IDRs Mislead Kinder Morgan Energy Partners and Kinder Morgan Management LLC's Financial Results

After the market close on July 18, sell-recommendations Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management LLC (KMR) reported financial results for the first time under new owners of the general partner including Wall Street house Goldman Sachs (GS), leveraged buyout operator Carlyle Group, and insurance company, American International Group (AIG). The most important step we would like to see the reputedly honorable new owners take is to abolish the 50% incentive distribution rights (IDRs) that distort the valuation of publicly-traded units of KMP and KMR.

Failing that, we would like to see transparent accounting of the dilutive effect of the IDRs on the value of partnership equity. The timing to make those changes now is good while market conditions are permissive for highly leveraged entities. Should financial conditions worsen unexpectedly, the partnership could rapidly become insolvent and make the general partners targets to be penalized for losses by limited partners who relied on misleading accounting of the IDRs.

How the IDRs Mislead

Misnamed IDRs give the general partner 50% of incremental cash flow, and 43% of average cash flow generated from the partnership’s energy properties. Should IDRs be counted as compensation or ownership? Too often, services for research and information such as Bloomberg just forget about it in calculating the widely respected unlevered cash flow multiple (EV/Ebitda) for valuing energy investments (see table). If IDRs are compensation, the amount should be excluded from earnings before interest, tax, depreciation and amortization (Ebitda). If idr’s are equity, their value should be included in Enterprise Value (EV).

It looks like Bloomberg fails to make either adjustment, and as a result, computes an unlevered cash flow multiple that is too low by practically a half. We blame Bloomberg’s failing on the misleading manner in which IDRs are reported in the financial statements. It takes too much work to find the appropriate numbers to make an honest assessment. We would not say whether the general partner intends that the financial statements be misinterpreted to the limited partner’s detriment, but the longer
the misinterpretation continues the more the presumption must be that the general partner’s obfuscation is deliberate.

Surge of New MLPs May Be Competition for KMP

A few days pass without a new disclosure of a strategy to form a Master Limited Partnership [MLP]. On July 17, upon announcement of its acquisition of Pogo Producing (PPP), Plains Exploration and Production (PXP) promised to create a new income stock. On July 18, buy-recommended Devon Energy (DVN) announced its plans to create an MLP to hold its midstream natural gas gathering, processing and marketing operations. When asked about the trend on the KMP earnings conference call, chief executive Kinder exclaimed that KMP’s oil fields were among the most suitable for an MLP. We agree, but what Mr. Kinder did not say was that his compensation as a general partner at 50% of incremental cash flow makes KMP much less attractive to investors.

KMP vs. KMR 1-yr chart:

Originally published on July 19, 2007.

Comments

[flstearns:]

M* also prefers KMR to KMP, but was not as clear as K. Wulff in re why.

2007 Aug 15 11:28 AM