Kinder Morgan Energy Partners (KMP) has come under the spotlight recently for accounting practices and the stock has fallen sharply. The analysis highlighting the accounting treatment of capital expenditures brings nothing new to the market and the company is still one of the most solid in the MLP space. Besides a stable dividend, the shares are now one of the most undervalued income investments and investors can feel secure in adding the company to a portfolio.
Unrivaled scale and growth
Kinder Morgan Energy Partners is the pipeline and storage arm of the Kinder Morgan group of companies. The structure of Master Limited Partnerships (MLPs) can be confusing but because of the tax-advantaged status of these companies, most energy companies sell off their pipeline and storage assets to a MLP company that will manage them and still provide the services.
The graphic below, from a recent Kinder Morgan presentation, shows the massive scale of assets owned by the Kinder Morgan group. The firm is the 3rd largest energy company in North America and the largest independent transporter of petroleum products. Through almost 70,000 miles of natural gas pipelines it is connected to every important resource play in the United States.
Over 80% of the company's cash flow is tied to fee-based contracts and not exposed to pressures on commodity prices. Much of the remaining exposure the company has to energy prices is hedged - 93% of 2013 cash flow is fee-based or hedged.
With the surge in energy production in the United States, pipeline and storage companies are scrambling to fill the need. Kinder Morgan has a $14 billion growth capital expenditure backlog, of which 90% is for fee-based services. Best yet for long-term investors at some point the need for large amounts of growth capital spending for U.S. systems will slow and all this money will be added to distributable cash flow.
The company has made more than $40 billion in capital spending to increase production over the last 16 years. Return on invested capital has averaged 13.9% over the last decade, well above the company's 7.2% cost of capital.
Accounting Hijinks or Media Hype?
The shares are down sharply over the last few months, largely a result of the increased media attention to how MLPs account for capital expenditures and a research note from short-seller Hedgeye Risk Management.
Hedgeye is arguing that the money Kinder Morgan is booking as growth capital should actually be maintenance spending since total production has not grown much over the last few years. By ignoring maintenance spending, the company is able to artificially boost distributable cash flow. This distinction between maintenance and growth capital expenditures doesn't make sense though because immediate spending on growth doesn't always mean higher total production. If some assets are producing less, even more growth spending may not increase total production and it may take several years for some assets to really ramp up production.
The analyst at Hedgeye writes that the threat to the accounting is that the company is exposed to "environmental or legal expenses due to poorly-maintained assets." If the company is neglecting its existing assets, it is certainly not coming through in accidents. In its liquids pipeline business, Kinder Morgan had just 0.08 incidences per 1,000 pipeline miles in 2012 and has averaged just 0.15 incidences per 1,000 miles over the last five years. This is less than a third of the industry's three-year average of approximately 0.55 incidences per 1,000 miles.
What is really important here is that the company has been consistent with its accounting and has not tried to change assumptions or the treatment of spending to fool investors.
Hedgeye is the same advisory firm that has questioned similar accounting issues at Linn Energy (LINE) and I imagine has made a good amount of money shorting the stocks before it went public with the reports. The advisory has attacked accounting practices that have been used for decades, practices that have been used in full view of the investing public.
You have to understand that a lot of what you hear in the financial media is not necessarily for your benefit but for the benefit of ratings and a profit by the investment house that has taken a position for or against the stock. I also own shares of Linn Energy and think that the resolution to the SEC inquiry and the acquisition of Berry Petroleum (BRY) could send the shares surging higher.
KMP has increased its distribution for the last 17 consecutive years at an annualized rate of 13% over the period. The company is a rock-solid income investment and the only difference is that now it is an extremely attractive value-play as well.
36% below the value of cash flows
Applying a dividend-discount model, the most appropriate valuation model for income stocks, I get a target price of $108.86 for the shares. The price is assuming a 7% dividend growth in the first four years followed by 5.5% growth in years five through ten. The terminal growth rate of 2.5%, is the assumed rate that the company can grow in perpetuity. These assumptions are fairly conservative and the stock has a good chance of outperforming this price as the U.S. enjoys its energy renaissance over the next decade.
This is well above the average analyst target of $91.69 for the next year and the shares could be volatile until the media hype over its accounting subsides. The fact remains that the company is extremely well positioned to provide a strong income return and is priced well below the value of its cash flows. Even assuming growth of just 6% in the first period, 4% in the second and a terminal rate of 2% the shares are worth $98, or 22.5% above the current price.
One of the most beneficial aspects of MLP investing is the taxation of distributions. Since most of the distributions are treated as a return of capital instead of a cash dividend, you do not pay the taxes you would normally pay with other income investments. These regular distributions reduce your cost basis in the shares so you pay your taxes when you sell the shares. Even better, if the shares are passed through an estate then the cost basis is marked up and the beneficiaries never have to pay taxes on previous distributions.
Adding to Retirement and Income Portfolio
The strong cash return and industry-leading assets is why I am adding the shares to my new Retirement and Income Portfolio. The portfolio is meant to highlight and track stocks that can be safely added to a retirement portfolio or one that needs to spin off a substantial amount of income without losing its value.
This equity portion of a retirement portfolio should comprise no more than 35% of your total assets with the rest invested in fixed-income and safer assets. Your equity investments will help hedge against inflation and rising rates, along with providing for the possibility of growth. For the fixed-income portion of your portfolio, I would recommend a laddered-bond strategy rather than bond exchange traded funds (ETFs) since these can often see price volatility similar to stocks.
The investment is not without risk but it is a generalized risk to which all equities and MLPs are subject. First, the company does have some exposure to oil prices and has budgeted $91.68 per barrel for their financial projections with about $5.9 million of distributable cash flow exposure for every $1 change in the price of crude. In the event of a recession, oil prices could come down significantly and bring distributable cash flow down as well.
All MLPs, along with REITs, risk losing their tax-advantaged status and would need to reevaluate their distribution plans if it ever happened. The issue comes up every once in awhile but is never seriously proposed.
Despite the sharp drop in the share price over the last month, Kinder Morgan Energy Partners has a track record of growth and income that goes back more than two decades. Besides a stable dividend yield, the shares are extremely undervalued and investors could see significant capital gains. The special tax treatment on distributions means that you get to keep more of the money and may never have to pay the taxes if the shares are passed through an estate. These factors make Kinder Morgan Partners a great addition to any retirement or income portfolio.