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Understanding high cash flow, "low earnings" accounting (ie KMI)


CRHawk
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Hi all!

 

I’m fairly new to value investing, and this is my first post here.  If I’m missing something that can be answered by reading something, please suggest readings.  I’ve searched a lot, but haven’t found anything that addresses my questions.

 

Anyways.  I’m trying to make sure I understand some concepts about a high cash flow, “low earnings” company.  I’ve been looking at KMI, but I suspect the lesson is applicable to other accounting situations. 

 

Right now KMI has a high P/E ratio – about 45 according to Google, despite the huge drop in share value.  The 2014 annual report for KMI states “We believe the primary measure of company performance used by us, investors and industry analysts is cash generation performance.“  Pay no attention to earnings, in other words. I know that earnings can be manipulated, at least in the short term.  But don’t earnings matter eventually? 

 

Here’s what I’m thinking:

 

Joe’s Oil Transport company borrows 100 million dollars, and spends 90 million buying a pipeline.  Next year, they earn 10 million in transport fees and pay 3 million in interest, giving them a cash flow of +7 million.  But they also write off 6 million in pipeline depreciation, assuming a 15 year lifetime.  Net earnings a paltry 1 million.

This can go on for a few years… lots of cash, low earnings.  But I figure eventually either....

 

a) Your depreciation was artificially high, the pipeline lasts far longer, and your earnings shoot through the roof at year 15.  Or…

 

b) You depreciation was accurate and your pipeline needs to be replaced at year 15.

 

To value a high capex company, don’t you need to know what the asset lifetime really is?

 

Is this a situation like rental real estate where depreciation isn’t a real cost but is useful for lowering taxes?

 

I appreciate any hints or clues I can get!

 

Thanks!

 

-Jeff

 

 

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I think you're forgetting that the company is also subtracting maintenance capex, and even opex which is an offset to depreciation. Now what could be a legit concern is understating maintenance capex... For earnings, you have to keep in mind that different cos recognize revenues at different times, so the underlying economic performance may not be reflected in I/S. Eg. for service firms, you want to look at cash flow.

 

TL:DR : each industry has a unique way of interpreting financials. For MLPs like KMI, you should focus on EBITDA, DCF, and Debt/EBITDA. What is happening with them is that their cost of capital is rising to 9%, and their leverage (D/EBITDA) is elevated, which hurts their ability to finance projects, damaging growth expectations.

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I think you're exactly right. You need to make your own assumption about the ongoing capex assumptions and compare that to what they're currently depreciating. I don't know anything about oil pipeline, but it sounds reasonable to assume that a pipeline lasts significantly longer than 15 years if properly maintainted. In that case depreciation would overstate the annual expense.

 

Two examples I'm currently invested in:

1. Outerwall - They own Redbox and Coinstar kiosks. They had a huge buildout of kiosks and are currently depreciatign ~$200M per year. Maintenance capex to keep the boxes running is somewhere probably in the $50 - $75M range. In this case the depreciation overstates their annual expense.

2. Rouse (short) - They own "B" (maybe "C") retail malls. The malls are built so they point investors to a cash flow metric before depreciation while spending significant amounts of money annually to upgrade aging facilities. The real maintenance cost is probably somewhere between the $0 they indicate and the amount they depreciate.

 

Seth Klarman has a really good discussion of depreciation in his book.

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KMI splits out maintenance vs growth capex which is definitely useful.

 

In 2014 they had depreciation of $2B vs maintenance capex of $500M. For this level of capex to be sustainable, that would imply the useful life of their PP&E is 4x as long as it is accounted for - on average 80 years instead of 20 years. Seems unrealistic.

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CRHawk,

 

For more information on the subject, you may want to search on the topics of Owner Earnings, as defined by Buffett.

 

Since you also mentioned you are fairly new to value investing, here's what I consider to be the 3 key learnings:

1) understand your circle of competency and take it into account when evaluating an opportunity (i.e. the more you stray from it, the more careful you have to be, and the biggest margin of safety you should require);

2) look to the downside first (i.e. Buffett's no called strike), otherwise we often end up fooling ourself; and

3) if you are not able to determine how much a business is truly worth based on something else than its capitalization, you do not know your margin of safety and, thus, are speculating rather than investing.

 

Many happy returns!

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CRHawk,

 

For more information on the subject, you may want to search on the topics of Owner Earnings, as defined by Buffett.

 

Since you also mentioned you are fairly new to value investing, here's what I consider to be the 3 key learnings:

1) understand your circle of competency and take it into account when evaluating an opportunity (i.e. the more you stray from it, the more careful you have to be, and the biggest margin of safety you should require);

2) look to the downside first (i.e. Buffett's no called strike), otherwise we often end up fooling ourself; and

3) if you are not able to determine how much a business is truly worth based on something else than its capitalization, you do not know your margin of safety and, thus, are speculating rather than investing.

 

Many happy returns!

 

+1

 

You need to figure out your circle of competence, define its edges and expand it.  From your questions it is clear that you need to work on both general accounting, at least as it relates to investing, and industry specific knowledge. For example what is (are) the key financial ratio(s) and best operators in the business, either in pipelines or where you work?

 

But don't think of this as a burden you have many things to learn--make that rewarding!  And keep reading and asking questions.  You are in the right place.

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Thanks everyone!  Great point about looking for the split of maintenance and growth capex.

 

As for circle of competence, I've decided that "high debt" is well outside of it, so will be staying away from KMI and CHK.

 

I am very interested in learning operator earnings, and understand the theory but need more work at it.  Are there any good "workbooks" for analyzing company accounting that includes the answers so I can gauge my competence?  I've been looking at this one - http://www.amazon.com/Art-Science-Value-Investing-WORKBOOK/dp/1304802809/ref=sr_1_4?ie=UTF8&qid=1447763769&sr=8-4&keywords=buffett+workbook 

 

I will also find the Seth Klarman PDF.

 

-Jeff

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KMI splits out maintenance vs growth capex which is definitely useful.

 

In 2014 they had depreciation of $2B vs maintenance capex of $500M. For this level of capex to be sustainable, that would imply the useful life of their PP&E is 4x as long as it is accounted for - on average 80 years instead of 20 years. Seems unrealistic.

 

Some pipelines have lasted 60 years.  And I think some have lasted even longer than that.

 

The maintenance costs will likely rise a lot after 50-60 years.  I'd expect defect rates to go up and require more constant surveys+repairs.  The worst case scenario is that most of the pipeline would need to be replaced (e.g. people freak out over having dangerous pipelines in their area).

 

The pipelines themselves don't need a lot of maintenance capex.  The other businesses like the E&P segment, the Jones Act ships, and the gathering networks have cash flows that decline much faster.

 

Is this a situation like rental real estate where depreciation isn’t a real cost but is useful for lowering taxes?

 

Companies keep separate books for tax and GAAP reporting purposes.  In rare cases, they must use the same rules for things like LIFO/FIFO inventory.

 

Kinder Morgan's (cash) taxes will likely go up in the future.  If it keeps growing, it can keep deferring taxes.

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I am very interested in learning operator earnings, and understand the theory but need more work at it.  Are there any good "workbooks" for analyzing company accounting that includes the answers so I can gauge my competence?  I've been looking at this one - http://www.amazon.com/Art-Science-Value-Investing-WORKBOOK/dp/1304802809/ref=sr_1_4?ie=UTF8&qid=1447763769&sr=8-4&keywords=buffett+workbook 

 

 

I think Hagstrom has a workbook to go along his "Warren Buffett Way" book, but I have not used it myself. The book itself is not a bad place to start, but sooner or later you'll probably want to hear it from the horse's mouth and go straight to Berkshire's website and read Buffett annual letters, or Cunningham's published version of them. You can probably still find Buffett's earlier letters to his pre-Berkshire investors online. Onward and forward!

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