KMI – Conversation with Kinder Morgan’s management re Distributable Cash Flow

The first item we discussed was the ratio of long-term debt to trailing twelve months (“TTM”) EBITDA. The ratio I calculated for Kinder Morgan, Inc. (NYSE:KMI) and comparable midstream energy master limited partnerships (“MLPs”) appeared in Table 6 and, for sake of convenience, is repeated below:

Table 6: Enterprise Value (“EV”) and TTM EBITDA figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

KMI noted that its higher ratio (see column 6) does not take into consideration that the November 26, 2014, merger transactions pursuant to which KMI absorbed Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipeline Partners (NYSE:EPB) effectively eliminated structural subordination of debt. That means that KMI’s lenders are not structurally subordinated to lenders who loaned money to operating companies that are subsidiaries of KMI. Prior to the merger transactions, the latter were structurally senior, meaning that KMI’s lenders could only be repaid from the operating assets after the operating company lenders had been repaid. Thus, following the mergers, KMI’s lenders are in a better position than they were before.

KMI pointed out that Table 6 does not make adjustments for structural subordination, but that the rating agencies do take this fact in to account, and that KMI’s debt is rated investment grade, a more favorable rating than some of the peer companies appearing in the above table.

My response is twofold. First, KMI investors do not have sufficient data to adjust the column 6 ratio for structural subordination. Second, and more importantly, although the elimination of structural subordination may confer an advantage in KMI’s ability to obtain an investment grade rating, the impact of this advantage primarily relates to a reduced cost of debt (and, by implication, also total cost of capital). The lenders’ pecking order in terms of enforcing their rights against KMI is less important to limited partners. In my view, column 6 does provide a useful metric for comparing the overall risk of excess leverage between the entities.

We also discussed the calculation of EBITDA. The main differences appear to be that the company excludes “Certain Items”, adds KMI’s proportionate share of joint ventures’ depreciation, depletion and amortization expenses, and subtracts KMI’s proportionate share of the joint ventures’ maintenance capital expenditures to arrive at EBITDA. These differences are also relevant to the derivation of distributable cash flow (“DCF”) and are further discussed below.

The final topic discussed regarding my column 6 calculation was the determination of long-term debt (the numerator). It seems there are several differences between us. First, KMI reduces debt by the amount of cash on hand. That is a reasonable adjustment which I will adopt. Second, KMI excludes debt fair value adjustments (value of interest rate swaps). Third, KMI excludes a preferred interest in the general partner of KMI. I do not exclude the latter two items because they are classified and reported as part of the company’s long-term debt (these items totaled $1.7 billion as of June 30, 2015).

Another item we discussed was the method of deriving distributable cash flow (“DCF”). The method used by KMI to report DCF and the method I use to determine what I call sustainable DCF were compared in Table 3 of my article. For sake of convenience, it is set forth below:

Table 3: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

The $1,668 million in depreciation and amortization in the Sustainable DCF column is taken from KMI’s cash flow statement. The $1,906 million figure in the Reported DCF column adds to that KMI’s proportionate share of the joint ventures’ depreciation, depletion and amortization expenses, less KMI’s proportionate share of the joint ventures’ maintenance capital expenditures; hence the $338 million difference.

I pointed out that an adjustment for the amount of cash actually received by KMI from its share of the joint ventures’ operations already appears in cash provided by operating activities (the adjustment involves subtracting KMI’s share of joint ventures’ earnings and adding its share of their distributions). Thus cash received from joint ventures is included in my sustainable number.

KMI contends that not all cash received from joint ventures appears under net cash provided by operating activities (some joint venture cash distributions are captured in cash provided by investing activities) and that because of timing mismatches between earnings of and distributions made by the joint ventures, the company’s method better reflects DCF.

My response is that it is appropriate to exclude contributions to and distributions from equity investments that are non-operational in nature. In any event, the amounts are relatively small. I am not comfortable with the timing mismatches argument and prefer a method that ties cash available for distributions to the actual amount of cash held by KMI. After all, if the cash is not there, how can it be distributed? I have the same question with respect to $107 million of “certain items” and $347 million of “other” in the table above.

I would like to express my appreciation to KMI Investor Relations for discussing the article with me. In the absence of standards covering non-GAAP measures, various approaches can be used in calculating key metrics and reasonable people can differ on which approach makes most sense.