What's Wrong With Kinder Morgan?

| About: Kinder Morgan, (KMI)

Kinder Morgan (NYSE:KMI) shares fell yet again last week, as the company offered a new three-year outlook that was less than investors had been hoping for (presentations are available here). This decline comes after a pretty disappointing performance over the past twelve months. While the S&P rallied 30% last year, KMI shares are down 9% over the past twelve months and currently only sit 5% above their 52-week low. Even with a solid 4.8% dividend, KMI has been a disappointing investment, so what's wrong with Kinder Morgan.

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Chart Source: Yahoo Finance

To understand what's wrong, we need to understand what KMI is. First, it owns and operates some midstream oil and gas properties. These assets tend to generate 15-20% of KMI's cash on a gross basis. However, after accounting for interest and other expenses, they burned $16 million over all of 2013. While these assets (mainly terminals and pipelines) are an important part of KMI, they clearly are not the driver. Moreover, KMI has been selling these assets down to the partnerships it manages, which will make them a smaller part of the business going forward.

That is where KMI's second and primary business comes in. It is a general partner ("GP"), meaning it operates limited partnerships. It makes investment and operational decisions on behalf of the partnership, while limited partners ("LP") simply own the equity. It is analogous to how investors in John Paulson's hedge fund have equity in the fund, but Paulson, as the general partner, decides what stocks to buy and sell. In exchange for undertaking these managerial decisions, KMI is compensated with a share of the cash flow. KMI is the GP in two MLPs (Master Limited Partnerships): Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipeline Partners (NYSE:EPB).

Now, KMI receives compensation through Incentive Distribution Rights ("IDR"), which essentially entitle KMI to a portion of the cash flow that KMP and EPB generate. As they generate more cash, KMI gets a bigger payment. However, there is further incentive for KMI to ensure its MLPs perform well because the IDRs are not a constant rate. Instead, as KMP and EPB pay higher distributions, KMI gets a higher share of each incremental dollar generated. In other words, there is a progressive IDR scale.

Thanks to the strong performance of KMP and EPB over the past decade, KMI is now in the top IDR bracket, where it earns 50% of each additional dollar earned. As a consequence, if KMP pays a 5% higher distribution to limited partners this year, KMI's IDR payment will be roughly 8% higher. In this sense, KMI is a levered play on the success of its MLPs. As such, it is important to consider the health of KMP and EPB when deciding whether or not to invest in KMI

With this understanding of KMI's business, we can better dissect what is troubling investors. When it returned to the public markets in 2011, KMI management set a goal of growing the dividend by 8-10% annually. However, at its annual investor conference, management targeted an 8% dividend growth rate through 2016. Many investors were still looking for a 10% growth rate, so this guidance was a bit underwhelming.

In all of 2013, KMP paid $1.986 billion to KMI, while EPB paid $441 million (full-year 2013 results available here). Now, at the analyst conference, management said EPB would keep its distribution steady through 2015, while KMP should grow at a 5% pace. With these growth rates at the partnership level, it would be hard for KMI to grow its dividend by 10%. In fact, using 2013 figures and management's forecast, I calculated future cash flows from its IDRs in KMP and EPB and ownership of LP units in both. Here are the results:

As you can see, KMI's cash flow will be increasing in the 7% range thanks to growth from KMP, while EPB will mainly be stagnant. With the 7% increase and some costs like interest relatively flat, dividend growth in the 8% area is a reasonable project. While KMP continues to show solid growth, EPB is holding back KMI's overall growth rate and reducing the pace of dividend growth. EPB has struggled with lower rates in Wyoming and a lack of new projects coming online in the next twenty-four months. If the firm can resume distribution growth in 2017 when some projects should be online, then KMI may be able to accelerate its dividend payment. Until then, it will be difficult to grow at the 10% rate.

Overall, KMI's performance is held hostage by the performance of the MLPs it manages. When they do well, KMI does well. When they struggle, KMI's results will suffer. One of its MLPs continues to perform solidly, while another is challenged. As a consequence, KMI can continue to grow its payout but only at the low end of previous guidance. With a 4.8% yield that is still growing at a respectable pace, KMI certainly looks attractive, but with disappointing guidance, shares will likely remain under pressure for some time. With KMP yielding over 6.8% and no exposure to El Paso, I think investors may be better in KMP than KMI. EPB is what's wrong with KMI, and until it improves, KMI's performance will be hurt.

Disclosure: I am long KMP. 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.