Kinder Morgan Inc (NYSE:KMI) and its family of companies have released earnings for the quarter ended June 30, 2014, so it's time to take a deeper look at the results. It turns out that there are some disturbing signals in the numbers from Kinder Morgan's pure natural gas play, El Paso Pipeline Partners (UNKNOWN:EPB.DL).
A growth story
El Paso is a master limited partnership (MLP), providing tax-advantaged current income to its investors. The company owns or operates more than 13,000 miles of natural gas pipelines, and storage facilities with a capacity of over 100 billion cubic feet. It also has liquefied natural gas (LNG) plants in Georgia and Mississippi. Kinder Morgan, the largest midstream energy company in North America, owns the company's general partner.
El Paso's investment in the LNG industry is potentially very profitable. Demand for LNG is huge in Asia due to lack of pipeline infrastructure, China's need for a cleaner burning fuel, and Japan's move away from nuclear power. The current expansion of the Panama Canal will make the U.S. Gulf Coast a key supplier for Asia. Demand in Europe is poised to grow as well due to geopolitical instability and possible cutoffs of pipeline gas supplies.
In May, subsidiaries of El Paso began the environmental review process for liquefaction facilities at its terminal near Pascagoula, Mississippi, a project with a proposed capacity of 10 million tons per year (MTPA) of LNG. The company has also filed an application for its proposed liquefaction project at Elba Island near Savannah, Georgia, which could be producing 2.5 MTPA as soon as 2016 or early 2017.
El Paso continued to grow during the quarter, having completed a $2 billion purchase of assets at the end of April. That transaction included the purchase of a 50% interest in Ruby Pipeline, a 50% interest in Gulf LNG, and a 47.5% stake in Young Gas Storage, all from its general partner, Kinder Morgan.
These purchases are reflected in the company's asset growth from $6.5 billion to $8.1 billion during the quarter, as well as in the growth of partners' capital from $1.9 billion to $3.0 billion. El Paso made great strides in reducing its debt as well, reaching a debt to equity ratio of only 168% from 232% at the end of the prior quarter.
So much for the good news. The bad news is that when we look at sequential quarters, several key metrics have deteriorated, as shown in the table below.
|Metric||March 31, 2014||June 30, 2014|
|Same-Quarter Revenue Growth||-1%||-2%|
|Same-Quarter Net Income Growth||-1%||-4%|
|Debt / Equity||232%||168%|
|Coverage Ratio (DCF/Distributions)||115%||95%|
Revenues, margins, and net earnings declined from the same quarter last year, just as they did in the quarter ended March 31. But for the quarter ended June 30, these declines in revenue and earnings have accelerated.
Also, although distributable cash flow (DCF) increased from the same quarter last year, the past two consecutive quarters tell a different story. DCF dropped precipitously from the prior quarter from $0.75 per unit to $0.62 per unit. More ominously, the DCF coverage ratio dropped from 1.15 to 0.95, a clear warning sign for MLP investors. That's because a coverage ratio below 1.0 means that El Paso is not retaining enough cash to even maintain its existing capital, a poor practice for long-term distribution stability.
The Zen of Foolishness
Bigger is not always better. Growth must be accompanied by efficient use of assets to sustain profitability over the long haul. There's clearly no need to panic of course, especially for short-term investors. El Paso is still comfortably profitable and is expanding into potentially lucrative markets.
These are just red flags that could eventually limit longer-term growth if El Paso doesn't address them at some point. But many MLP investors are interested in eventually passing on their units to heirs, taking advantage of the hugely beneficial cost basis reset. These long-term investors should keep an eye on these metrics, as they speak to the ultimate sustainability of El Paso's performance.