On Monday, Kinder Morgan Energy Partners (KMP) announced that it would acquire two oil tanker companies from private equity firms (press release here). While the market neither cheered nor booed the acquisition with units trading in line with the broader market, I do believe this acquisition is a strategic mistake for KMP and am disappointed they made the deal. I do not consider these transactions to be a reason to sell as I believe KMP remains at major discount to its fair value, but nonetheless, it is a disappointing action that could be problematic if it is a sign that KMP plans to move more significantly into the tanker industry. I would also note that this analysis applies equally to Kinder Morgan Management (KMR), which is KMP's sister company that issues a stock dividend instead of cash.
Let's first examine the details of these deals. In total, Kinder Morgan Energy Partners will pay $962 million in cash to purchase American Petroleum Tankers (APT) and State Class Tankers (SCT), which ship oil domestically via tankers. APT has five tankers with 330,000 barrels of capacity. On average, they are four years old (which is relatively young in the industry). On the plus side, they operate with long-term contracts (similar to how KMP operates its pipelines), which have four year remaining lives. On the other hand, SCT does not actually have ships in the water. However, there are four under construction that will be delivered in 2015 and 2016 at which point they will operate under longer term contracts as well. To complete the tanker construction, Kinder Morgan Energy Partners will have to pay another $214 million.
In total, KMP will spend $1.176 billion for possession of nine tankers that will all be in operation in 2016. KMP has plans to invest a total of $14.4 billion in growth cap-ex projects in its traditional pipeline and storage business, so this is a pretty significant deal. KMP expects the deal to close in the first quarter of 2014 and that it will be immediately accretive. APT is generating $55 million in EBITDA, and when SCT ships are in the water, KMP expects $140 million in EBITDA. Using the total cost, the deal has an 8.4x EBITDA multiple, which is attractive. I was also glad to see General Partner Kinder Morgan (KMI) will not take any incentive distributions in 2014-2016.
Currently, Kinder Morgan Energy Partners trades at an Enterprise Value/EBITDA multiple of 13.4x. So assuming KMP funds this purchase with a similar ratio of debt and equity (about 38% debt, 62% equity), it is clear that this deal should be accretive in the short term at least. KMP clearly purchased these ships at an attractive valuation, which begs the question: why would the ships sell at such a low valuation?
The answer in my opinion is that the tanker business is lousy. The growth in U.S. production has made our demand for international oil a lot lower, which has been a drag on tanker rates. Companies like Nordic American Tankers (NAT) and Frontline (FRO) have been forced to cut their dividends as lower tanker rates have depressed cash flow. Unsurprisingly, their shares have suffered as well. With the U.S. energy boom, international oil trade will be far lower going forward than it has been in the past. Importantly, KMP's new tankers do have two major differentiating features.
First, the tanker companies that have suffered the most are those that operate in the spot market where lower demand has eroded pricing. KMP will operate long-term contracts, which keeps rates relatively high and adds stability. However, if spot rates are low when the next contract is negotiated, KMP could be stuck with a low rate for several years. Second, KMP will operate its tankers domestically not internationally. As such, declining U.S. demand for international oil is not a headwind.
In fact, one might argue that increasing U.S. production could benefit the domestic tanker industry. However alongside the production boom, we continue to develop other forms of transformation. As KMP and others build more and more miles of pipeline that connect the entire nation to major shale formations and oil basins, the need for tanker transportation declines. In my view, KMP's existing business threatens the value of this acquisition. Moreover with much of the new U.S. production landlocked, I believe growth in the pipeline business far exceeds potential growth in the tanker industry.
At the end of the day, I would rather see KMP stick to its core competency and spend an extra $1.2 billion on pipelines rather than tankers. While this deal may be accretive in the immediate term, I expect contract rates beyond 2016 to be under pressure as the U.S. imports less oil and a larger pipeline network limits the need for domestic tankers. As a consequence, future EBITDA growth could be extremely hard to come by. Furthermore, I believe a dollar invested in a pipeline will return more than a dollar invested in a tanker. I would much rather see KMP invest another $1.2 billion on pipelines. While this deal could be accretive compared to do nothing, it will be a loser when compared to expanding the pipeline network more aggressively.
Sometimes, companies like to argue they are safer because they are diversified. However, investors can get this same diversification by buying shares of companies in different sectors. If an investor were bullish on pipelines and tankers, he could invest in a tanker company and a pipeline company. Investors are rarely better off when a company diversifies, especially in KMP's case where its existing cash flows are relatively certain thanks to long-term contracts. I hope that this tanker deal is an exception rather than a norm. Not all oil transportation is the same and not all kinds will benefit from the U.S. production boom.
KMP should stick to its core competency of pipeline transportation where there is far better growth potential. The cheap valuation in this deal is another sign that the tanker market is in secular decline. Given its strong dividend and undervalued unit price, I am not selling my KMP, but I am deeply disappointed in this unusual strategic miscalculation.