For the past year, Kinder Morgan Energy Partners (NYSE:KMP) has been a battleground stock with analysts like Hedgeye's Kevin Kaiser forcefully arguing it is very overvalued. This battle has kept a lid on the stock with units finally surpassing $80 again during Tuesday's session. For much of the past nine months, I have been bullish on KMP, but on Tuesday, I decided to sell my holding as I believe that some of the concerns are real and that at $80 further upside is limited. Now to be clear, I am not going as far as saying Kinder Morgan is a house of cards waiting to implode. In many ways, the bear case is overstated, but I do think there are issues that should concern investors and believe that now is a wise time to reconsider one's position. As a side note, this analysis applies to Kinder Morgan Management (NYSE:KMR), an LLC that solely owns KMP units and reinvests distributions.
In many ways, KMP traditionally functioned like a toll road. Its pipelines transport oil and gas across the country and it is compensated based on volume rather than the price of the commodity. In this way, its business is far more stable than that of an exploration and production firm. As I believe in the US energy boom thanks to major finds in the Eagle Ford and Permian, I am generally a fan of the pipeline business. However, KMP has been diversifying away from this business into new ventures where it does not have an established core competency. This is troubling to me and could suggest that growth opportunities in the pipeline business may not be as big as I previously hoped.
For instance in December, KMP spent about $1 billion buying several Jones Act Tankers, which are far different than pipelines. Given the extensive pipeline network in existence and being built, I don't foresee a dramatic increase in oil by tanker, especially with major production areas landlocked. Also, there is no indication congress is interested in making oil exporting legal again as that could raise domestic prices. With landlocked production continuing to increase, I expect tanker rates to be challenged in coming years. On Monday, KMP announced it would build an additional tanker, which will cost another $200 million or so (press release available here). When I see a company move further into a different business, I get concerned. That is happening here.
As Barron's noted in its negative KMP write-up several months ago (available here), KMP is aggressively accounting for its tanker unit. Investors in MLPs focus on distributable cash flow ("DCF"), which is essentially operating cash flow less maintenance cap-ex. DCF, which determines the quarterly distribution, is essentially sustainable free cash flow, and growth cap-ex is excluded. For the tanker division, I think KMP should allocate something for the replacement of its tanker fleet. With a roughly 30 year useful life, KMP could be allocating upwards of $30 million or $0.07 per unit (all financial and operating data available here). Instead, KMP is allocating nothing and only $2 million for maintenance. In the grand scheme of things, $0.07 per unit is not too large of a figure, but it could be emblematic of aggressive accounting elsewhere, which could hurt distribution growth in future years.
Finally, I have been gradually reconsidering my view on KMP's corporate structure. Kinder Morgan Inc (NYSE:KMI) is KMP's general partner and essentially runs KMP. It deserves to be compensated for this, but its compensation has become excessive. KMI is paid through incentive distribution rights ("IDR") where it gets a proportion of DCF. This is a good set-up as KMI is paid more as KMP make more money, aligning incentives. However, KMI gets 50% of each marginal dollar KMP generates from here even though they don't put up any of the capital. In other words, KMP unitholders fully fund projects but only receive half of the return. This system seems to benefit KMI at the expense of KMP, and KMI now receives about 44% of KMP's distributable cash flow with unitholders getting the other 56%.
This structure may also make it harder for KMP to grow accretively in the future. KMP has a project backlog of over $14 billion, which I had been seeing as a sign of strength, but now, I am unsure. As it distributes all of its cash, KMP has to fund this backlog by issuing equity and debt. KMP currently yields about 6.9%, so issuing equity is very expensive. If rates rise in coming years, its cost of debt may also increase. With KMI taking half of the cash flow, KMP's required rate of return is not 6.9% but over 13%. To appreciably increase the distribution, KMP needs to invest in projects with an ROI of at least 15-20%, and those are often few and far between. In the long run, if the backlog cannot generate this return, the backlog can be dilutive for unitholders. The IDR structure makes it very difficult for KMP to grow in the future.
Given KMP's move into new businesses and burdensome IDR structure, I think $80 is a reasonable price as it currently yields less than 7%. With KMI taking 50% of incremental cash flow, I think KMP will struggle to sustainably grow the distribution by 5% annually in coming years while rising maintenance requirements particularly from the CO2 unit could drag on results. If we see a pullback to $70-72, I will consider buying back in as it would yield closer to 8%. With KMP having the need to constantly issue equity to fund its backlog which may not be as accretive as hoped, I expect units to struggle from here. Given these problems, now is a good time to take some money off the table and wait for a better price. That is why I sold my shares after previously being fairly bullish.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.