This is the second of two articles on the puzzlement presented by the Kinder Morgan companies. The following subjects are covered as indicated.
Background - How an investor needs to understand the makeup of the various entities.
The current hot topic: Dealing with KMI's IDRs from KMP
The "L" game: Limited Partnerships and Limited Liability companies
The why and how of KMP and KMR
What does everyone want? Distributions and dividends! When do they want them? Now!
The Great Mystery: Why does KMR sell at a discount from KMP?
The last battle: Does KMR provide funds for KMP?
WHAT DOES EVERYONE WANT? DISTRIBUTIONS AND DIVIDENDS! WHEN DO THEY WANT THEM? NOW!!
Let's start with an easy one. Kinder Morgan Inc. (NYSE:KMI), being a corporation, pays dividends in cash out of its earnings so of course they are taxable. Well, maybe. It seems that KMI wants to play with the rest of the family so it pays dividends as follows: It takes all the cash it collects, mainly from Kinder Morgan Partnership (NYSE:KMP), in the form of its percentage ownership by virtue of being the GP, plus the distributions it receives as owner of units plus the cash it receives from dividends paid by Kinder Morgan Management (NYSE:KMR). Of course KMR doesn't pay cash dividends so KMI takes the shares it receives as stock dividends from the KMR shares it owns and sells them for cash. That is the official process. In real life they don't sell the stock received until they need the cash.
KMI also adds in the money that El Paso Pipeline Partners (NYSE:EPB) sends as its distributions on units owned by KMI, and KMI also receives various other cash from such things as the El Paso assets that have not been dropped down to the MLPs.
They take all of these cash sources, subtract such things as General and Administrative Expenses and debt service and pass most of the rest on as dividends. The following table shows a summary of the figures for 2013. (Source: KMI 10-K for 2013; p.65)
(Source: KMI 10-K for 2013, p.64 and p.113)
The above excess of dividends over income results in a charge to Retained Deficit of $429 million bringing the balance in that account to a deficit of $1,372 million. The importance of these figures is that, unlike MLPs, a Delaware Corporation cannot declare dividends in excess of Surplus or if Surplus is inadequate, out of earnings for the current or preceding year.. KMI on a consolidated basis has a "Surplus" (as calculated under Delaware Corporate Law, Sec 170) of some $13,796 million at 12/31/2013.
My thoughts on all of the above are:
. There doesn't appear to be any danger of running into the Delaware dividend restriction at least for the foreseeable future.
. The taxes paid by KMI are a significant amount and of course the dividends will again be subject to taxation at the stockholder level. This would seem to be a strong argument for changing the KMI/KMP situation. Management may not want to expend funds for making any changes and either or both KMI and KMP/KMR may suffer in the annual distributions for a period but at least some portion of that half a billion dollars in taxes not paid will flow through to all parties each and every year.
KMP, being a partnership, issues distributions in cash to all limited partners except for the I-Units owned by KMR. KMR is paid in additional I-Units which have about the same value as the cash distributions. These distributions are considered "return of capital" by the IRS. They do reduce the amount in the partner's capital account. The yearly earnings of the partnership are credited to each partner's capital account in proportion to his units. These earnings are taxable and are reported on the partner's K-1 which shows those items that need to be included on the partner's tax return.
As noted above, distributions received by you reduce your capital account and your share of KMP's earnings increase your account as does the purchase cost of your units. Since distributions are almost always much larger than earnings, your capital account will soon get down to zero (barring additional purchases which increase your capital account). At that point the distributions become taxable as a long-term capital gain. There are many other taxation issues with KMP especially in connection with tax advantaged accounts but also in relation to inheritances and gifting. You can start with my past article noted at the beginning of the Part I article but it is wise to talk to a tax expert even before you buy.
KMR, an LLC that has elected to be taxed as a corporation, issues additional shares of its stock as a stock dividend to its shareholders. These stock dividends are not taxable. Their only impact is to reduce the per share basis of shares owned. Your total basis is not changed by these stock dividends - there are just more shares to divide into the total cost, thus lowering the individual share basis. As such, no 1099 is issued and of course there is no K-1. The only time that any tax is due on KMR shares is at the time they are sold and the gain or loss would be a capital gain or loss.
Note that there can be some differences between the value of the shares received as dividends and the cash payment to KMP unit owners. That is because of the difference between the per share value of KMR at the time the dividend is computed and the value at the date of payment.
THE GREAT MYSTERY: WHY DOES KMR SELL AT A DISCOUNT FROM KMP?
We have seen that each share of KMR is represented by exactly one unit of KMP. We have seen that a share of KMR receives almost exactly the same value in dividends that a unit of KMP receives as distributions. Since KMR sells at a lower price, the return to KMR stockholders is slightly higher. There was a short time when KMR did sell at a premium to KMP but that was clearly due to when for a short period after the IPO a share of KMR was convertible into a unit of KMP.
To add to this enigma, we have Enbridge Energy Partners (NYSE:EEP) and Enbridge Energy Management (NYSE:EEQ), the only other real example of a MLP and a shadow company. In that instance, the shadow company, EEQ, often sells at a premium to the MLP. As can be seen from the following chart, KMR has rarely sold at a premium while EEQ usually does sell at a premium.
Chart Courtesy of Philip Trinder (mlpprotocol.com)
Linn Energy (LINE) and its shadow Linn Co (LNCO) operate in a very similar fashion but the company structure is different and cash dividends are paid. The graph below shows that LNCO trades at a premium to the MLP about one-third of the time.
So why has KMR sold at a discount from KMP for almost its entire existence? Even the executives of Kinder Morgan are at a loss to explain the discount and feel there is no justification. The discount and the resulting increased rate of return is the reason so many insiders seem to favor acquiring KMR over KMP.
Numerous theories have been advanced for this phenomenon.
- Investors like to receive cash rather than stock.
- There is a cost to convert the KMR stock received to cash.
- The market for KMR shares is less liquid that for KMP units; the float for KMR is less than half of that of KMP
- Financial news reporting almost always shows KMR as paying no dividend thus misleading and discouraging investors.
- Institutions own triple the percentage of KMR shares as compared to KMP units.
Considering that the average discount for 2013 ran about 5%, I do not believe that any combination of the above factors much less any one of them can account for the discount with the possible exception of the last cited.
Institutions hold roughly the same number of KMR shares (80M) as KMP units (85M) but in the case of KMR this represents 64% of its market cap versus 19% 0f KMP's market cap. This large percentage difference in institutional ownership is one of the few statistics that stands out between the two organizations. (The other being the difference in market cap: 35B for KMP and 9.6B for KMR.) Institutions deal in trades many times the size of most individual trades which can result in lower prices and in some cases the prices are negotiated rather than priced in the open market. Now if I were writing my Master's thesis. I would now present the results of tracing the size, pricing and purchasers/sellers of 100s of transactions supporting my perception. Instead, I will leave it as my unproven but somewhat logical theory. If anybody does check it out, please add me to the hyphenated theory name, remembering that my name is spelled with two "L"s.
And if my theory does not prove out, well, I have done no worse than anyone else.
THE LAST BATTLE: DOES KMR PROVIDE FUNDS FOR KMP?
KMR was set up for the purpose of providing an inflow of investment dollars from institutional investors. An added benefit is that it created an investment vehicle that mirrors the progress of KMP without the need for even a 1099 at tax time much less a K-1.
The conflict comes into play with this question: When KMR receives I-Units in lieu of cash for its distribution from KMP, does that provide additional DCF coverage for KMP, DCF coverage being a major metric in evaluating the health of MLPs? Although KMP does not pay cash distributions on the I-Units, the company states that it does set aside the cash that would be required to pay an amount equal to the distribution it makes on the public units. Since KMR owns some 30% of all units, we are talking about a major amount of dollars. A significant enough amount that Richard Kinder has stated he foresees a time when such cash could fund the cap ex requirements of KMP. Under the current rate of KMP cap ex that would be an extraordinary accomplishment. KMP reflects the following for 2011-2013:
Looking at the "Net Overage " line, is there a difference between these funds and DCF funds held back by say Enterprise Product Partners (NYSE:EPD)? Many, including one of my favorite MLP authors, Ron Hiram, say yes. Mr. Hiram says that the true picture is obtained by looking at what the impact would be if KMP had to pay the distributions on I-Units in cash rather than in additional units. For instance, for the year 2012, he showed that instead of the overage of the $466M that KMP shows (Note A), it would turn to a deficit of $66M if an estimated $532M (Note B) had been distributed on the I-Units. The $66M, as adjusted, is negligible considering the averages used and supports management's argument that it sets aside the equivalent amount that would be paid on the I-Units. However, when the same information for 2013 and for 2011 is displayed, the 2013 deficit becomes sizable at $271M but the year 2011 shows a surplus of $8M.
Which year represents "normal?" It is a case of bad news, good news. The good news is that two years appear to cover what would be a cash dividend. The bad news is that there seems to be a trend toward larger deficits
It is also argued that KMP does not and will not pay out the cash to KMR and thus it is a true savings. However, the issuance of additional I-Units is dilutive at least in the short term. In the eyes of the loyalists, the money will soon be accretive because Richard Kinder doesn't spend money unless it will be accretive.
In answer to the question posed above, I think that there is not a significant difference from what EPD does.
NOTES: (A) The 2013 10-K shows $3,279M as available for the year 2012 as opposed to the $3,177M shown on the 2012 report which was the basis of Mr. Hiram's computation. I was not able to account for the $102M difference.
(B) Mr. Hiram used the ending number of I-Units outstanding as opposed to an average of the beginning and ending units. This amounts to $41M less in the estimated distributions.
Excluding the effects of Notes (A) and (B), Mr. Hiram showed that the shortage as being $208M instead of the above $66M.
In my opinion, not enough importance is placed on a company's leader and management team, probably because it is difficult to gauge until after the fact. But here we have a record of success over a relatively long term. Together with the financial results to date, this makes for a group of successful companies. The negative publicity seems unwarranted in the face of the subsequent disclosures by management in the matter of inadequate maintenance. In light of all the controversy I am somewhat surprised that there isn't a footnote to the financial statements of the pipeline MPLs where all maintenance costs, no matter what they are called, are pulled together.
As to the question of which of the companies to invest in, my own plan has been to accumulate shares of both KMR and KMI. I think the costs of ownership of KMP with the need to handle and track K-1s, etc., are more of a problem than that distributions are made in additional units in KMR. The fact that you need to sell shares of KMR in order to get the equivalent cash that the distributions provide is, in some ways, easier to control. You can sell the KMR shares exactly when you want instead of getting cash every quarter.
The question of whether value is received by having a public company for a GP is a legitimate one especially in one that is at its maximum IDRs. The easiest and least costly solution is for the investor to hold both KMR and the GP, KMI. The only question at this point is in what proportion to hold the two. This can be a good problem because you can decide what proportion is the best specifically for you. In my case, I am heavily skewed toward KMR only because I started buying KMR first - my buying a proportionate amount of KMI would throw me significantly over my personal rules of how much to invest in any one stock (or stock family).
Disclosure: I am long KMP, KMR, KMI, EPD. 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.