Description

Kinder Morgan Energy Partners LP (NYSE: KMP) – Short

February 25, 2012

What do you think about a retail investor favorite whose attractiveness depends on its reliable cash distribution, which in reality generates little net cash flow to shareholders while distributing over $1 billion per year to its manager?  Oh, and did I mention that the company has its roots in Enron?  

Summary Thesis

Kinder Morgan Energy Partners LP (“KMP”) is a massively overvalued MLP currently trading at an all-time high. Shorting KMP offers a low risk and high return investment opportunity.  Under its charter, KMP must distribute all of its Distributable Cash Flow (“DCF”) to its limited partners and general partner.  Wall Street and hordes of retail investors assign value to KMP based on the faulty presumption that DCF equals free cash flow.  This erroneous equality, the proliferation of which owes to the widespread reporting of DCF per unit and its ease of use as a quick heuristic, drives a fundamental misevaluation of the free cash flow power of the underlying business.  In particular, KMP’s DCF significantly overstates its recurring free cash flow.  Investors are thinking fast when they should be thinking slow.  Adjusted for significant earnings from declining E&P assets, KMP trades at 24.2x 2012B (2012 Budget) distributable cash flow per unit and 32.3x 2012B net income per unit, implying yields of 4.1% and 3.1%, respectively.  Comparable MLPs trade at yields of 6-7% based on 2012 estimated DCF, implying that KMP is 50 – 70% overvalued, despite the fact that comparable MLPs have far superior growth prospects due to their smaller size and lower costs of capital.  Moreover, these comparable LPs maintain reasonable cash flow coverage of their quarterly distributions of 1.1 – 1.4x, whereas KMP maintains coverage of 1.0x on a reported basis and meaningfully underearns their promised distributions once adjusted for systematic underreporting of maintenance CapEx.  KMP goes to great lengths to advertise its cash flow stability and distribution growth prospects and often refers to itself as owning “toll road assets.”  However, over 26% of KMP’s distributable cash flow is generated by a highly volatile and declining E&P operation in Texas that management disguises by hiding in a segment known as “CO₂” that contains a much smaller CO₂  extraction and distribution business, for which 36% of demand is generated by KMP’s own E&P operations.  Furthermore, KMP’s recently constructed Rockies Express pipeline, which generates approximately $272mm of net EBIDA to KMP, will likely need to divert cash flow for deleveraging (currently 5.5x leveraged) in advance of anticipated low contract renewals in 2014 and 2019.  KMP’s complicated corporate and ownership structure obscures the economics and valuation of the underlying businesses.  Historically, virtually all distributions to limited partners have been financed by new share issuances.  Net of share issuances, limited partners have received no net cash in the last three years!  In addition, the traditional LP / GP structure of MLPs incentivizes the GP – where management and the private equity backers hold nearly all of their interests – to profit at the expense of the LP by pursuing growth at all costs since they earn 50% of incremental cash flows but invest none of the capital.  The reliability of KMP’s quarterly distributions and strong track record of distribution growth has lulled a yield-hungry retail investor base into viewing the company as a “growing bond with inflation protection” and ignoring risks to the distribution, volatile and declining cash flows from the substantial E&P operation, dimming growth prospects for non-E&P operations, a parasitic GP relationship, and an astronomical valuation.

Although the VIC write-up contains the entire write-up and all tables, if you would like something easily printable (and with better formatting) see the links below:

Valuation Model

http://dl.dropbox.com/u/64131340/Kinder%20Morgan%20%28Complex%29_2-25-12.pdf

Write-Up

http://dl.dropbox.com/u/64131340/KMP_VIC_2-25-12.pdf

Business Overview

KMP operates through five reportable segments, which I have expanded to six to individually highlight the oil and gas E&P operations.

Product Pipelines – ($734mm in ‘12B EBIDA and 17% of pre-corporate total EBIDA) – The Product Pipelines segment owns stakes in 6 refined products pipelines, 49 terminals, and 6 transmix processing facilities.  Unlike natural gas pipelines, for which the pipeline operator typically receives a fixed capacity reservation fee under long term take-or-pay contracts, product pipeline operators receive fees based on pipeline throughput and as such are subject to the vagaries of the market for gasoline, diesel and jet fuel demand.  KMP product pipeline volumes declined (0.1%) in 2011.  Some oil and refining analysts believe gasoline consumption in the United States is in long term secular decline owing to increased engine efficiency and the proliferation of electric / natural gas-fed vehicles.  Interstate pipeline shipments are regulated by the Federal Energy Regulatory Commission (“FERC”).  FERC governs rates on interstate pipelines and for product pipelines allows a maximum annual rate increase of PPI (for finished goods) + 2.65%. Up until the Great Recession, product pipeline volumes grew reliably and when coupled with inflation-based rate increases resulted in comparisons with inflation protected bonds like TIPS.  

Natural Gas Pipelines – ($1,303 in ‘12B EBIDA and 30% of pre-corporate total EBIDA) – Natural gas pipelines represent the premier MLP asset due to long term take-or-pay contracts with customers and regulated, utility-esque returns under FERC.  Upon construction, a pipeline operator typically sells nearly all of his newly constructed capacity under ten year take-or-pay contracts based on a regulated return on construction costs.  Based on our research, the maximum allowable return on equity has historically been 11 – 13%, assuming a “reasonable” capital structure.  This rate is then fixed for the duration of the contract. Practically speaking, the FERC simply sets the maximum allowable rate, below which the buyer and seller may negotiate the overall contract.  While FERC does not actively police pipeline returns on equity, customers and operators can file disputes with the FERC to resolve conflicts arising from requested rate increases or decreases.  Parties usually resolve these conflicts out of court, so as to avoid the scrutiny of the FERC.  KMP has recently been involved in a number of rate cases in its Product Pipelines segment, for which the company has accrued over $300mm in future liability.  While historically stable assets, natural gas pipelines face both risk and opportunity from new shale sources of natural gas. Incumbent pipelines (such as Rocky Express) may face volume risks as sources of supply migrate, while operators will likely see opportunities for new pipeline construction to transport gas from the shale plays.  KMP owns stakes in 8 long distance natural gas pipelines (including one very large unregulated intrastate pipeline in Texas) and 5 gathering pipelines (smaller pipelines that gather gas from the well to transport it for processing and ultimately to a large long distance pipeline). 

CO₂ – ($345mm in ‘12B EBIDA and 8% of pre-corporate total EBIDA) – For purposes of my analysis, I have extracted KMP’s E&P operations from this segment. The remaining assets of the CO₂ segment include ownership interests in 3 CO₂ deposits (caverns) and 7 CO₂ distribution pipelines. CO₂ is primarily used for enhanced oil recovery (“EOR”) operations, in which an E&P operator will inject CO₂ into a well in order to extract additional oil or natural gas from a deposit that lacks its own innate pressure for typical extraction techniques.  EOR has enabled older plays, especially in the Permian, to produce for much longer than originally expected. CO₂ is typically sold at a percentage of the oil reference price.  KMP’s E&P operations in the Permian consume ~36% of KMP’s CO₂ production (charged at a market-based price between segments).   

E&P – ($1,036mm in ‘12B EBIDA, 24% of pre-corporate total EBIDA and 26% of marginal EBIDA) – KMP owns stakes in 3 oil reservoirs in Texas – SACROC, Yates and Katz – which produce ~12 mm-bbls of oil and a modest amount of NGLs per year. KMP has proved developed and undeveloped reserves of 79 mm-bbls.  Despite contributing the large majority of the CO₂ segment’s cash flows – not to mention a large percentage of aggregate cash flows – management has elected to deemphasize the operations and bury them in a loosely related segment so as not to call attention to its cash flow profile.  When questioned about the E&P operations on conference calls, the management team constantly emphasizes the fact that they hedge their production and have “little exposure to oil price volatility.”  Since they hedge 85% of the annual production, management advertises that every $1 / bbl change in WTI only results in an incremental $4 million of cash flow. While oil price fluctuations may have only a modest impact on the next year of cash flows, they have a dramatic impact on the lifetime cash flows of the asset.  E&P assets are of a fundamentally dissimilar nature and value to the rest of traditional MLP assets.               

Terminals – ($757mm in ‘12B EBIDA and 17% of pre-corporate total EBIDA) – The Terminals segment contains liquids terminals that store petroleum products, ethanol and chemicals, dry-bulk terminals that store coal, coke, fertilizer, steel, ores and other industrial raw materials, and rail transloading terminals for train and truck loading.  KMP’s 25 liquids terminals possess storage capacity of 60.2 mm-bbls and their 90 dry-bulk terminals handled approximately 100.6 mm-tons of product in 2011.  Cash flows from these operations are based on storage rates and throughput, which are driven primarily by basic supply and demand. For any given region there is a certain amount of terminal capacity which drives the supply side of the equation.  For liquids terminals, demand is primarily driven by refined products consumption, and for bulk terminals tends to fluctuate with the general industrial sector (fairly GDP correlated).           

Canada – ($201mm in ‘12B EBIDA and 5% of pre-corporate total EBIDA) – The Canada segment owns stakes in 3 pipelines primarily transporting crude oil, the largest of which is the TransMountain pipeline which moves product from the Alberta plays to the West coast of Canada.  While not the recipient of much capital investment, the Canada segment has exhibited dependable growth over the last five years.

Structure

Like most MLPs, the cash flows of the underlying assets of Kinder Morgan are divided between LPs and the GP based on hurdle rates, which are supposed to incentivize the GP to grow annual distributions per unit so as to earn into higher percentages of incremental cash flows.  KMP operates in the “high splits,” which means that the GP receives 50% of all incremental cash flows.  Based on current cash flow levels, the GP – KMI – receives approximately 45% of total cash flows, although this number will approach 50% if KMP continues to grow. KMI is one of a handful of publicly listed GPs and is owned primarily by founder Richard Kinder (~32%) and the private equity sponsors (Goldman Sachs, Carlyle, Riverstone, and Highstar collectively own roughly 45%) that partnered with Mr. Kinder to LBO the GP in 2007 and subsequently take public in February 2011. In addition to standard LP interests, which are purchasable under the ticker KMP, Kinder Morgan has issued a security known as i-shares to an entity called Kinder Morgan Management, which is publicly traded under the ticker KMR.  Many institutions are unable to directly purchase MLP interests due to the unrelated business income (“UBI”).  As such, Kinder Morgan effectively opened up the stock to a new class of investors by taking LP units, housing them in a blocker corporation, and then issuing traditional shares in the blocker corporation.  While KMP pays quarterly cash distributions to unit holders, in order to preserve near comparable tax treatment for KMR investors, KMR pays its distributions in kind – effectively like a PIK equity (which management advertises as a “dividend reinvestment program”).  KMR shares trade at a discount to KMP shares due to the lack of current yield, a smaller potential investor base and disadvantageous tax consequences resulting from trying to replicate the quarterly cash flows of KMP by selling received share dividends for cash.  Management likes to trumpet that they prefer owning KMR (by a ratio of 3:1) and that they think the discount is too wide, although the amount of capital they have invested in KMP / KMR pales in comparison to the amount they have invested in KMI.  The real reason management prefers KMR is that over time it might create a “self-funding” MLP, where “reinvested” dividends of KMR function like quarterly equity raises to fund acquisitions and expansion CapEx – a permanent capital source for the GP to harvest.  By offering both KMP and KMR, Kinder Morgan and the GP have effectively segregated the market between people that care about “value” (KMR doesn’t receive any cash flows – only residual value in the assets) and people that care about quarterly cash flow (KMP).  In addition to owning the GP, KMI owns direct stakes in KMP, KMR, and one small other asset that I exclude from my analysis for simplicity (it has an inconsequential impact on the numbers). 

Most MLPs do not have publicly listed GPs, which complicates valuing the assets on an enterprise value basis – the publicly traded LP interests only represent a portion of the “market cap” of the equity interests and one must make a discretionary adjustment for the estimated value of the GP.  Hence, nearly all analysts and publications focus on distributable cash flow to the LP and ignore the fundamental valuation of the assets they own a stake in.  Most analysts perform equity valuation by taking the current distribution level, assuming a certain level of distribution growth (usually 5 – 8%) based on the growth stage of the LP and historic growth rates, and then discounting these cash flows based on a discount rate derived from looking at other MLPs.  This process results in a self-feeding, reflexive valuation cycle and the tendency of investors to view their LP stake as an anonymous interest defined by its yield and growth, ignorant of the quality, outlook and valuation of the underlying assets. Fortunately, since KMI is publicly traded, we can consolidate the market value of all three entities – KMP, KMR, and KMI – and consider the aggregate valuation of the underlying assets.

The following table outlines the share structure:

Key Earnings / Metrics

The following table outlines earnings by business segment, distributable cash flow, a comparison of DD&A to CapEx, and key operational trends:

Valuation

As of December 2011, KMP / KMR had net debt of $12,304mm and KMI had net debt of $3,335. To determine the consolidated equity market value, I back out the shares in KMP (~21.7mm) and KMR (~14.1mm), since the market value of these shares should be reflected in KMIs market valuation.  This process results in a consolidated market capitalization of $49,052mm, implying a TEV of $64,681mm for the entire complex (“TEV of Complex”).  Note that this calculation takes into account the relative taxability of the various underlying assets – cash flows to KMP / KMR pay no federal corporate income tax, while cash flows to KMI are taxable. From this TEV, I subtract 2x the PV-10 of the E&P assets per the most recent 10K (a 2x multiple used to compensate for fairly regular underestimation of value in PV-10 calculations, public E&Ps trading at a premium to PV-10, and oil price appreciation since the beginning of the year), which results in an implied TEV of $60,293mm for the non-E&P operations (“TEV of RemainCo”). I then adjust 2012B earnings for the contribution from the E&P segment and for multiples of full enterprise level cash flow I deduct G&A, CapEx, and cash taxes at KMI.  After these adjustments (calculations illustrated in detail in the attached sheet), I derive the following key multiples and yields. Note there is often a fairly wide discrepancy between multiples of “after D&A” and “after sustaining CapEx” cash flow, owing to the fact that the Company’s sustaining CapEx is so low relative to D&A. Since I believe the company underreports sustaining CapEx, but that D&A likely overestimates true sustaining CapEx (pipelines and terminals are primarily steel and concrete), I would argue the appropriate multiple of true free cash flow to consider is in between these two multiples. 

Note that the valuation analysis conservatively assumes that KMP hits their 2012B, which calls for nearly 10% growth in DCF per share.  Missing the 2012B may prove another source of upside for the short investor.   

As shown in the table above, the key valuation metrics are:

At an enterprise level:

TEV of RemainCo / EBI ex (ex. E&P): 34.8x / yield of 2.9%

TEV of RemainCo / EBIDA – Sustaining CapEx (ex. E&P): 26.2x / yield of 3.8%

At the KMP level:

KMP / Reported Distribution per Unit (how everyone looks at the stock): 18.2x / 5.5% yield

KMP / Reported DCF per Unit: 18.1x / 5.5% yield

Now, adjusted for the E&P assets:

KMP (ex. E&P) / DCF per Unit: 24.2x / 4.1% yield

KMP (ex. E&P) / Net Income per Unit: 32.3x / 3.1% yield

At the KMI level:

KMI (ex. E&P) / FCF per Share: 40.7x / yield of 2.5%

Memo: While based on the above stated yield, you may ask “Why shouldn’t I short KMI?” KMI, in some sense, is leveraged exposure to KMP.  Management likes to say that if KMP grows 2 – 3%, then KMI should grow 4 – 6%. The KMI story is further complicated by the El Paso acquisition.  Without having a firm view on KMI’s value, beyond the fact that I think its stake in KMP is overvalued by the market, I take comfort in shorting the LP units and not the GP units, due to the preferential nature of the relationship for the GP and the fact that Richard Kinder keeps his wealth in KMI.

For reference, the table below outlines the earnings adjustments utilized in the valuation table above.

Why is KMP Mispriced? / Investment Merits 

-  Significant, Declining E&P Cash Flows – As illustrated above, KMP’s E&P assets, which are fundamentally dissimilar and less valuable than the rest of the asset base, generate 26% of the cash flows.  At current production levels, KMP will exhaust its proved reserves in 6.4 years.

-  Underreporting of “Sustaining” CapEx – MLPs utilize a concept of “sustaining” CapEx which is supposed to approximate maintenance CapEx in determining their distributable cash flow. Kinder Morgan defines sustaining CapEx as capital which does not expand the capacity of an asset. This has a peculiar effect when applied to the nearly $300mm per year KMP spends to drill new wells to stem the decline of its E&P assets. 
This capital spend should clearly be classified as maintenance or sustaining CapEx in light of the fact that production continues to decline, however KMP classifies it as expansion CapEx since it increases the capacity of the asset (an asset for which production would otherwise decline rapidly).  Reclassifying this CapEx from expansion to sustaining would result in an immediate 10% reduction in DCF per unit, reducing 2012B DCF per Unit from $5.00 to $4.58, well below their stated distribution level of $4.98.  Without similar “smoking gun” proof, I believe KMP may also be classifying certain other sustaining CapEx items as expansion capital in order to allow for greater distributions to shareholders (and thus increased GP distributions). During 2011, sustaining CapEx equaled 27% of D&A, a ratio that I regard as almost unheard of among industrial businesses, and especially for an asset base with many terminals which require a fair amount of maintenance CapEx.

-  Astronomical Valuation – Adjusted for the E&P assets, KMP trades at a 3.1 – 4.1% yield, relative to comparable MLPs at 6 – 7%.

-  Skewed Payoff Structure / Limited Downside – Based on true, recurring free cash flow, KMP trades at a yield of 3.1 – 4.2%.  This is a yield on assets with finite lives and somewhat volatile underlying cash flows. 30 year treasuries trade at a yield of 3.3%.  Unlike most other businesses trading at such large multiples of free cash flow (Amazon, Salesforce.com), there is no risk of huge future growth with KMP, and at some point the valuation of KMP must be anchored in the underlying assets and their replacement cost.

-  Retail / Yield Focused Investor Base – Retail investors comprise 50 – 70% of the investor base for MLPs. In today’s low yield environment, yield-hungry retail investors have flocked to MLPs as a bond replacement in their portfolio. Despite a beta of ~0.5, the Alerian MLP index has returned 42.9% gross since the beginning of 2010, compared to 21.8% for the S&P 500.

-  Complex Structure Obscures Value and Economics of Underlying Businesses – As articulated above, investors view MLPs as streams of presumably stable and growing cash flows, focusing on yield and yield growth instead of underlying valuation and business quality.  As shown in the table below, net of share issuances, limited partners have received no net cash flow in the last 3 years while the GP has received nearly $3 billion.

-  Lack of Attractive Growth Opportunities / High Growth Expectations – With a TEV of $65bn, KMP has reached a size where large reinvestment or acquisition opportunities are few and far between. Moreover, since KMP operates in the high splits and the GP takes 50% of incremental cash flows, KMP is at a major disadvantage to MLPs with cheaper equity funding (due to lower GP takes). As shown in the attached analysis, acquiring a terminal, for example, at 11x EBITDA and assuming 10% maintenance CapEx and 50/50 debt to equity funding is barely accretive.  Despite these facts, management believes DCF will grow by 10% in 2012 and analysts generally believe KMP can grow the distribution by 6 – 10% p.a. over the next 2 to 3 years, an outcome I regard as highly unlikely.

-  Renewal Risk at Rocky Express Pipeline – Due to growth in Shale plays, the recently constructed Rocky Express pipeline is facing underutilization and contract renewal risk. 10% capacity client BP has already publicly indicated it will withdraw from the pipeline (they are the only client with early withdrawal rights). I believe this pattern will continue with the 2019 contract renewal process.

-  Interstate Pipeline Regulatory Risk – Based on conversations with the INGAA, regulated returns on natural gas pipelines would likely be closer to 10 – 11% if challenged today, instead of the historical 11 – 13%, due to lower interest rates and costs of debt funding.  Moreover, when the regulatory rate setting and approval process was established, pipelines were predominantly held in C-corps.  Should a customer ever successfully challenge regulated returns based on the legal thesis that a pipeline is held in a tax-free entity (and that taxes should not be deducted in calculated returns on equity as they are today, regardless of the entity), there would be a wholesale revaluation of the industry.

-  Loss of Favorable MLP Tax Treatment – While probably a longshot based on the current state of affairs, should the favorable tax treatment for MLPs ever be repealed or scaled back, it would obviously result in a major re-rating of the entire MLP universe. Under President Obama’s proposed corporate tax reform measures, consideration would be given to taxing passthrough structures like MLPs.  While unlikely to pass, including this issue in the proposed tax reforms suggests that the tax treatment of MLPs is at least up for discussion, the risk of which does not seem reflected in the current stock price.

-  Parasitic Relationship with GP / Misaligned Incentives – The GP receives 50% of all incremental cash flows at KMP, while fronting none of the capital. Thus, the GP is incentivized to grow KMP even it does not grow distributions per share, resulting in suboptimal utilization of generated cash flow. Management holds the large majority of their wealth in the GP, KMI.

Investment Risks

-  Strong Management Team / Track Record of Success – Kinder Morgan’s management team has posted an incredible track record over the last 16 years, growing LP distributions and total distributions at CAGRs of 14% and 39%, respectively, since 1996.  KMP’s market value has appreciated at a CAGR of 26% since 1996.  This success has resulted in massive wealth for Richard Kinder and his team – he has a personal fortune in excess of $7 billion. In late December he purchased $500mm of KMI from Goldman Sachs, in what must be one of the largest single management stock purchases of all time. If you read the Company’s public documents, you will find a group acutely focused on value creation, operational excellence, and limiting expenses. Richard Kinder takes no salary or bonus, there are no employee perquisites, no executive business class flights with company money, executive compensation plans are sensibly defined, and the bulk of the senior management team has more personal wealth exposure to fluctuations in the stock price, through direct ownership, than through their annual bonus or other incentives.

-  Shale Expansion – Shale gas has revolutionized natural gas availability in the United States, creating a number of opportunities for new pipelines and processing facilities. While this will likely result in reduced utilization of existing natural gas distribution infrastructure, for at least the next few years there is a strong runway for capital deployment.   

-  Tax Treatment of LP Units Discourages Selling – One of the most attractive features of personally investing in MLPs is the tax deferred treatment of 70 – 90% of your distributions.  Each distribution reduces your basis in the MLP, the tax on which is primarily recognized at sale. This gives individual investors a strong incentive to hold MLP shares for the long term.

-  Oil Price Exposure – While the E&P cash flows and the associated capital spending drive a significant portion of the overvaluation of KMP, should oil continue to appreciate KMP will continue to post strong earnings growth despite volume declines.  The 2012 budget assumes WTI averages $93.75 / bbl, so with WTI at $109 / bbl, there is cushion in numbers already.

-  “Drop Downs” from El Paso Acquisition – KMI is currently attempting to acquire pipeline operator El Paso Corp.  Some of the price appreciation in KMP over the last three months may owe to excitement over the prospect for asset “drop downs” to the MLP.  A GP can “drop down” an asset into the tax advantaged MLP by selling the asset from the GP to the LP. Historically, this has been a source of distribution growth for LP interests. I struggle to understand why this should be particularly beneficial to the LP, however, since there is a liquid market for MLP-qualifying assets and I cannot understand why the GP would sell an asset to its own MLP at a preferential valuation. Nevertheless, LP investors and analysts regard the El Paso acquisition has having established a strong pipeline of future acquisitions. Conversely, should the El Paso deal be blocked it would likely be viewed as a major negative for KMP / KMR and thus buttress the short case.

Catalyst