Hidden Leverage At Kinder Morgan

Jul.20.14 | About: Kinder Morgan, (KMI)


Bulls like KMI because it is a levered play on KMP, but this also increases downside risk.

The IDR structure gives KMI a higher proportion of future cash flows but increases sensitivities to declines.

KMI is also fairly levered, but the cash flows it receives are from a levered company, leading to a multiple effect of sorts.

This structure effectively increases effective leverage closer to 7x rather than the 3x reported.

Investors often wonder whether they should purchase Kinder Morgan Inc (NYSE:KMI) or Kinder Morgan Energy Partners (NYSE:KMP) if they are bullish on the company's prospects. While KMP offers a higher current yield, bulls argue that KMI will have a higher growth rate in coming years, making it a superior investment. If we examine the partnership structure, this is definitely the case assuming the bulls are right about KMP. At its core, KMI is a levered play on KMP. While its structure magnifies potential upside, it does also increase the downside risk, which should give pause to investors. Beyond that, there is structural subordination that amounts to hidden leverage. In this article, I will first explain the partnership structure and then the structural subordination. Given these factors, I believe investors underappreciate KMI's risk.

KMP is a master limited partnership ("MLP"), and investors in KMP own limited partner units. KMI is its general partner, the company that actually operates the assets in the MLP. This is analogous to the structure of a hedge fund. The hedge fund's assets are owned by limited partners, but the general partner (i.e. John Paulson or Bill Ackman) actually makes all of the investment decisions. The limited partners realize the gains or losses the assets generate. The general partner earns a fee from the partnership for operating it. Most hedge fund GPs charge 2% and a 20% incentive fee, which incentivizes the manager to perform better.

KMI is paid very handsomely to manage KMP thanks to its incentive distribution rights ("IDRs"). This gives KMI a proportion of all cash flow that KMP generates. However, there is a sliding scale that gives KMI a higher proportion of cash flows as cash flows grow. KMI is currently in the top IDR bracket and now receives 50% of all incremental cash flow. In the last quarter, KMI received about 46% of KMP's distributable cash flow ("DCF") (KMP's financial and operating data available here). KMP's general partner obligations account for 65% of the cash flow KMI generates (KMI's financial operating data available here). Its ownership of some KMP limited partner units accounted for another 8% of its cash flow.

Now, let's say KMP added $50 million in incremental DCF. KMI would receive $25 million while KMP unitholders would receive the other $25. This would increase KMI's GP receipts by 5.2% while KMP limited partners would see cash flow allocated to them increase by only 4.5%. This is because of the sliding IDR scale. While KMI received 46% of current cash flows, it receives 50% of incremental cash flow, giving it a higher growth rate. Conversely if KMP lost $50 million of incremental DCF, KMI's receipts would fall by 5.2% versus a 4.5% drop for limited partners. Again, this structure where KMI is at the highest IDR rate levers it to KMP's operating performance. When times are good, it does disproportionately well. When times are bad, it does disproportionately poorly.

Hopefully, you now understand why KMI is a levered play on KMP's operations. Now on a stand-alone basis, KMI is a fairly levered company. It carries about $9.3 billion in debt. Meanwhile, the carrying value of its tangible assets is only $2.5 billion. KMI's real value is in those IDRs it holds, not internal operations. Before interest payments, KMI should generate about $2.9-3 billion in cash flow, mainly from those IDRs; this figure is analogous to EBITDA. KMI has a leverage ratio of about 3.1x, which is not too excessive. Over the next year, it should face interest expense of approximately $400-430 million for an interest coverage ratio of about 7x.

In other words, KMI carries a fair amount of debt, but it is not unsustainable. Now, it should be noted that KMI chooses to distribute virtually all of its after-tax cash flow in the form of dividends and buybacks. With relatively few assets left that it could drop down to its MLPs, it is hard to see its debt balance shrinking materially from here. Barring a decision by management to cut its dividend to pay down debt, which is extremely unlikely (i.e. less than a 5% chance in the next 30 months), KMI will be left with this debt load and forced to roll over debt as it matures. This does subject KMI to refinancing risk and the prospect of rolling over debt when interest rates are higher, which will eat into cash available for dividends.

Now, this leverage appears on KMI's own balance sheet, and investors can account for it easily. However, KMI is not like other companies that are levered 3x because KMI's cash flows are determined by the operations of another company, KMP. Now, KMP carries a significant amount of debt, $20.7 billion. KMP's debt to EBITDA is 3.7x and its interest expense coverage ratio will be about 5.6x in the next twelve months. Obviously, creditors of KMP are the first to get paid. The cash left over is then available for limited partners and KMI. As noted above, KMI's cash flow are more volatile to the upside and downside. If times got bad, KMI would bear a worse hit than KMP holders. This essentially subordinates KMI to KMP creditors and limited partners.

Now, some investors may want to de-emphasize KMP's leverage when looking at KMI. To them I offer this example. Let's say there are two stocks, Company A and Company B. A is very highly levered, let's say 10x and pays out a $1.00 per share dividend. This high leverage makes that dividend constantly at risk, so shares trade at only $8 (a 12.5% yield), reflecting the risk of a dividend cut. Company B merely owns stock in Company A and passes on the $1 in per share dividends and carries no debt. Technically, Company B has a leverage ratio of 0x, but shares shouldn't trade very high, say 25% (a 4% yield), because in reality, this cash flow is highly levered. B's cash inflows are dependent on the cash flows of a levered company, and so it will trade like a levered company, right around $8 as well.

Now by carrying debt of its own, KMI is essentially adding leverage to already levered cash flows. When times are good, this model can be fantastic, allowing for a sizable dividend (4.5%) and some share repurchases. If KMP has to roll over debt at a higher interest rate, its payments to KMI will fall, thereby weakening KMI's dividend capacity. Investors need to consider the leverage at KMP before feeling comfortable with KMI as it and the IDR structure amount to leverage beyond the 3x KMI itself carries. Instead, there is an almost multiplier effect of leverage.

Theoretically a 20% decline in KMP's EBITDA would have no impact on creditors' interest income, but would cut limited partner's income by 17% and KMI's GP income by 30%. That type of cash flow decline is more analogous to a company that carries 7x leverage. KMI's structural subordination to KMP debt and unitholders essentially amounts to another 4x leverage beyond the 3x it itself carries. Thus, it is clear that KMI is a very levered play on KMP. If you are bullish on KMP, I can understand the impetus to buy KMI to juice future returns, but one must also be aware of the disproportionate downside. KMI should focus more on debt repayment and less on dividends to reflect structural leverage. Given its risk, I would be hesitant to buy KMI stock.

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.