We focus on cash flow instead of net income because we believe cash is the best gauge of underlying asset performance. Kinder Morgan’s Distributable Cash Flow (DCF) has historically been an accurate proxy for sustainable cash flow. The main difference between net income and DCF is net income is reduced by GAAP depreciation and DCF is reduced by sustaining capital.
Some believe GAAP depreciation is a good measure for the annual costs needed to maintain assets. We believe a vastly more precise determination of expenses and capital required to maintain safe, reliable, compliant assets can be derived using a project by project, asset by asset bottom-up approach incorporating asset-specific characteristics and current technologies.
There are multiple reasons why sustaining capital is more precise than GAAP depreciation. First, sustaining capital varies greatly by the specific asset characteristics (age of pipe, pipeline diameter, amount of compression, size of compressor units, utilization of the system, number of high-consequence areas on the system, geography, historical maintenance of the pipe, and others). Second, technological advancements have significantly improved and are expected to continue to lower maintenance costs. Third, GAAP depreciation is based on the book value of assets. There can be a meaningful disconnect between book value and actual value of an asset depending on several factors including if an asset has been owned for a long period of time or if it was recently acquired.
It is also important to note that a material amount of the dollars we spend maintaining our assets is recorded as operating expenses, not maintenance capital. “Pipeline integrity” and “third party damage prevention” are two significant maintenance categories for pipelines, and the vast majority of these expenditures are recorded as operating expenses. This includes remediation work involving inspection digs and repair work which might include recoating, sleeving, or the replacement of a pipeline joint. Under GAAP accounting, a substantial amount of pipe must be replaced in order for the work to be capitalized.
Operating expenses and sustaining capital are both deducted in determining DCF. However, GAAP depreciation does not take in to account expenses already incurred to maintain and extend the lives of our assets despite the fact these expenses are already deducted from operating income.