This High Yield Energy Stock Is Fund Manager Andy Sutton's Highest Conviction Pick

Andy Sutton is the Founder and Chief Strategist for Pennsylvania-based Sutton Associates, a Registered Investment Adviser.

We had the opportunity to ask Andy about his highest-conviction stock holding, and he selected gas and oil pipeline provider Kinder Morgan Partners (KMP), a 'buy and hold' position in some of his client portfolios. He believes the stock is currently 'a bit overpriced' for new investors, but presents a compelling income opportunity on a pullback.

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Andy Sutton (AS): My highest conviction stock position at this time is a Master Limited Partnership - Kinder Morgan Energy Partners (KMP). Kinder Morgan has the benefit of being able to participate in rising global demand for energy through its role in the transportation of fuels, but is insulated to a large extent from the increased volatility in the prices of those fuels. KMP’s cash distributions have increased 2.9% in 2009 and are forecasted to increase approximately 4.76% in 2010 to $4.40 a share. Kinder Morgan’s organization as an MLP lowers tax liability at both the Federal and State levels and thus allows for increased effective distributions to shareholders.

Seeking Alpha (SA): Tell us a bit about the company and what it does.

AS: KMP is in the gas and oil pipeline business and operates more than 37,000 miles of pipelines and 170 terminals. KMP transports energy-related products such as oil, natural gas, coal, methane, and CO2. KMP is the largest publicly traded Master Limited Partnership with a total enterprise value exceeding $25 Billion. KMP’s two biggest pipeline projects are the Rockies Express Pipeline and the Fayetteville Express Pipeline. The Rockies Express will be one of the largest pipelines ever constructed in the United States, stretching nearly 1,7000 miles from Colorado to Eastern Ohio. This pipeline will have a capacity of 1.8 billion ft3/day. REX is a joint venture between Kinder Morgan (owns 50% and operates 100%), Sempra Pipelines (SRE), and ConocoPhillips (COP). Binding commitments from shippers have been secured for nearly 100% of the pipeline’s capacity.

The Fayetteville Express will be a new addition to KMP’s portfolio and is expected to be in service by early 2011. The initial capacity of this pipeline running between Arkansas and Mississippi will be 2.0 Billion ft3/day. Kinder Morgan also owns and/or operates a number of pipelines in Canada including the Cochin pipeline, the Trans Mountain Pipeline, and the Puget Sound Pipeline. Given the fact that Canada is a primary exporter of petroleum products to the US and that its role is likely to expand in the coming years, KMP’s presence in this area will be a real asset moving forward.

SA: Can you talk a bit about the industry/sector? How much is this an "industry pick" as opposed to a pure bottom-up pick?

AS: This subsector is a fantastic area for those investors who desire to get some exposure to the energy investment theme without taking on the increased risk of investing in companies that produce the energy or the commodities themselves. As a sub-sector, energy transportation is widely expected to generate growth well in excess of broader macroeconomic measurements in 2010. I differ slightly in the assessment of CAPEX projects for 2010. It continues to be my opinion that there will be at least two more shocks to the credit markets. The first will come from commercial real estate, the second from Prime and alt-A option ARM resets that will begin to mount this year. While the magnitude of these shocks is debatable, mostly hinging on the ability of the financial authorities to mitigate, postpone or dilute them, I am wary of giving an all-ahead green light on any type of major commitments of capital at this point. Kinder Morgan and its competitors mostly operate in the US, and as such are susceptible to fluctuations in US petroleum demand. Less oil used is less oil transported, pure and simple.

KMP is both an industry pick and a bottom up pick. I like the sub-sector both because of the insulation from commodity price swings and the MLP designation, which creates solid, predictable income streams for investors. From the bottom up, Kinder Morgan is the largest of the publicly traded MLPs in terms of enterprise value and the second largest in terms of market capitalization. Kinder Morgan returned 11% on revenue in its most recent quarter. It also has a diverse portfolio of assets, which have helped it successfully weather periods of market uncertainty in the past.

The distribution yield is currently 6.58% based on a 1/12/10 price of $63.56/share. KMP carries a beta of .28 and offers the combination of stable income minus the whiplash volatility associated with some of the producers. For example, BP pays a 5.43% dividend, but has a beta of .76. In KMP, investors get a higher yield with 1/3 the volatility of BP.

SA: Can you describe the company's competitive environment?

AS: The pipeline business is rather unique in that competition, while present, is somewhat limited. It is analogous to electricity lines in that most locales will not allow multiple pipelines through the same area. The bottom line here is that once you have a pipeline built it is exceedingly expensive, and difficult from a regulatory perspective, for another player to enter the market to compete directly. Plus, much of the work done by KMP and the other players in the market is by long-term contract. While the possibility exists to lose a contract, the competitive profile of KMP is drastically different from most other types of businesses.

SA: Can you talk about valuation? How does valuation compare to the competitors?

AS: At the current time, KMP shares are within 1% of their 52-week high. I added KMP to my Centsible Investor model portfolio on 3/13/09 at a yield of 9.57% with a gain so far of 52.47% including distributions. Price to book (P/B) as of MRQ is 3.5, which is a bit high. The P/E currently stands at 58.3, which is also high. By comparison, Buckeye Partners (BPL) has a P/E of 38 and a P/B of 3.1. Enterprise Products Partners (EPD), the largest competitor by market capitalization, has a P/E of 21.3, but a slightly higher P/B of 3.8. S&P estimates the fair value of KMP shares to be in the $35 range. I disagree with this given the potential for growth both in the industry as a whole and KMP in particular with the new pipeline projects coming online. I am also of the opinion that the current price is a bit high and don’t see it getting too much higher before investors start to bail out because of yield destruction. KMP’s yield is now lower than most of its MLP counterparts.

SA: What is the current sentiment on the stock? How does your view differ from the consensus?

AS: The current market sentiment is clearly bullish. KMP has been tracking the broader markets upward much in the same fashion as its competitors. Analyst reports carry bullish undertones, and the forecasts for 2010’s earnings are for $2.30/share EPS vs. $1.42/share EPS for 2009 – an increase of 62%. This type of outcome would certainly propel shares higher. My biggest concern with the bullish hype right now is the yield. Obviously, yields are one major reason why investors seek to invest in MLPs and unless KMP plans on increasing its distributions significantly, further price appreciation could take the yield below 6% and drive investors away. From a technical standpoint, both the RSI and Full Stochastics are significantly overbought on the intermediate term (weekly) chart. It is my opinion that investors who are looking at a play like Kinder Morgan will have an excellent opportunity to lock in this MLP at a higher yield (lower price) over the next few months. KMP is a buy-and-hold stock in my newsletter model portfolio as well as several client portfolios.

SA: What catalysts do you see that could move the stock and are there risks involved?

AS: There are a couple of factors that could pull the stock in either direction at this point. Completion of the Fayetteville express pipeline on time, an increase in distributions beyond what is expected, and a meeting or exceeding of analyst expectations for 2010 earnings could pull the stock up. Factors that could drive the stock down are technical factors, deteriorating yield, and political risk.

It is rather obvious that the federal government would love to put some sort of cap and trade system in place or otherwise regulate/tax CO2. While proposals have run the gamut from flat taxes on energy consumers and producers to some type of credit purchase system it is obvious that energy is in the bureaucratic crosshairs. One thing that might play in favor of KMP and other transport and storage firms is that they are neither producers nor consumers of the energy – only transporters and as such may miss part of the wrath of zealous government intervention. Enough cannot be said about the political risk at this point. However, with no certainty and at least an outward appearance of gridlock in Washington, our best bet is to watch, wait, and come up with contingency plans in the meantime.

Other risks to KMP are the continuing recession, which could further eat into petroleum consumption and therefore the need for transportation of liquid fuels. If we see a rekindling of the credit crunch as I expect, then capital expenditures of many firms would once again be likely to be shelved. KMP, like most other capital-intensive companies, carries a significant portion of debt. KMP currently carries nearly $10B in total debt, which is very comparable with competitors of similar size, but still a source of concern should credit markets freeze up as they did in 2008. The good news for KMP in this regard is that its largest current projects are nearing completion so further financing shouldn’t be necessary.

SA: What is the bottom line on KMP as a portfolio holding?

AS: The bottom line for KMP is that it provides a nice level of income with comparatively low volatility. It is my feeling that at $63.50 the shares are a bit overpriced, and all else equal I am looking for a target yield on this stock of 7.5% or $56/share at the current distribution rate. That would put the yield into the middle of the group of KMP’s competitors – nearly all of which are MLPs. Again, holding off for a few months should result in a much better outcome for investors looking at KMP.

In conclusion, KMP is a favorable income play and features advantages such as low volatility and the prospect for growth moving forward. That said KMP and Master Limited Partnerships in general are not for everyone. Tax-deferred investment accounts are one example where KMP is not recommended because those investors give up the tax savings. What many MLPs have done to allow tax-deferred investors access to their businesses is set up corporation holding companies that can issue common equity. In Kinder Morgan’s case, Kinder Morgan Management LLC (KMR) holds some of the limited partner interests and allows tax-deferred investors to invest in its common shares.

SA: Thank you so much for your time and investment thesis, Andy.

AS: Happy to participate.

Disclosure: Andy Sutton holds KMP in client portfolios, but not in his personal portfolio.