Business description:

Kinder Morgan is a midstream MLP focused on natural gas distribution. They take very little, if any, commodity price risk on their distribution assets, thus this business is driven by the volume (not price) of natural gas that flows through their pipelines, which is very stable.  This is a very steady, minimally economically sensitive business where many of its routes are either regulated or a local monopoly. They also own a small oil production business with prices hedged below even today’s prices. Richard Kinder, the CEO, is considered to be one of the finest operators in the business and is highly aligned with unit holders. He takes a $1 salary, as an example. There are two “classes” of shares that trade under symbols KMP and KMR. KMP is the traditional MLP and KMR is an “institutional class” that avoids the headaches of getting a K-1.  As MLPs are yield vehicles, they are often valued on a dividend yield basis relative to the 10 year treasury bonds.

Investment Thesis:

At a time when investors should be seeking safe stable businesses, KMP is trading at nearly all time wide yields both absolutely and relative to treasuries, due to the current credit environment and overblown fears about the MLP space. In addition, you get a free call option on the price of oil above $44.

If you buy via KMR, you are getting an additional discount and the current yield is around 11%. In addition to the current yield, an investors return would consist of the growth in distributions as well as the potential for significant capital appreciation should this trade back to historical yields which we think it will in time. If you take the current yield of 11%, presume 4% distribution growth in the near term (lower than historical average of 8%+, due to the difficulty to finance new projects), and presume that the yield reverts to 7% over a two year period, you’d receive roughly a 40% IRR.

Historical yield, spread, and distribution growth:

Given VIC’s familiarity with midstream MLPs, I’ll just jump to the numbers….

-          Over the last 10 years the yield of KMP has been fluctuated between 6% and 7%, spending only a small fraction of that time out of that range, and more often lower than higher. The current yield at KMP is 9.26%. This is very close to the all time highest yield.

-          KMR trades typically at a discount to KMP of between 0 and 15% and currently trades at a 14% discount. The yield at KMR is 10.76%, though it is paid in addition shares. (this is part of why they don’t have to issue K-1s to this class).

-          The spread between KMP and the 10 year treasury (a common valuation metric for the space) has averaged between 160 and 200 bps, depending on the time period.  Since it’s IPO in 1992, KMP’s spread has briefly spiked out to 400 bps during times of panic but didn’t stay there for long. It is currently 606 bps, also near all time wides.

-          Over the last 5 years KMP has increased it’s dividend by 8.6% per annum. Roughly half of this growth comes from organic increases in the business (they get to increase their regulated tariffs each year, etc….) and half come from new capital projects that they either buy or build. This second portion of this growth is at risk while the credit markets are so expensive. The way this works is that they earn roughly low teens pretax returns on the projects and have financed this historically with a 50-50 mix of 5-7% debt and 6-7% distribution yield MLP units, which is highly accretive.

How the current credit market affects them and how is doesn’t:

         The company has a rock solid investment grade balance sheet, though there is some leverage. With a steady business, EBITDA covers interest 5x and they are levered 3-4x EBITDA. Their debt is rated BBB, the bottom end of the investment grade range. Their debt currently yields 8.7% slightly tighter than the BBB market, but above their historical levels. They could issue bonds even in today’s market, but they view the cost as being temporarily too expensive and are funding the business from a line of credit. They should be able last all of 2009 without needing access to the capital markets and have less than 10% of their debt coming due in the next 2 years.

         Where the credit markets are hurting them is a follows. Being massively cash generative (that’s where all the distributions come from), they don’t need capital for their existing assets, but do need to regularly access the capital markets to fund new projects as they distribute most of the free cash from existing assets as dividends. There are two risks, one availability and two cost.  As long as they can fund their current backlog (see below), they can just stop building new projects if the capital markets close. Should they tap markets now when costs are high, the new projects won’t be as accretive as in the past which will slow distribution growth, which I’ve modeled well below historical levels. Keep in mind that these projects are still accretive, even at these levels, and that the distribution should grow slightly each year due to price escalations. They can price future projects to reflect higher financing costs.

         One concern the market currently has is that they have $3 billion of projects that they’ve committed to that are in the process of being built. Some of these have committed debt facilities, but they do have a funding gap. To me, its not a matter of their ability to finance this but the cost. The General Partner has offered to invest up to $750 million, if needed to fund projects, together with their access to the markets (but at a slightly higher price), so they should be able to fund their current backlog.

Free call on oil prices:

This isn’t as exciting with Oil sub $50, but they have a small division that produces 35k barrels of oil a day (they got into this business as they were transporting the CO2 to the fields for tertiary recovery) and they hedge most of their exposure several years into the future to provide stability to the distributions. 2008 was hedged at $44 dollars. 2009 and 2010 are hedged at $49 and $56, respectively. Should oil prices recover, this grows to be a substantial asset. Using a LT price of $85, they could increase the distribution by over 20%.

Investment Risks:

·       BBB market closes

Catalysts:

Passage of the current panic driven spreads

Continued distribution growth

Resolution of the funding gap       

Disclosure: We and our affiliates are long KMP and KMR, and may buy additional  shares or sell some or all of our shares, at any time.  We have no obligation to inform anyone of any changes in our views of KMP or KMR. Do your own work, this isn’t a recommendation to buy or sell shares.