- Barron's has argued KMP is significantly over-valued.
- DCF is not overstated, and the CO2 unit is being accounted for properly.
- The general partner, while costly, has added value by finding growth projects, as the backlog now totals $14 billion.
- With a 6.9% yield, KMP is an attractive income investment.
On Saturday, the investing world was rocked as Barron's dedicated its cover story (available here) to a negative article on Kinder Morgan Energy Partners (NYSE:KMP) and its general partner Kinder Morgan (NYSE:KMI). By extension, the article is negative on Kinder Morgan Management (NYSE:KMR), an LLC that owns KMP and automatically reinvests distributions. The magazine joins a parade of bears led by Hedgeye's Kevin Kaiser. Of course, last year, we saw Barron's turn negative on Linn Energy after Mr. Kaiser did. Barron's negative thesis focuses on three areas: DCF (distributable cash flow) accounting, the role of the GP, and valuation. Let's examine each of these three points.
First, Barron's has concerns over how KMP accounts for its DCF. DCF is the cash flow the partnership generates and can return to unitholders. Essentially, it is operating cash flow less maintenance cap-ex. DCF is similar to free cash flow, with the important exception that growth cap-ex is not subtracted. Instead, KMP funds growth projects, like new pipelines, with debt and newly-issued equity at a roughly 50/50 ratio. If an MLP were to label sustaining cap-ex as growth cap-ex, its DCF would be higher, but it would then have to issue more debt and equity to fund the cap-ex budget since it is paying out more than it should. It is important to note DCF is a non-GAAP number, so there are no clear rules regarding its calculation.
Kinder Morgan Energy Partners explains the way it calculates DCF in its partnership agreement. Sustaining cap-ex is defined by the cap-ex needed to maintain throughput and capacity, not cash flows. Barron's seemingly argues this is a bad definition and points to KMP's CO2 oil production division, where sustaining cap-ex of $14 million is dwarfed by expansion cap-ex of $676 million. This has been the case for years, even though production has not grown very much. As a consequence, KMP's DCF is too high, making it less sustainable. This also matters because KMP pays 50% of incremental DCF to its GP, KMI. By having too much DCF, it pays too much to KMI, effectively robbing KMP unitholders. In other words, DCF accounting is extremely important; I think both bears and bulls would agree on that point.
I think the issues at the CO2 unit are a little overstated. First, sustaining cash flows is difficult to calculate because oil and gas prices fluctuate. If oil prices rose 10% in a year, cash flows would be higher even if production was lower. Conversely, if prices were to crash, no amount of cap-ex could maintain cash flows. In fact, thanks to inflation, oil and gas prices will rise over time, though there will be upticks and downticks along the way. This means that over time, to sustain the same level of cash flows, production should be allowed to decline mildly (about 2%-3%). Maintaining the same level of production will lead to higher cash flows over time. Therefore, a firm that has relatively constant production (like KMP) should show its cap-ex budget as being mainly growth cap-ex. Investors should also note that KMP is focusing less on its CO2, with the majority of its $14 billion backlog focused on pipelines, so CO2 will be a smaller piece of the equation going forward.
Barron's also suggests KMP is allocating too little cap-ex to its pipeline maintenance, with a Jefferies analyst noting it allocates half of the maintenance per mile as Spectra (NYSE:SEP). If KMP was spending too little to maintain its pipes, there would likely be a spike in accidents. We are not seeing that, and KMP has a better-than-average accident rate. Looking at the entire sector, KMP spends a similar amount of maintenance as a percentage of EBITDA and fixed assets as other firms. Thanks to its strong expansion record, KMP also has relatively young pipelines, which tend to require less maintenance. It also is budgeting 34% higher maintenance cap-ex in 2014, not something a firm would do if it is trying to inflate DCF. When it comes to CO2 and pipelines, KMP's DCF accounting is transparent, accurate, and fair.
Now, Barron's does make a stronger, though imperfect, case in regard to the recent tanker acquisition. Many tanker companies set cash aside every year to cover replacement costs. The tanker acquisition totals $962 million, so with a 30-year expected life, it could be argued KMP should set aside about $30 million a year. The investment group that sold the tankers to KMP planned to set aside $11 million for replacement. While KMP is allocating $2 million for maintenance, it is not allocating any money for replacement. Now, the world may be a different place in 30 years, and KMP may choose not to replace its tankers. I, for one, am still uncertain KMP is making a wise decision going into the tanker business. If you wanted to allocate a full $30 million (and the fair figure would be less, as the money would earn interest over 30 years), it amounts to less than $0.07 per unit. In other words, it is not a major figure as far as the distribution is concerned. If $0.07 is the biggest problem with the distribution, I am not too concerned.
Barron's also criticizes the role of the GP. KMP pays Kinder Morgan incentive distribution rights ("IDR"), which is a proportion of incremental cash flow. This provides incentive for the GP to find growth projects, and it seems to be working well given the $14 billion backlog. Going forward, KMI gets 50% of incremental cash flow, even though it does not help fund the projects. No doubt, this is a hefty sum. In a perfect world, I wish it were a lower percentage; I am sure most KMP holders feel the same. However, this arrangement has worked well, with KMP consistently growing the distribution thanks to a very expansionary GP.
KMI now gets 43% of KMP's DCF. Going forward, it takes an incremental 50% of cash flow, so its payout growth will exceed the rate of KMP. However, if KMP faced problems and its cash flows began to fall, KMI would see a steeper decline. In this sense, it is a levered play on KMP. Barron's notes that much of the "smart money" (meaning institutions versus retail) owns KMI not KMP. Kyle Bass, for instance, has amassed a sizable holding in KMI. One would not invest in KMI without believing KMP has a very bright future. One would not buy KMI if there were concerns about DCF accounting or growth projects. The fact institutions are moving into KMI is validation, not condemnation of KMP. In other words, all is not as bad as Barron's seems to suggest. While the GP payments are large, CEO Richard Kinder has delivered growth for KMP unitholders, and the backlog portends continued growth.
Last, there is the issue of valuation. Valuation is dependent on future cash flows. As the future is always unknown, it is impossible to be certain what the appropriate valuation is, though history can serve as a useful guide. Barron's notes KMP trades 33x earnings and 16x EBITDA, which is expensive compared to utilities and cable companies. It also prefers a more conservative DCF of $4.00 (KMP is guiding to $5.58) and 15x multiple to get to $60, while Kevin Kaiser thinks $50 is fair. Barron's correctly notes KMP isn't growing as fast as it used to, mainly thanks to its increased size. Still, 5% growth this year isn't awful, and the total backlog should push DCF up by at least 30%. Further, KMP is moving into growth areas like Utica and Marcellus, where production is booming. I actually expect KMP to reaccelerate distribution growth beyond 2015 closer to 6%-7%.
Because the company operates fixed assets, it reports significant depreciation, which distorts net income. Financial depreciation is far different than the actual decline in the value of the pipelines, which makes it a spotty number. An EBITDA or DCF-based valuation makes far more sense. 16x EBITDA for a firm growing 5% is actually an attractive valuation that suggests long-term returns of 9.5%-11%. If anything, KMP is undervalued, as it has a far longer growth runway than a utility firm.
While Barron's is quite negative on KMP, I don't share the pessimism. No company or stock is perfect, but KMP doesn't face problems that would send units down 40%. The DCF accounting is appropriate, and the GP continues to find projects that grow cash flow. While KMP's growth has slowed, it currently yields 6.9% and is growing the distribution at a 5% pace. Under $80, KMP is an attractive investment. Between the recent secondary and this article, I expect units to remain under pressure, which caps near-term upside. It is a solid income play, and investors should not sell on the Barron's wrongheaded and overly negative article.