Kinder Morgan Should Stop Hanging With Those MLP Kids: Gadfly

Kinder Morgan Inc. is back in Warren Buffett territory. The pipelines giant’s stock closed below $15 on Wednesday for the first time since February 2016, when anything energy-related had all the appeal — and consistency — of week-old roadkill.

Naturally, that’s when Berkshire Hathaway Inc. showed up:

News of Buffett’s entry marked the bottom in Kinder Morgan’s stock and the wider midstream sector. But the famously long-term investor was gone within a year, and news of his exit roughly coincided with the beginning of another long slide down.

It could be that we’ll discover within a couple of months that the Nebraskan cavalry has charged in once more. But maybe not; the obvious catalyst of oil bouncing from $30 a barrel no longer holds, for example. That puts the onus on Kinder Morgan to inject some enthusiasm of its own.

It’s been trying. Last summer, it announced plans to bump its dividend up — having slashed it just before Buffett bought in — and even repurchase stock. Yet no one’s buying it, seemingly. Worse, having taken out its master limited partnerships years ago, Kinder Morgan shouldn’t be as exposed to the recent tax ruling that touched off this month’s rout in MLPs (see this). Someone clearly forgot to tell the market that.

A grinding approvals process for the Trans Mountain Pipeline expansion in Canada is one headwind. But the grinding process of working off Kinder Morgan’s debt looks more important. Like many midstream peers, it went on an acquisition spree when capital markets were wide open, funding a big dividend too. Debt hit 5.8 times adjusted Ebitda by September 2015, just before the dividend got cut. Just over two years later, that has come down to 5.1 times — better, but still high. Ebitda, forecast to grow at an average of less than 4 percent per year through 2020, according to consensus figures, isn’t cutting the denominator quickly enough. Little wonder that a $2 billion buyback plan, which serves to maintain leverage without growing the business, has failed to impress.

The traditional route in this situation is to sell stuff.

An oft-discussed candidate is the CO2 division, which produces carbon dioxide and uses some of that to produce oil from mature fields (the rest gets sold to third parties). Kinder Morgan has said it is open to selling but hasn’t because it would be dilutive. On paper, that makes sense: The business might fetch only 6-7 times Ebitda, lower than the company’s multiple. But that argument is getting ever less compelling:

Using the company’s guidance for 2018 and assuming the CO2 business could fetch 7 times an estimated Ebitda of about $850 million, the resulting $5.9 billion valuation would trim Kinder Morgan’s pro forma leverage to 4.9 times at the end of 2018 versus its target of 5.1. Granted, not the biggest needle move, there — but that isn’t the point.

Selling CO2 would remove a slug of commodity-price exposure, one of the biggest turn-offs for midstream investors who were pitched for years on owning stable energy “toll road” assets. Yes, about 11 percent of Kinder Morgan’s Ebitda would go with it. So too, though, would the persistent discussion about the fate of this anomalous oil-production business that seems quite out of proportion to its actual contribution. And that could help on the equity front.

While it has been a regular C-corp. since late 2014, Kinder Morgan retains many of the trappings of MLPs. After consolidating its partnerships, it clung onto the pre-crash MLP model of grow-and-dilute, teeing up its funding crunch and dividend cut at the end of 2015. Even today, it stresses distributable cash flow — a metric very familiar to seasoned MLP investors but less so to generalists.

Indeed, one of the reasons given for keeping CO2 is that its maintenance capital expenditure is so low — which matters in MLP-land because distributable cash flow is calculated before you take out “growth capex.” The latter is actually high for the CO2 business, even though its oil output in 2017 was the same as in 2013 — which rather undermines the whole line of argument.

Changing perceptions about the company’s identity might be dismissed as window dressing. But perception matters because, judging by what’s happened to MLPs, their seasoned investors have gone on strike, and it’s the generalists that might actually step in and deploy some money. Only on Wednesday, Viper Energy Partners LP announced it would shift to being a taxable entity precisely so it could attract a bigger pool of investors — and that’s despite it being one of the few MLPs that hasn’t been battered this year.

After all, if this is what’s happening to your multiple, then the story could probably use a refresh:

For Kinder Morgan, a simpler business portfolio pitched with a simpler value proposition centered on earnings growth, stable cash flow and deleveraging could reset the market’s view of it and attract a new set of investors. Who knows, Buffett might even show up again.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.