Kinder Morgan Relative Valuation: KMI Vs. KMP And EPB

Dec.17.13 | About: Kinder Morgan, (KMI)

For the average investor looking for exposure to the high yield pipeline space there seems to be a dizzying array of options. Even when you find a pipeline company you like you still often have the choice between buying shares in the Limited Partner (LP) or General Partner (GP). The LP often has the higher yield but the GP often has a higher growth rate. Which should you buy?

In this article I'm looking into this question for Kinder Morgan, Inc (NYSE:KMI), the general partner of Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipeline Partners (NYSE:EPB). I am a fan of Kinder Morgan and its LPs due to a number of its structural competitive advantages (How Kinder Morgan is like Berkshire Hathaway and Why Both Should Outperform) and believe they should outperform…but is it better to own KMI or its LPs?

Since much of KMI's value is derived from its ownership of KMP and EPB's stock and Incentive Distribution Rights (IDRs) it isn't difficult to form a direct comparison between them. The best way to compare KMI to its limited partners is a sum of the parts look into how much of Kinder Morgan's valuation is derived from:

  • Direct ownership of units of each LP,
  • Owning the Incentive Distribution Rights (IDRs) of KMP and EPB,
  • Its other assets and direct liabilities

This analysis will give you a better look at what exactly you own when you buy a share of KMI, and whether buying KMI or one of its LPs is a better choice for you.

The simplest item to value is KMI's direct ownership of KMP and EPB units. KMI owned the equivalent of 43 million units of KMP and 90 million units of EPB as of the end of last quarter. Divided over its 1,036 million shares, this means an owner of 100 KMI shares owns the equivalent of 8.7 shares of EPB and 4.2 shares of KMP. At current valuations, out of KMI's $32.83 price tag, $3.28 is from shares of KMP and $2.96 is from EPB.

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The next easiest item to value is its ownership of other assets. After netting out its ownership of its LPs, Kinder Morgan has assets worth $9.3 billion. Unfortunately, most of this value is goodwill acquired through the purchase of El Paso's general partner. As we are valuing El Paso's previous assets one piece at a time, we can remove the $18.0 billion of goodwill KMI carries on its books, giving us an $8.7 billion tangible equity deficit, primarily from debts of $10.7 billion. For the purposes of this valuation I will break out KMI's $3.7 billion in investments (most of which it plans to drop down to its partners) from the remainder of its net assets, with a book value of -$12.4 billion.

KMI's investments are worth $3.63 per share, whereas the rest of KMI's equity deficit brings down its value by $12.01 per share, a net impact of -$8.38 per share.

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The largest portion of KMI's value is in its ownership of KMP and EPB's Incentive Distribution Rights, the money it earns by growing its LP's earnings beyond preset targets. As its LP's distributions grow, KMI gets a larger and larger piece of the total pie; KMI's cash flows start at only 2% of its LP distributions for any amounts less than the first target but grow to 50% of LP distributions over and above its highest target. With both KMP and EPB past their highest targets, KMI earns 50% of every incremental dollar its LPs make. As its LPs continue to grow KMI's cash flows eventually approach 50% of the total, as the amounts earned above the 50% target make up a higher and higher proportion of its earnings (shown below).

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Another way to put this is that KMI's cash flows are equal to a percentage of each of its LP's cash flows (unlike the last graphs which looked at the GP compared to the total cash flows paid to both LP and GP). In this view, as its LPs grow, KMI earns a greater and greater amount relative its LP's cash flows, with these amounts nearing 100% as the LP cash flows grow, meaning at very high levels both the GP and LP are paid an equivalent amount (shown below).

You could use this fact to come up with an approximate value for KMI's ownership of its LP's Incentive Distribution Rights by valuing each right as if KMI owned this ratio of each company. For example, if a GP were earning 1/3 of the total cash distributed by its limited partner with its LP earning the remaining 2/3, the GPs cash flows would be 50% of what its LP makes, and the GP could value this IDR at 50% of its LPs market value.

This valuation technique allows us to use the market value of KMP and EPB to come up with an approximation for the value of each IDR, although this doesn't factor in that KMI earns a growing part of each LPs' cash flows, so KMI should naturally have a "Growth Premium" above and beyond this value.

This calculation values KMI's KMP General Partner shares and IDR at roughly 314 million shares of KMP, or about 30 shares of KMP per 100 KMI shares. KMI's EPB General Partner shares and IDR are worth roughly 79 million EPB shares, or about 8 shares of EPB per 100 KMI shares. The KMP and EPB IDRs add roughly $24.02 and $2.57 per share to KMI's value, respectively.

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Between the actual share ownership, the ownership of IDRs and the ownership of other assets, KMI is worth roughly $24.44, meaning it trades at a 34.3% premium to the sum of its parts. This price premium of $8.39 per share could come from a few different places:

  • "Growth Premium" of both EPB and KMP's IDRs
  • Premium over Book for future drop down assets
  • Spread (higher rates on LP and IDR vs. a lower cost of debt)

I personally believe the vast majority of this price premium is from each IDR's "Growth Premium."

Although it is possible that KMI will obtain a modest premium over book value for its drop down investments, their $3.63 value means this would have a modest impact, if any, on KMI's total valuation. Since recent deals have been structured at or close to book value, a conservative investor should value this piece of KMI's value with little or no premium (although there will be more clarity over the next 6 months to a year as they plan to drop down these assets by end of year 2014).

It is likely some of KMI's premium is from earning a positive spread on its debt. With $10.7 billion in debt having a lower cost than the return it earns on its shares of KMP and EPB, KMI benefits from this difference, similar to how a bank earns higher rates on its loan portfolio than it pays to its depositors. With KMI's debt cost close to 6% and its KMP and EPB shares yielding close to 7%, KMI earns a spread of roughly 1% or about $100 million or $.10 per share in cash flow. Valued at a similar multiple to its shares of KMP and EPB, it would have a value between $1.00 and $1.50. I would take this figure with a grain of salt, as it is likely that KMI will retire much of this debt in the near future as it was primarily taken on to finance the El Paso acquisition and KMI should have an inflow of cash from asset drop downs in the near future.

KMI's "Growth Premium" for its IDRs seems to be the source of most, if not all, of KMI's valuation premium. Because of the way the IDR's are structured, KMI's cash flows from them have a higher growth rate than their underlying partnership. From current levels the IDR for KMP will grow 16.5% faster than the LP distribution for KMP (a 6% growth in KMP's distribution grows KMI's payment by roughly 7%). This effect is far more prominent for EPB. The IDR for EPB will grow 135% faster than EPB's distribution (a 6% growth in KMP's distribution grows KMI's payment by over 14%).

For each share of KMI, $24.02 of its value is from KMP's IDR, and $2.57 is from EPB's IDR. With KMI owning the equivalent of $26.59 of KMP and EPB shares with a weighted average growth rate 28% faster than their underlying stock (a growth rate of 7% would become roughly 9%), it is easy to see why KMI shares would trade at a "Growth Premium."

Aside from simply growing faster because of EPS growth in its LPs, KMI also benefits from the growth in share count of KMP and EPB. KMI earns its Incentive Distribution Rights not just on current shares, but also on every extra share that is put into existence in the future. If the EPS were to stay the same in one of its LPs and its share count grew 10%, KMI's IDR cash flows would grow by 10%.

Over the last 10 years the number of KMP shares has more than doubled, going up 131.6%, or 8.8% annually. Although this rate will likely decrease in the future, as KMI's large size makes large deals less likely, it isn't unreasonable to expect mid-single digit growth in cash flows from this source. Combining growth in share count with modest distribution per share growth makes double digit distribution growth reasonable and attainable. Management backs up these expectations by predicting distribution growth of 5% for EPB and KMP and 10% distribution growth for KMI. Share count growth is a major determinant of KMI's value and the "Growth Premium."

Aside from this "Growth Premium" there is another major factor facing an investor choosing between KMI and KMP or EPB: the tax consequences of being an MLP. This is a factor I am not going to get into in detail, as I am not a tax expert and you should seek your own advice from an advisor. In general, MLPs shift the tax burden of the partnership down to investors. In general investors with higher tax rates may prefer KMI, since it is a corporation and has normal dividends, whereas lower tax rate investors may prefer KMP or EPB, as both are MLPs. Also holding MLP shares in a tax deferred account has tax consequences.

Overall, it appears that the price of KMI seems reasonable, if not somewhat inexpensive, on a sum of the parts basis. From current prices KMP, EPB and KMI should all experience impressive total returns going forward.

The primary determinant of what to purchase should be based on an investors risk and style preferences. The $8.39 price premium helps illustrate the excess risk KMI faces above and beyond that of KMP and EPB; if growth expectations of its LPs were to shrink not only would the direct value of KMI's holdings go down, the "Growth Premium" would also shrink, causing declines above and beyond that of EPB and KMP. These losses are compounded due to the leverage employed by KMI. If instead KMP and EPB were to experience excess growth these would be similarly magnified on the upside.

Stylistically, KMP or EPB would appeal more to investors seeking current income, although it could also appeal to income growth investors. KMI is more firmly in the income growth camp, but would still be a fitting holding for a growth investor.

Summary

When you buy a share of KMI (at its current $32.83 price), you are buying the equivalent of $27.30 of KMP, $5.52 of EPB, taking on $8.38 in debt and other tangible equity deficits, and paying a $8.39 premium for the excess growth KMI will experience from owning its LP's IDRs. KMI seems to be fairly valued to slightly inexpensive on a sum of the parts basis. Investors should choose between KMI, KMP and EPB based on their risk profile; investors with a higher risk profile would be rewarded by owning KMI whereas lower risk investors, or those seeking current income should look toward KMP or EPB.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.