Pipeline behemoth Kinder Morgan (KMI-NYSE) cut its dividend last night by 75%–ending a three year string of getting their money for nothing and your dividends for free (with apologies to the band Dire Straits).
This issue is causing investors to give all North American pipeline stocks a higher discount rate–and therefore a lower Net Present Value–on their dividends for years to come. That has been showing up in lower stock prices for midstream (pipeline) stocks for most of the year.
As you will read below, my NPV calculation gives Kinder Morgan a price of $13.82. And that’s with dividends growing 15% a year from the new level of 50 cents a share annually. But the Market will like a lower payout ratio–now 22% vs. 90% previously–and will likely bid the stock higher now.
What do I mean by free dividends? The free dividends came courtesy of the U.S. Federal Reserve’s Zero Interest Rate Policy (ZIRP) of the past few years (free money!). It allowed capital intensive businesses like pipelines to rapidly expand their asset base using low-cost debt financing. The low-cost debt provided lots of excess cash flows–above debt service costs–that were paid out as dividends to investors, make them (and company management!) rich in the process.
All this debt-driven dividend growth led to the current income/dividend stock craze, with no sector benefitting more than the MLP sector–Master Limited Partnerships. (Canadians: think income trusts…) One of the most beloved MLPs at the time, Kinder Morgan (now a regular C-Corp), grew revenue by more than 100% from 2011 to 2014 (from $7.9 billion in 2011 to $16.2 billion in 2014).
They did it by increasing their total asset base from $16.8 billion to $38.5 billion. They are in the asset leasing business (owning very expensive pipelines and charging tolling fees to customers), so more assets = more income!
The $21.7 billion increase in assets was financed via a $26.6 billion increase in debt (to just over $42.7 billion) over the same period. That allowed distributions to grow from a CAD$1.20 per unit annually rate in early 2011 to CAD$2.04 per year today.
That’s a lot of numbers, but the punch line is this: KMI borrowed $26 billion from 2011 to 2014 to buy $22 billion of pipeline assets and nearly doubled their distributions to equity holders in the process.
In 2014, Kinder grew distributions 9% and investors believed North American oil production could grow forever and cheap credit would allow Kinder, and many others, to expand their assets into perpetuity – locking customers (oil producers) into take-or-pay contracts often spanning 20 years that would guarantee the stable cash flows.
OPEC thought differently, however, and Kinder has seen their share price decline by more than 2/3 in just one year! With that kind of decline, it must be cheap, right?
Investors view MLPs (and income stocks) as cash flow streams rather than equities or operating companies, which is why they tend to be valued more richly than most companies. Everyone loves cash. Until last year, investors rarely questioned if MLP distributions would grow – they only asked how quickly the growth would occur and what dividends would be a few years from now. As a result, investors simply HAD to own MLPs!
Using a simple Net Present Value model (NPV) to show that despite the surge in MLP valuations, I can show investors were actually acting quite rationally. Kinder’s stock was $43 prior to the energy market crash. Apply a simple 6% discount rate (roughly their cost of capital) to 9% distribution growth for 20 years, and the Net Present Value of Kinder’s dividends from 2015 onward were roughly $47 per unit, as this chart shows:
But as oil prices collapsed, investors saw increased risk in MLP cash flow streams – something few thought was possible just months prior. After all, aren’t they fixed price, 20 year contacts?!?!? In the case of Kinder, as oil prices collapsed, revenue declined from $4.266 billion in Q3 2014 to $3.57 billion in Q3 2015.
This scared investors as they realized there actually WAS risk to cash flows, and thus future dividend growth. Using the same NPV model above, but lower the expected dividend growth rate to 4.50%–then KMI units are now worth just $30.14:
As you can see, a relatively small change in dividend growth expectations has a HUGE impact on the value of the cash flow stream – and thus the company.
Notice, however, the discount rate didn’t change. The discount rate is effectively the hurdle rate – or minimum rate – investors believe they need to earn in order to justify risking their hard-earned money in an investment. When interest rates are low and times are good, discount rates can be very low (sub 5%). When interest rates increase, investors have alternatives–some of you may remember the days when savings accounts offered 5% interest rates!
When a sector is believed to be risky, as the entire energy sector is today, investors want higher returns to compensate for the risk. Would you buy an interest in an oil well today promising a 5% return? Probably not! 10%? Nope… Start talking 30% to 50% and I’ll sit down and listen to the pitch.
While sub-5% rates of return were previously the norm back in the good old days of 2014 (when KMI yielded 4.6%), in today’s market investors want MUCH higher returns… I could make a pretty long list of companies offering 10%+ yields that I would not buy today. In the case of KMI, prior to yesterday’s distribution cut the yield was 12.97%!
And what happens if we increase the discount rate from 6% to 10%? The Net Present Value of expected Kinder distributions – still growing at 4.5% per year – declines to $21.10.
It could be argued the sector is oversold. It may be, but discount rates don’t recover overnight. If oil went to $100 tomorrow, investors would still remember the pain of 2015 and require a higher rate than they did a year ago. The very same cash flow stream investors valued at $43 a year ago ($1.85 in 2015 dividends growing 9% per year for 20 years at a 6% discount rate) is only worth $31.08 if investors believe the sector is more risky today and thus require a 10% discount rate rather than 6%.
Bottom Line: Don’t expect MLPs to come roaring back to new highs, even if oil prices do!
So how did Kinder units fall under $16.00? They did something most (honest) MLP CEO’s are doing: They admitted they could cut their dividend. In fact, on Monday the WSJ reported Kinder held an emergency Board meeting to discuss cutting their dividend and late last night they announced the 75% cut – to $.50 per share annually.
Often times perfectly honest management teams that swore they would never cut their dividend end up doing so when investors expect them to – the shares continue to slide until they do and at some point, companies realize they are no longer getting credit for maintaining their dividend but rather being punished for not cutting it!
Besides keeping investors from worrying, there are some benefits to cutting your dividend – even when you could afford to continue paying it. Quite obviously you can build up some cash to pay back debt, make acquisitions or just keep for a rainy day (like today). As perverse as it sounds, dividend cuts also allow companies to offer much higher growth rates in the future, which as we now know investors value (higher growth rate = higher unit price).
Three years from now I guarantee you will hear more than one company say something like “three consecutive years of double-digit dividend growth” in their PowerPoint presentations, leaving out the bullet that mentions they cut their dividend in half in 2015.
But what happens if we cut KMI’s 2016 dividend by 75% in our NPV analysis, to their announced $.50 per unit, but then increase the growth rate going forward to 15%? in half in our NPV analysis, to $.93 per unit, but then go back to a 9% growth rate?
You get a stock price that finds a home somewhere near $13.82–pretty much what just happened to the stock in the last week. Despite the ‘higher growth rate’, the units get slaughtered… Cash in 2016 is worth much more than cash several year in the future – hence the ‘Present Value’ in Net Present Value…
It’s a big and humbling setback for both KMI and the industry that investors thought were immune to big commodity price swings. The stock will certainly be down in the first couple hours of trading Wednesday, but I’m very curious to see what happens to the pipeline stocks that have a much lower payout ratio on their dividends (KMI was near 90%; others are closer to 50% and should therefore be safer).
If the old song for KMI was based on Dire Straits 1986 hit Money For Nothing (and Your Chicks for Free), maybe the new one should be Don Henley’s 1989 hit–End of the Innocence.
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