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Update: A 10%+ Cost of Capital for Midstream Equities Is Reality

publication date: Nov 3, 2015
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author/source: Valuentum Editorial Staff

< This article was published on www.valuentum.com on October 27 and was subsequently modified yesterday. >

Kinder Morgan (KMI) disclosed how it would raise much-needed financing October 26, and our worst fears were realized: The marginal cost of raising capital in the midstream space has soared. As recently as earlier this year, Kinder Morgan’s executive team had been guiding analysts to a 3.3% cost of capital (“hurdle rate”), (see page 28 here), a level we had outlined was absolutely ludicrous. The 3.3% mark broke down into a 4.1% yield on equity and a 2.4% cost of debt, evenly split. Here’s what we wrote in our June 30 piece, “Kinder Morgan’s Fair Value: $29 Per Share,” when Kinder Morgan’s shares were in the high-$30s, nearly at $40:

“We think a ~3% discount rate makes little sense in terms of an investor hurdle rate, and we posit a high-single-digit discount rate is much more appropriate given both the corporate’s existing leverage and non-existent cash cushion to pay out dividends organically. The discount rate should match the average expected rate over the duration of the cash flows of its assets, or into the perp, not that of today. Kinder Morgan may have unlevered project returns of 8%-12%, but that’s very close to its cost of capital in our opinion. The company’s ~3.3% ‘Analyst Day Hurdle Rate’ assumption is “fantasy” when it comes to long-term intrinsic value estimation.

We assign Kinder Morgan the lowest cost of equity measure in our coverage universe at ~8.9% and assume a 6.6% long-term after-tax cost of debt, which we think is reasonable in light of evaluating long-term intrinsic worth. We discount future enterprise free cash flows at ~8%, our estimate of the company’s true cost of capital. We disclose the value breakdown, by phase, from our valuation model below. Of note, we value over 1,000 equities, and Kinder Morgan is a significant anomaly in our valuation process, which is why we’re issuing ongoing warnings to investors. (this article was our third warning to investors, released June 30)”

To continue reading the June 30 note that walks through all of our valuation assumptions to arrive at the then-$29 fair value estimate for shares >>

The unrealistically “low-cost-of-capital” days are now over, in our view.  

Kinder Morgan recently announced that it would float $1.6 billion in mandatory convertible preferred stock, effectively “delayed” issuance of equity capital, which would carry a stated interest rate of 9.75%. Management had previously noted around its third-quarter earnings release that the new financing would not be equity capital, so the announcement was rather strange because, from our perspective, the end result of this transaction after three years would, in fact, be equity capital. It is only because management stated that it would not be raising equity capital that we had thought Kinder Morgan would instead “max” out the revolver as a way to finance the dividend and upcoming projects. The company may still have to “max” out said revolver, or at least Moody’s believes it might have to:

Through the third quarter of 2016 Moody’s expects the company will have nearly $11 billion of cash from operations and liquidity resources to fund about the same amount of dividends, capital expenditures and debt maturities. The company will have about $5 billion of cash from operations, together with pro-forma cash of $1.7 billion and an essentially unused credit facility of $4 billion (expires 2019). We expect dividends in the mid-$4 billion range, capital expenditures around $4.5 billion, and debt maturities in Q4 2015 and Q1 2016 totaling $2.4 billion.”

We continue to find it puzzling that a corporate, not an MLP, that essentially may have to “max” out its revolver (+$4 billion) and raise equity at expensive prices (+$1.6 billion) to retain liquidity to meet obligations just for the next few months is an investment-grade credit. Let me repeat the concern: Moody’s is justifying an investment-grade rating for a corporate that is 1) already near 6 times leveraged, 2) on the basis of previous dividend growth expectations of a 10% CAGR, may have had to pay out more than its distributable cash flow as dividends in the coming periods (please view its third-quarter conference call transcript for this reference here) 3) has had to raise expensive capital that will eventually be equity, and 4) may have to “max” out its revolver just to meet dividend, capital spending, and debt maturities for the next few months. The revolver is a corporate credit card that may translate into an even higher debt load for the company. We’re just not seeing the case for the credit rating agencies assigning the company an investment-grade rating given that Kinder Morgan is faced with meaningful commodity-price exposure, or at least enough to cause the firm to miss expectations quarter after quarter.

That the recent convertible preferred issue (which will turn into equity) was priced at $49, below the $50 face value, suggests the marginal cost of capital for Kinder Morgan (or the effective yield) is close to ~12% {[9.75% + (1/50)] = 11.75%}. We’re not sure how a near-12% cost of capital float was more appealing than the cost of equity capital today, but if it is, the very thought that the marginal costs of borrowing debt or floating pure equity are greater than 12% for midstream equities is near frightening. As of November 2, we use an ~8% weighted average cost of capital assumption in our valuation model of Kinder Morgan, but a notch upward to the double-digits in the discount rate would push the equity’s fair value toward the lower end of the fair value range (near $23). Our present fair value for Kinder Morgan is $26 per share.

Unfortunately, we think the implications on the master limited partnership arena are even more dire. As we had outlined in this chart here, we believe investors continue to “price” equity in the MLP space (AMLP) on the basis of a “mid- to- high-single-digit” yield-equivalent on their distributions, a function of the industry’s definition of “distributable cash flow,” which we have noted our objections to in the past. We think all midstream corporates should disclose non-GAAP free cash flow, as defined as cash flow from operations less all capital spending. In the event, however, that MLP distributions are “valued” on a 10%+ discount rate, unit prices on MLP equities would tumble. There’s more downside risk to the prices of units across the MLP space, in our view, but we’ve been rather surprised by the magnitude of the bounce in recent weeks.

We understand that, after our warnings on Kinder Morgan, the market wants us to be wrong on our views on MLPs so bad, and we’re listening. We’re always open to new information, and we’ll be releasing our fair value estimates for MLPs under coverage in a later post to this one. You can access them now at our website at www.valuentum.com. We want to make sure that readers understand that, while we generally aren’t favorable on the long-term outlook for MLPs, their equities have intrinsic value, and we want to share our estimates with readers. Just like when we called the collapse in Kinder Morgan’s shares from $40 to the mid-$20s today, every company has value, even if we’re not necessarily bullish on shares. This is a very important distinction that is sometimes lost in articles, but not within our 16-page reports and 500-line valuation models. It’s so important to view equity analysis through the lens of a discounted cash-flow valuation model – to me, it is far better than even the most elegantly-written prose.

I hope you enjoy our continued coverage. I can be reached directly at brian@valuentum.com for any questions, comments, or corrections. Thank you for reading!

Valuentum (val∙u∙n∙tum) [val-yoo-en-tuh-m] Securities Inc. is an independent investment research provider, offering premium equity reports and dividend reports, as well as commentary across all sectors/companies, a Best Ideas Newsletter (spanning market caps, asset classes), a Dividend Growth Newsletter, business/investing book reviews pre-public release, modeling tools/products, and more. Independence and integrity remain our core, and we strive to be a champion of the investor. Valuentum is based in the Chicagoland area.

Disclosure: I do not own, nor have I ever owned, shares of Kinder Morgan. Valuentum does not own shares, nor has it ever owned shares, of Kinder Morgan. I am not short shares, nor have I ever shorted shares, of Kinder Morgan, and Valuentum is not short shares, nor has it ever shorted shares, of Kinder Morgan. Independence and integrity remain the cornerstone of our business.


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