Author: Ron Hiram
Published: February 25, 2017
- Adjusted EBDA declined 6.2% in 4Q16 and 3.7% in 2016, mostly due to sharply lower gas-gathering volumes and crude/condensate gathering volumes.
- Cash generated by operating activities declined 28.1% in 4Q16 and 9.7% in 2016; consequently, reported and sustainable DCF were also lower.
- Management‘s 2017 guidance indicates no substantial improvement over 2016 in terms of Adjusted EBDA, DCF and leverage.
- Management seems to be planning to announce a substantial dividend increase late in 2017; it may be premature to do so before showing significant improvement in key operational parameters.
- KMI is now on a much more solid financial footing; growth projects are being funded with internally generated cash flow without needing to access equity markets.
This article focuses on some of the key facts and trends revealed by Kinder Morgan Inc. (KMI) results for 4Q 2016.
Adjusted earnings before depreciation and amortization (“Adjusted EBDA” or “Segment earnings before DD&A and certain items”) is one of the important yardsticks used by management to measure its success in maximizing returns to shareholders, to evaluate segment performance, and to decide how to allocate resources to KMI’s five reportable business segments. Adjusted EBDA over the past 8 calendar quarters is shown in Table 1 below:
Table 1: Figures in $ Millions (except per share amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Adjusted EBDA generated by Natural Gas Pipelines, by far the largest segment in terms of EBDA contribution, was down 10.4% in 4Q16 vs. 4Q15 and down 3.7% on a per unit basis in 2016. Management stated this was largely due to lower contributions from SNG as a result of selling 50% of this pipeline in 3Q16. But there are notable declines in gas gathering volumes (down 21.4% due to reduced production at the Eagle Ford, Haynesville and Bossier shale formations, and in and Northwest Louisiana) and in crude/condensate gathering volumes (down 15.9%). Management expects improved performance by this segment will be driven by increased demand for gas in the power sector, increased exports to Mexico and increased exports of liquefied natural gas (“LNG”). It is encouraged by the uptick in rig count at t Eagle Ford and Haynesville.
Adjusted EBDA increased 6.6% at the Products Pipelines segment and 15.2% at the Terminals segment, but declined 18.5% at the CO 2 segment due to lower oil prices and an 8% decline in production. This segment’s business includes: a) production, transportation and marketing of CO 2 for use as a flooding medium enabling increased production in mature oil fields; b) interests in and/or operation of oil fields and gas processing plants in West Texas; and c) ownership and operation of a crude oil pipeline system in West Texas. CO 2 continues to adversely affect overall results primarily due to lower commodity prices.
In total, Adjusted EBDA in 4Q16 is down $123 million or 6.2% from 4Q15, largely driven by the $114 million decline in Natural Gas Pipelines.
To derive net income, KMI deducts from Adjusted EBDA depreciation, depletion and amortization (“DD&A”), general & administrative (“G&A”) expenses, interest expenses, taxes, non-controlling interests’ share of net income, and reverses “certain items” (typically expenses) required by GAAP to be reflected in the income statement. Management defines these as items that typically: a) do not have a cash impact (for example, asset impairments), or b) by their nature are separately identifiable from normal business operations and are likely to occur only sporadically (for example certain legal settlements, hurricane impacts and casualty losses).
While individual components of “certain items” may occur sporadically, in the aggregate they occur every quarter and have a significant impact. The $951 million favorable swing from $736 million net loss in 4Q15 to $215 million net income in 4Q16 is principally due to the $988 million change in these certain items:
Table 2: Figures in $ Millions (except per share amounts). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Excluding “certain items”, net income attributable to common shareholders totaled $409 million in 4Q16, down 20.4% vs. the $514 million in 4Q15. The “certain items” are an aggregation of various gains (losses) detailed in Table 3 below:
Table 3: Figures in $ Millions (except per share amounts). Source: company 10-Q, 10-K, 8-K filings and author estimates.
As shown in Tables 3 and 4, $239 million of “certain items” were reversed from the GAAP accounts in deriving net income in 4Q16. The amount of “certain items” reversed from the GAAP accounts in deriving Adjusted EBDA in 4Q16 was larger and stood at $389 million (presumably because items such as debt amortization and book taxes are not included).
The principal components of the $239 million adjustment in 4Q16 are reversals of several GAAP items. Management reduced the value of Ruby Pipeline LLC by $250 million, reduced the value of other assets by $93 million, and partly offset that by decreasing legal and environmental reserves by $71 million. The write down the value of the Ruby natural gas pipeline was “ driven by a delay in expected west coast natural gas demand growth to beyond 2021” (KMI Form 8-K, 1/18/17).
In the prior quarter, management reduced the value of another natural gas pipeline by $350 million ( Midcontinent Express Pipeline LLC) following “commercial discussions during the third quarter of 2016 with current and potential shippers on regarding the outlook for long-term transportation contract rates” (3Q16 Form 10-Q). There were also large asset impairment adjustments in 1Q16, 4Q15 and 3Q15. These included a $170 million write-off of costs associated with the NED Market and Palmetto Pipeline projects, and a$1,150 million write-off of other assets within the Natural Gas Pipelines segment.
To derive Distributable Cash Flow (“DCF”), KMI adds the negative values and subtracts the positive values in Table 3. KMI then makes further adjustments for purposes of deriving DCF, as shown in Table 4:
Table 4: Figures in $ Millions (except per unit amounts. Source: company 10-Q, 10-K, 8-K filings and author estimates.
DCF is one of the primary measures typically used by a midstream energy master limited partnership (“MLP”) to evaluate its operating results. Because there is no standard definition of DCF, each MLP can derive this metric as it sees fit; and because the definitions used vary considerably, it is exceedingly difficult to compare across entities using this metric. Additionally, because the DCF definitions are usually complex, and because some of the items they typically include are unsustainable, it is important (albeit quite difficult) to qualitatively assess DCF numbers reported by MLPs.
Given the magnitude and frequency of “certain items”, there is a high “noise” level in KMI’s results. This causes me to assign a lower rank to the quality of its DCF numbers. Of course, this is a subjective, non-quantitative, assessment.
The generic reasons why DCF as reported by a master limited partnership (“MLP”) may differ from what I call sustainable DCF are reviewed in an article titled “ Estimating sustainable DCF-why and how”. DCF definitions used by other MLPs are described in an article titled “ Distributable Cash Flow”.
Table 5 provides a comparison between the components of reported and sustainable DCF for the quarters and the trailing twelve months (“TTM”) ending 12/31/16 and 12/31/15:
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Cash generated by operating activities was down 28.1% in 4Q16 and down 9.7% in the TTM ending 12/31/16 vs. the comparable prior year periods. Consequently, for the same periods reported DCF is down 20.8% and down 3.4%. Sustainable DCF is down 6.9% in 4Q16 and is down 4.0% in the TTM ending 12/31/16 vs. the comparable prior year periods.
The variances between reported and sustainable DCF result, in part, from differing treatments of working capital cash flows. DCF numbers reported by KMI ignores all such cash flows, while my sustainable DCF calculation deducts cash used for working capital because cash consumed is not available to be distributed. However, despite the apparent contradiction in the methodology, I ignore cash generated by liquidating working capital because I do not consider it a sustainable source. Over reasonably lengthy measurement periods, working capital is not typically a huge consumer of funds for MLPs. However, in the periods under review KMI’s working capital cash outflows in the quarter and TTM ended 12/31/16 totaled $100 million and $90 million, respectively. I deducted these amounts in calculating sustainable DCF.
Another source of variance between reported and sustainable DCF in Table 5 is categorized as “Other”, the components of which are shown in Table 6:
Table 6: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The DD&A and tax adjustments in Table 6 reflect KMI’s share of equity investees’ DD&A and KMI’s share of equity investees’ book tax differentials.
Due to the dividend being cut by 75% in 4Q15, it is now amply covered and distribution coverage ratios have become less meaningful, whether based on reported DCF or on my sustainable DCF calculation:
Table 7: Figures in dollars except percentages and ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The dividend cut decimated quarterly cash inflows many investors were counting on and came on top of large capital losses caused by the precipitous drop in the stock price. However, investors who maintained, or recently initiated, their positions have a stake in a company that is now on a much more solid footing.
The simplified cash flow statement in Table 8 shows substantial increases in the amounts of excess cash being generated by KMI after instituting the dividend cut:
Table 8: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates
Cash from operations after deducting maintenance capital expenditures and distributions totaled $2,975 million in the TTM ended 12/31/16. This excess cash, made available following the sharp dividend cut, was supplemented by cash contribution by affiliates and used to fund growth investments and reduce leverage.
The reduction in leverage is also being achieved through asset sales. In June, KMI completed the sale of a 50% interest in its $500 million to-be-constructed Utopia pipeline project to Riverstone Investment Group LLC for half of the project capital costs plus an amount in excess of its share of project capital. In September, KMI completed the sale of a 50% interest in its Southern Natural Gas pipeline (SNG) to Southern Company for $1.4 billion plus Southern Company’s share of SNG debt. As a result of this transaction, KMI no longer holds a controlling interest in SNG and therefore now accounts for its remaining interest as an equity investment
KMI significantly reduced its growth capital backlog from $18.2 billion as of 4Q15 to $12.0 billion as of 4Q16 and plans further reductions. A single project, the $5.4 billion expansion of the Trans Mountain Pipeline from ~300,000 to 890,000 barrels per day, underpinned by long-term take-or-pay contracts, accounts for 45% of the current backlog and has encountered delays). Management intends to syndicate ~50% this project. KMI’s second largest backlog item is the $1.9 billion Elba Liquefaction Project. It is planned to produce 2.5 million tons per year of LNG for export, equivalent to approximately 350 million cubic feet per day of natural gas, and is supported by a 20-year contract with Shell. Production should commence in mid-2018 and reach full capacity by early 2019. Management intends to syndicate ~50% this project too.
Management‘s initial 2017 guidance indicates no substantial improvement over 2016: dividends of $0.50 per share (unchanged from the current level); DCF of approximately $4.46 billion or $1.99 per share (vs. $4.51 billion or $2.02 per share in 2016); Adjusted EBDA of approximately $7.20 billion or $3.23 per share (vs. $7.40 billion or $3.32 per share in 2016); investments totaling $3.2 billion in growth projects, to be funded with internally generated cash flow without needing to access equity markets; and ending the year with a net debt-to-Adjusted EBDA ratio of approximately 5.4 times (unchanged from 2016, but below the 2015 year-end ratio of 5.8 times).
In the analyst call discussing 3Q16 results, management articulated a target debt-to-Adjusted EBDA ratio of “around 5 times”. Once that target is reached, management plans to resume funding expansion projects using 50/50 debt/equity and to use the excess cash for the equity portion rather than issuing new equity (as was done in the past). Management indicated a preference for using the balance of the excess cash to modestly increase the dividend. But management now seems to be planning a substantial dividend increase, saying “the best way to deliver the [increase in shareholders’] value is through substantially increasing our dividend in the latter part of this year” (Earnings Call Transcript, 1/18/17). It may be premature to do so before showing significant improvement in key operational parameters.
I began reducing my MLP investments the fall of 2014 and eliminated my KMI position in 2Q15.