Over the past six months, despite a buoyant equities market and solid advances by most master limited partnerships, the grand-daddy of the mid-stream MLP space, Kinder Morgan, has been a notable laggard. Limited partner and general partner investment vehicles Kinder Morgan Energy Partners (KMP/KMR) and Kinder Morgan Inc. (NYSE:KMI) are respectively trading 22% and 30% off of their May 2013 highs even while many large-cap peers such as Enterprise Products Partners (NYSE:EPD) have been hitting new all-time highs on a weekly basis.
Curiously, it appears to be sentiment, rather than any deterioration of fundamentals, that has driven this stark underperformance. Most investors are by this point familiar with a controversial analysis of maintenance capex accounting by independent research firm Hedgeye Risk Management. This report has garnered a great deal of publicity in the financial media in recent months and has given rise to much angst among the retail investor base of KMP/KMR. However, this analysis has for the most part been widely discredited among the institutional investor community. Arguably, what has led to a re-rating of both KMP/KMR and KMI is the more credible thesis of a secular slowdown in Kinder Morgan's growth trajectory resulting from its sheer size and perceived equity cost-of-capital burdens.
Notably, the growth slowdown thesis, while credible, does not appear to be backed by solid evidence or a compelling line of reasoning. In addition, from a behavioral perspective, circumstantial evidence suggests that market participants and the financial media are currently demonstrating irrational herding tendencies-a well-established behavioral bias--that may have served to amplify recent negative sentiment on Kinder Morgan and excessively depress share and unit prices.
In reality, any secular slowdown in the growth rates of KMP/KMR and KMI is arguably already incorporated into share and unit prices. Furthermore, to the extent that the slowdown thesis proves, in the fullness of time, to be inaccurate or exaggerated, current valuations and historical performance both suggest that KMP/KMR and KMI are likely to rally significantly from current levels perhaps on the order of 30% or more over the next 12-18 months. Given a relatively low business risk profile as well as high current distributions, KMP/KMR and KMI may represent one of the most compelling risk-reward profiles in an over-bought, over-valued US stock market with stretched profit margins and tepid earnings growth prospects.
Backdrop to Deterioration in Sentiment
KMP's unit price peaked in May of 2013 at $92.99 in tandem with a general surge in yield-oriented securities as longer duration US interest rates remained pinned at historically low levels. In June, Federal Reserve Chairman Ben Bernanke's speech hinting at an eventual wind-down of quantitative easing programs served to puncture the emerging "zeal for yield" bubble with Treasuries, REITs, utilities stocks and MLPs selling off hard. KMP promptly plunged from $92 to $80, bounced briefly and then proceeded to consolidate in the low $80s. In September, a controversial report and short-sale recommendation issued by Hedgeye Risk Management, alleging understatement of maintenance capex spending, served to generate short-term volatility as well as elicit an extensive rebuttal from Kinder Morgan. Nonetheless, KMP closed out 2013 at a price of $80.66-roughly where it had marked time for several months after the summer correction even before the release of the Hedgeye report.
In January, after a brief rally in anticipation of favorable 2014 guidance, Kinder Morgan disappointed the sell-side analyst community during its Q1 earnings call and its annual Analyst Day two weeks later when it announced a three-year distribution growth trajectory of 5% for KMP/KMR and 8% for KMI. Previous guidance had suggested a "long-term" growth rate of 6-7% for KMP/KMR and 9-10% for KMI. The market was further disappointed by flat three-year growth forecasts, driven largely by regulatory rate cases on natural gas pipelines, for El Paso Pipeline Partners (NYSE:EPB), an affiliated MLP controlled by KMI.
In recent weeks, a steady stream of negative coverage by the financial press has served to further sour sentiment on KMP/KMR and KMI with each making new 52-week lows over the past couple of weeks. In short, Kinder Morgan has in recent months suffered through a "perfect storm" of negative sentiment. Yet, a close look at each prong of the growth slowdown thesis suggests that much of the concern may be misplaced.
Distribution Growth Winding Down?
Historically, Kinder Morgan has been the subject of many "growth scares" over the years. During the recent Analyst Day, chairman Richard Kinder, attempting to downplay recent concerns over slowing growth, cited a 2002 Wall Street Journal headline expressing unfounded concerns over KMP's size and growth prospects as far back as 12 years ago. Also, in 2006, KMP/KMR and the original incarnation of KMI underperformed the market for a period of over two years on fears of slowing growth when KMP/KMR temporarily slowed the annual rate of increase of its distribution to 5% during 2005-07. Notably, during this period, the original KMI entity was taken private by Richard Kinder and a private equity consortium in a leveraged buy-out eventually to be spun back out to the public in 2011.
In the past, these growth scares have proven to be largely unfounded. While the rapid growth trajectory of KMP and KMI during the partnership's early years has indeed moderated over time, the group has continued to grow robustly and has outperformed the broad market in a big way since both 2002 and 2006 even with the sharp underperformance of the past two years. In other words, while large companies such as the Kinder Morgan group are certainly subject to the "law of large numbers" and inevitably face slowing growth, the market has in the past proven to be overly pessimistic on the growth prospects for Kinder Morgan, and selling into either of the past two growth scares was clearly a mistake.
Coming back to the present, the first question is whether the recent three-year distribution growth targets represent a "guide-down" which can be taken as evidence of slowing growth. Were the earlier forecasts of 6-7% and 9-10% overly optimistic? Does this cast doubt on management's forecasting abilities? Is it likely that even these reduced targets may be missed in the future?
What most of the sell-side analyst community appears to have missed in its reaction to the guidance is the fact that the original targets were stated to cover the period from 2012-2016. The table below sets out actual distributions for KMI since 2012 and also extrapolates the 2016 level of distributions based on the recent 8% guidance.
|Calendar Year||KMI Distribution||Year-over-Year CAGR|
|* KMI forecast distribution for 2014.|
|* Implied distributions based on 8% annual growth forecast.|
What this table demonstrates is that the new guidance does not represent a "guide-down" or failure to achieve the original forecasts. Rather, the year-to-year growth is front-end loaded and "lumpy" given the uneven timing of new growth projects. Nonetheless, KMI will have grown its distribution at a 9.5% CAGR from 2012 to 2016 right in line with the original forecasts.
Importantly, there are strong reasons to believe that distribution growth will re-accelerate after 2016. First, we have seen this movie before during the last cycle when distribution growth temporarily slowed for two years before briskly re-accelerating. Richard Kinder has expressly indicated that management expects to grow KMP/KMR and KMI faster than the near term 5%/8% trajectory after 2016, and the historical track record suggests that this is unlikely to be an empty promise or wishful thinking.
Second, a close look at the Kinder Morgan project backlog suggests that massive accretive projects will come online beginning in 2017 such as the $5.4 billion Trans-Mountain expansion. Such multi-year projects consume capital during their build-out phase, temporarily lowering cash flows, but do not generate incremental cash flow until they come online. This phenomenon is not unique to mid-stream MLPs -- Chevron (NYSE:CVX) is currently experiencing such a variation in capital intensity and cash flows as its gigantic LNG projects prepare to go on-line in a few years.
Third, Kinder Morgan, despite a well-diversified business mix, is heavily weighted toward natural gas pipelines, and drillers have over the past couple of years idled a great deal of "dry gas" activity in favor of liquids (oil and NGLs) given the epic crash in natural gas prices in recent years. It's no coincidence that large MLPs focused on crude oil or natural gas liquids, even those with IDR burdens such as Plains All American (NYSE:PAA), have been able to grow their cash flows at tremendous rates over the past couple of years while natural gas focused players have faced a more challenging environment. These types of industry trends are cyclical and are likely to reverse at some point.
Fourth, it is likely that well-financed large-cap MLPs such as Kinder Morgan with dominant footprints will be in a position to exploit the woes of weaker operators via acquisitions of assets or whole companies particularly if recently wide-open capital markets tighten at some point. Current guidance does not assume any acquisitions, yet history suggests they are likely to occur.
Despite all of this, sell-side analysts, notoriously prone to linear thinking and recency bias, are erroneously taking the most recent three-year forecast as strong evidence of a permanent secular slowdown in the growth trajectory. This is exactly the same mistake that investors made in 2006 when KMP/KMR's distribution growth temporarily slowed to 5% before re-accelerating.
Too Big to Grow?
Although it was January's Analyst Day that provided a catalyst for the latest growth scare, Kinder Morgan has always been vulnerable to such scares due to its size (it is the largest mid-stream operator in North America with a combined equity market capitalization of $80 billion). According to this line of argument, the sheer size of the existing asset base makes it difficult to move the needle with organic growth while regulatory obstacles would make it challenging for Kinder Morgan to close the acquisition of any large-scale pipeline operators.
Again, while there may be some truth to the "law of large numbers," this argument is likely overstated given a number of factors. First, the available opportunity set for North American energy logistics is enormous and expanding rapidly; taken in the aggregate, this is a very large market. A recent report from consulting firm ICF International suggests the need for an additional $641 billion in mid-stream energy infrastructure investments between now and 2035. According to the report, this implies average growth capital investment of $30 billion per year going forward whereas over the past 10 years, a period of exceptional growth, the industry has only invested $10 billion per year. In other words, secular growth appears to be accelerating rather than slowing down.
Importantly, as Kinder Morgan has pointed out, growth and expansion opportunities often flow out of the existing asset network (pipeline expansions and re-purposings, lateral lines, etc.). As a result, Kinder Morgan is well positioned to capture a large chunk of these opportunities.
Second, Kinder Morgan, broadly speaking, is an energy logistics partnership rather than just a pipeline operator. Accordingly, longer term, there are likely to be numerous opportunities to enter new businesses or expand current activities in directions that are currently unanticipated. Prominent examples have already arisen over the past 18 months such as LNG export terminals, natural gas exports to Mexico and KMP's recent acquisition of a number of Jones Act tankers. Only a few years ago, none of this would have been anticipated. Another major MLP, EPD, has as recently as last month raised the possibility of ethane exports to Europe-another gigantic new growth opportunity for the industry. These types of new opportunities emerge frequently as the energy landscape evolves yet are seldom considered by growth trajectory pessimists.
Third, Kinder Morgan will likely see enhanced synergies over time due to its scale as its organic growth projects and acquisitions are effectively integrated. This is likely to result in higher operating margins over time. While such incremental effects may seem small, it is important to remember that a 6-7% growth target is not particularly demanding, and a small increase in operating margin on a gigantic asset base is likely to drive substantial increases in cash flow.
Finally, what is most peculiar about concerns over Kinder Morgan's size is the fact that many peer operators, while a bit smaller than Kinder Morgan, are not dramatically smaller, yet analysts do not seem to profess any concern whatsoever over the growth prospects of these other operators.
|Selected Mid-stream MLP Groups||Aggregate Market Capitalization|
|Kinder Morgan (KMP/KMR/KMI/EPB)||$80 billion|
|Enterprise Products||$64 billion|
|Williams (WMB/WPZ/ACMP)||$61 billion|
|Enbridge (ENB/EEP/EEQ)||$48 billion|
|Spectra (SE/SEP)||$38 billion|
For example, Enbridge has a combined market capitalization of nearly $50 billion, but ENB consistently carries a valuation implying much higher growth rates than KMI. Yet, market analysts do not seem to question the ability of ENB to find new avenues for growth.
IDRs and Equity Cost of Capital
Another refrain suggests that high pay-out ratios and/or the drag from incentive distribution rights (IDRs) owed by KMP/KMR to its general partner, KMI, have raised the group's cost-of-capital to the point where it is unable to competitively secure accretive new projects. Like so many other arguments, this line of reasoning also appears to be poorly grounded.
First, as Kinder Morgan itself has recently pointed out, KMP/KMR has been in the "high-splits" (i.e. 50/50 IDRs) since 1996 yet has nonetheless grown robustly since 1997. In other words, nothing has really changed in recent years with respect to the KMP/KMR IDRs that would impact the growth rate.
Second, IDRs merely govern the manner in which a limited partner and its general partner internally divvy up the cash flows from projects. It's true that a high IDR split could, even in the absence of other factors, slow down distribution growth for MLP limited partners, but such a slowdown would operate to the benefit of the MLP's general partner, which would skim off the accretion from any growth in the MLP. A prime example of this phenomenon would be Energy Transfer Partners (NYSE:ETP) and its general partner, Energy Transfer Equity (NYSE:ETE). Cash flows and the share price of ETE have soared over the past couple of years due to massive issuance of new ETP units while the distribution per unit at ETP has barely budged. Yet, this is clearly not what has hit KMP/KMR because the recent slowdown fears have impacted both KMP/KMR and KMI.
Third, equity cost-of-capital for MLPs is widely misunderstood. Commentators will often cite, for example, lower distribution yields or lack of IDRs as conferring a "cost-of-capital" advantage for certain MLPs such as EPD or Magellan Midstream Partners (NYSE:MMP). This implies that an MLP such as KMP/KMR is being priced out of competitive growth opportunities. Yet, this is an analytical fallacy.
This notion suggests, for example, that MMP, with a distribution yield of 3.5%, could invest in an equity-financed project delivering a 5% IRR, and such project would still be accretive (i.e. it would raise the distribution on the existing partnership units). However, while it's true that such a project would be accretive to the existing distribution, it would be dilutive to the implied future growth rate on such distribution, which is capitalized into the valuation of MMP units. Therefore, such a project would lead to a downward re-rating of the high valuation multiple (to which MMP's lack of IDRs is a contributor) that the market currently awards to MMP's units.
Therefore, in practice, so-called "low cost-of-capital" MLPs such as MMP and EPD tend to be extremely demanding with their investment return hurdles and actually shy away from competitive acquisitions or marginal growth projects because it's difficult for these MLPs to pursue such opportunities without effectively hurting their own unit prices.
For Kinder Morgan (and all other MLPs), what matters isn't internal equity cost of capital but rather IRR hurdle rates on new projects and acquisitions. To the extent that the market becomes more competitive and there are other MLPs willing to lever up on cheap debt financing and/or accept lower equity returns than KMP's unlevered 13% target, there would be a valid basis for expecting growth at KMP/KMR and KMI to slow. However, the KMP/KMR/KMI blended equity cost-of-capital is not a reason to fear a growth slowdown.
Media-driven Herding Bias - A Reliable Guide for Contrarian Strategies
Most investors are aware that "herding bias"-the inclination of most market participants toward group-think-tends to distort the prism through which investors analyze investments and invariably creates excellent opportunities. Typically, the financial media is a prime enabler of this phenomenon-coverage of any market, security or asset class is typically euphoric near market peaks serving to reinforce the recency bias of investors. Conversely, coverage is despondent near market lows serving to amplify investor pessimism.
Over the past month, in terms of fundamentals-driven news, Kinder Morgan has pre-announced that it will meet or exceed financial targets for Q1. As for financial media coverage, during the same period, we've seen the following in close succession:
- Barron's: Barron's publishes a one-sided article essentially re-hashing the largely discredited Hedgeye bear case against KMP/KMI published in September despite the lack of any additional information, analysis or developments to support such bear case.
- Bloomberg: Bloomberg publishes a one-sided, rambling, incoherent article discussing the perceived riskiness of the MLP sector of which Kinder Morgan is an acknowledged bellwether. Rather than accurately summarize well-established risks for the sector, the article prominently features a succession of scare-mongering quotes from various sources ("how can we blow ourselves up next?" and "the next great investment debacle") and extensive commentary from a retired postal worker from rural Georgia who sold a profitable MLP investment after becoming nervous based on his lack of understanding of the investment.
- Morningstar: A Morningstar dividend investor newsletter analyst announces that he is selling KMP and KMI from his existing model portfolio (after substantial nine-month declines) ostensibly on fears over replacement of upstream oil production slated to begin declining in 2020 (an issue which has been disclosed for many years) and because KMI and KMP are somehow suddenly "too risky for the conservative investor."
- Wells Fargo: Wells Fargo downgrades KMP/KMR and KMI from outperform to neutral based solely upon "headline risk" (potentially arising in relation to the Hedgeye bear attack) and "lack of a specific near-term catalyst" without any mention of the fundamentals or valuation that had prompted Wells Fargo to maintain an outperform on KMP/KMR and KMI for several months in the first place.
All signs suggest that pessimism on Kinder Morgan is at a feverish extreme. Anecdotally, many retail investors complain that the Kinder Morgan entities have gone sideways for over two years while the S&P 500 and Alerian MLP index have exhibited strong gains. While this is true, it was also true at the bottom during the fall of 2006 (when KMP had declined over 20% and traded at a 7.5% yield just as it does today). KMP subsequently rallied nearly 35% over the next nine months, delivering a total return of approximately 40% and dramatically outperforming the broad market.
As in late 2006, we have an overbought, overvalued equities market, and Kinder Morgan, with a business risk profile far lower than the average stock or MLP and below-market EV/EBITDA valuation multiples (relative to other MLPs), represents an outstanding risk/reward proposition particularly relative to the equities market at large. Given that much of the pessimism has been generated by a poorly reasoned growth slowdown thesis, the veil of negative sentiment is likely to lift in the near future as fundamentals at Kinder Morgan keep chugging along and price action begins to turn. Expect the units and stock to re-visit and ultimately eclipse their May 2013 highs within the next 12-18 months for low-risk capital gains in the ballpark of at least 30% with current yields of 7.5%, 8.0% and 5.4%, respectively.
Disclosure: I am long KMP, KMI, KMR, EPB, EPD, MMP, PAA, SXL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.