A Closer Look At Kinder Morgan Energy Partners’ Distributable Cash Flow

In an article titled Distributable Cash Flow (“DCF”) I present the definition of DCF used by Kinder Morgan Energy Partners LP (KMP) and provide a comparison to definitions used by other master limited partnerships (“MLPs”). KMP’s definition and method of deriving of DCF (what KMP refers to as “DCF before certain items”) is complex and differs considerably from other MLPs I have covered. Using KMP’s definition, DCF per unit for the trailing 12 months (“TTM”) ending 6/30/12 was $4.90, up from $4.40 for the TTM ending 6/30/11.

Segment earnings before depreciation and amortization are summarized below:

The Products Pipeline segment currently is expected to end the year slightly below its annual budget of 6% growth. The Natural Gas Pipeline is expected to exceed the year’s budgeted growth of 19% due to drop downs. The CO2 segment is expected to finish the year modestly below the 26% growth target indicated in its annual budget. The Terminals segment is currently expected to meet or exceed the year’s budgeted growth of 8%.

As always, I first attempt to assess how these DCF figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units. Given quarterly fluctuations in revenues, working capital needs and other items, it makes sense to review TTM numbers rather than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.

The generic reasons why DCF as reported by an MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to KMP’ results with respect to sustainable cash flowing to the LPs generates the comparison outlined in the table below:

The principal differences of between sustainable and reported DCF numbers in Table 1 are attributable to risk management activities and a host of other items grouped under “Other”.

Risk management activities present a complex issue. I do not generally consider cash generated by risk management activities to be sustainable, although I recognize that one could reasonable argue that bona fide hedging of commodity price risks should be included. In this case, the KMP risk management activities items reflect proceeds from termination of interest rate swap agreements rather than commodity hedging and I therefore exclude them.

Items in the “Other” category include numerous adjustments as detailed below:

These adjustments further illustrate the complexity and subjectivity surrounding DCF calculations. They also highlight the difficulty of comparing MLPs based on their reported DCF numbers, which is another reason why I exclude them from my definition of sustainable DCF.

Distributions, reported DCF, sustainable DCF and the resultant coverage ratios are as follows:

On a TTM basis, coverage ratios have improved somewhat despite the fact that net income has been declining due mostly due to write downs and other non-cash adjustments:

In 2011, there was a ~$167 million write down related to a change in accounting treatment (from equity method to full consolidation) upon acquiring the remaining 50% stake in a natural gas gathering and treating business in the Haynesville shale gas formation located in northwest Louisiana (KinderHawk) and ~$170 million increase in litigation reserves. In 1Q12 management wrote down by $322 million the value of assets to be disposed as a result of the FTC mandate in connection with the El Paso acquisition. Based on information gained in the sale process, this estimate was increased by over 100% (an additional $327 million) in 2Q12. While the write downs have no cash impact in their respective periods, it seems that the assets may fetch a significantly lower price than initially estimated and, consequently, more debt or equity will need to be issued when the El Paso assets are dropped down by Kinder Morgan, Inc. (KMI), KMP’s general partner.

Table 6 below presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $557 million in the TTM ended 6/30/12 and by $613 million in corresponding prior year period. In light of the low distribution coverage ratios noted in Table 4, how can this excess be explained? I believe the capital structure of the Kinder Morgan partnerships provides an answer. Kinder Morgan Management, LLC (KMR) owns approximately 29% of KMP in the form of i-units that receive distributions in kind. I estimate that had these units received cash instead, the outflow in would have amounted to ~$458 million for the TTM ended 6/30/12. Note also that KMI’s distributions are based on a calculation that assumes all KMR distributions are paid in cash. Therefore its share of total cash distributions was 52.6% for the TTM ended 6/30/12 (52.9% in 2Q12).

In 3Q12 KMI is expected to drop down into KMP 100% of Tennessee Gas Pipeline (“TGP”) and a portion of El Paso Natural Gas (“EPNG”). The price is projected by some analysts at ~$7 billion. Given the size of the drop downs, the difficulty in estimating whether and to what extent the drop downs will be accretive to KMP, and the uncertainty regarding amounts KMP can generate from the assets it is divesting, I believe other MLPs present a more compelling investment proposition.