Description

KSL

Kaneb Services LLC (KSL) is a limited liability company, formed from a spin-off from Kaneb Services Inc. (now Xanser Corp.) in June 2001, that owns the general partnership interest and approximately 5.1 million units of the limited partnership interest of Kaneb Pipe Line Partners, LP (KPP), a master limited partnership (MLP). KSL also has a low margin motor fuel marketing business.

MLPs generally own gas and oil pipeline properties and, like REITs, distribute the bulk of the cash flow from these operations to the unit holders of the partnership. The cash flows of the partnership are divided between the limited partnership interests and the general partnership (and controlling partnership) interests of the MLP. Initially, 98% of the distributable cash flow of the MLP goes to the limited partnership interest. As distributions increase, the general partnership interest percentage of the cash flow increases. These ‘step ups’ continue until typically the general partnership interest receives 50% of the cash flow above a certain threshold. (With KPP being an older MLP, the maximum percentage given to the general partnership interest is 30%.) Hence, the general partners have a large incentive to increase the cash flows of the MLP.

SPECIAL NOTE: Due to the structure of MLPs, the partnerships, in essence, do not pay federal or state income taxes. INSTEAD, the tax obligations are transferred to the unitholders (you and me). Therefore, if you own units in an MLP, you are responsible for taxes due in each state the partnership operates in. Unfortunately, this means you may (depending on the MLP) owe taxes in numerous states (up to 50 until further notice). Fortunately, taxable income for the partnerships in general is substantially below that of the cash distributions provided to the unitholders. Also, a portion (sometimes a substantial portion) of the cash distributions by MLPs is considered a return of capital, rather than a dividend. This classification reduces the unitholder’s cost basis and, unlike ordinary dividends, is not immediately taxable. Rather, it is taxed as a capital gain once the unitholder sells.

While related to the gas and oil industry, MLPs are not directly affected by changes in gas and oil prices, as they own the pipeline used by these commodities and not the commodities themselves. Therefore, the fortunes of these partnerships are tied to oil and gas volume rather than price, which, while affected by economic conditions, have historically followed a general up trend.

There are numerous MLPs currently listed, and the list continues to grow as oil and gas corporations (Williams, UDS, etc.) form MLPs to transfer their distribution properties into a more tax efficient vehicle. Being formed by a large corporation is an advantage for an MLP as it provides a ‘natural’ source for acquisitions, the primary driver of most MLPs.

Unfortunately, the KPP partnership does not have a beneficial parent offering numerous acquisition candidates. So why invest in KSL? Other than valuation (discussed below), KSL is unique in the fact that it owns the general partnership interest in the MLP. Other MLP general partnership interests are either privately held or embedded in a large corporation where the interest is a tiny part of the corporations’ earnings. With KSL, the KPP partnership cash flows (from both the general partnership interest and limited partnership units held) generate roughly 90% of the partnership’s cash flow during a typical year. Hence, as the cash distributions of KPP increase, the cash flow through to KSL increases at an accelerated rate as KSL receives the cash flow from its KPP unit holdings as well as the cash flow from the general partnership interest (a larger and larger percentage of total partnership cash flow as distributions increase). (I have an excel spreadsheet that better outlines this relationship if anyone is interested.)

Valuation:
There are numerous ways to value KSL. A simple one is taking its stake in KPP:

Number of KPP shares owned by KSL: 5,071,000
Price of KPP (11/9/01): 41.87
Value of KPP shares owned by KSL: 212,333,000

Estimated Debt of KSL: 21,000
Shares of KSL: 10,855
Per share value of KPP owned by KSL: 17.63

Price of KSL (11/9/01): 18.90
Market value of GP of KPP and marketing business: 1.27

At current prices, the market is valuing the general partnership interest of KPP, an interest that is currently providing 0.45 per share in annual cash flow, at 1.27 (valuing the marketing business at 0).

Using a comparative valuation, the ‘average’ MLP is currently yielding 6.8%. With a price of $18.90 and a distribution of $1.40, KSL is currently yielding 7.7%. While KSL may need to provide a higher yield due to KPP’s limited (relatively) acquisition prospects, the current spread appears too wide. A 7.0% yield on current distributions would equate to a $20.00 stock price. Of course, KSL, in my opinion, should not trade at a yield discount, and perhaps should trade at a premium, due to its strong coverage (discussed in the catalyst section) and general partnership ownership.


Risks:

1. Interest rates. Traditionally, MLPs have traded against the 10-year bond, with the yields of MLPs generally 200-250 bp higher than that of the 10-year. Therefore, KSL is interest rate sensitive, and an increase in long-term rates will most likely have a negative impact on KSL price appreciation. However, with projected double-digit earnings and cash flow increases for the partnership, an increase in yields would be more than offset by an increase in distributions.

2. Acquisitions. MLPs generally fuel increased earnings/cash flows through acquisitions. In effect, MLPs are in general roll-ups, as the partnerships purchase stable cash flows with their cheap capital and beneficial tax structure to increase returns on those cash flows. Therefore, KPP must be able to find accretive acquisitions in an increasingly competitive market without the benefit of an interested parent. While KPP’s acquisition track record is not outstanding, the controlling partners have indicated that they are increasing their focus on acquisitions after the KSL spin-off.

3. Product Marketing Operations. The discussion and valuation above is primarily focused on the company’s pipeline operations. KSL other business segment entitled Product Marketing Operations basically buys wholesale motor fuel, provides some marketing, and resells the fuel for a small profit (hopefully). The business segment provides large revenues (roughly two-thirds the total revenue of KSL) and extremely low margins. KSL also takes on some price fluctuation risk as the company does receive and hold the fuel for a short amount of time. Hence, the business segment has lost money at times and could lose money again in the future, although in general, the segment produces a profit between $1 and $2 million a year.

Catalyst

Catalyst:
As is the catalyst for MLPs, the catalyst for KSL will be the increased distributions from the partnership, in this case KPP. Unique to KSL, KPP maintained its distribution level throughout the reorganization process as the cash flow provided by the partnership’s assets continued to increase. Due to this, distribution coverage (distributable cash flow/cash distribution) increased beyond 1.20x, compared to typical distribution coverage of around 1.10x. Last month, the KPP partnership increased the distribution to limited partnership unitholders to $3.00 per unit per year, from $2.80 per unit per year. This increase was especially significant to KSL as it triggered the general partnership’s 30% (and maximum) participation in the cash flow of the partnership. In response to this, KSL increased its own distribution to $1.45 per share from $1.20.

Importantly, both KPP and KSL still have ample distribution coverage even after the increases (1.20x 2001 estimates for KPP, 1.17x for KSL, ignoring the product marketing division). Therefore, an increase in both distributions should be expected sometime within the next 18 months. Also, the percentage increase in KSL’s distribution should continue to outpace that of KPP’s as the general partnership interest owned by KSL claims a larger and larger percentage of the total partnership distribution.