but EBITDA will not, effectively decreasing the debt/EBITDA ratio. Using TTM EBITDA of $7.395 billion, debt would have to decrease by $2.128 billion to reach the 5.3x goal by year end. Obviously, $250 million won't be enough, and I am eager to see what tricks the management has up its sleeve.
Management Is Stubborn
In my previous analysis, I mentioned that the company is not in distress, hence there is no need to reduce debt. If the management disagrees with my sentiment that is fine; perhaps it can't access the credit market for whatever reason. During the conference call, multiple analysts questioned the management's current financial vision.
Shneur Gershuni from UBS asked if the management wanted to "pre-fund some of the upcoming maturities" given the current market condition (low spreads). The management conceded that the company could issue cheap debt at 4%, but maintained that there is no need to access the capital markets during 2016.
Craig Shere from Tuohy Brothers laid out the following plan:
Understood, I just, what I'm trying to get at is that there is a much higher value proposition potential. And that is if you get close to five times net debt-to-EBITDA towards the end of next year and we have this flexibility we still can issue 10 year debt, and it's up 4%. If you could fund half the cost of all of your growth CapEx at 6.5 times with cheap debt, you would have enormous amount of free cash flow to both fund growth CapEx and return to shareholders. And I guess I'm trying to get a sense of, if you think that having additional projects in line would be attractive than what you currently have, I mean there was a point you had over 20 billion of inventory. Do you think that there is prospect for the next two-three years to start to charge that?
What Craig is getting at is that the company can in fact take on more debt to enhance shareholder returns. Evidently, Craig does not feel that the company is in financial distress. The management agreed with him as well, saying that it's "absolutely something we will look at," but stops short of actually promising to implement the strategy. If you are wondering why Kinder Morgan may not be financially distressed, you can read my analysis here.
So the management admits that the credit market is offering the company the opportunity to acquire cheap debt to refinance and to expand, but will not take part out of principle (something that is unclear at this point).
Perhaps, I sounded overly negative, but Kinder Morgan has proved nothing in the second quarter. I fail to see a clear path towards the 5.3x debt/EBITDA goal under the existing plan. Furthermore, I question the need to lower debt in the first place, a sentiment shared by some of the analysts. By stubbornly continuing with the original plan, Kinder Morgan is throwing away golden opportunities offered by the credit market, lowering shareholder value as a result.
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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.