Kinder Morgan Energy: A Little Corruption, American Style

Sell-recommendations Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management LLC (KMR) offer neither the upside potential nor the downside protection investors need to keep up in an inflationary environment for capital. It hardly matters what seeming progress the partnership reported in its quarterly financial disclosures after the market close on October 18, as long as the statements fail to take full account of the 50% equity dilution by the general partner.

The statements don’t recognize properly that when the partnership makes a dollar of investment in energy infrastructure, it gets fifty cents of value. Contrast that with investments in developing countries that Americans may criticize as corrupt when a dollar of public money get perhaps eighty cents of economic value. In a subtle counter criticism, a well-known former ambassador from a Middle Eastern country characterized the twenty percent leakage as a “pretty good deal for the economy” as we paraphrase it. What might we say about 50% leakages?

General Partners Not Complaining

The fifty percent leakage in unit holder investment goes to prominent general partners – a Wall Street House that has furnished two Secretaries of the Treasury in recent years, a Washington leveraged buyout fund that rewards politicians, and a large insurance company that apparently has used an off-the-books offshore fund to pay bonuses to its executives. A former chairman of the Securities and Exchange Commission, whom we have often admired for his defense of individual investors, serves as a paid advisor to two of the general partners. In addition that person is a television commentator for and a director of a financial publishing house that relays information on the partnership that we term misleading.

The World Functions Imperfectly

Global economic progress is favorable despite all those who would take unfair advantage. Cynics might say that is what drives it all, get ahead by taking unfair advantage. We are not that cynical, but we watch our wallet. Certainly the Finance Minister of Canada took advantage of investors when he reneged on the promise of no federal taxation of income trusts. The Alberta Royalty Review Panel would cheat by changing the deal under which billions of dollars were invested. Russia has changed deals made in the Wild West early years of its transition to market capitalism. The U.S Congress would impose punitive taxation on oil companies and give the contraband to venture capital promoters and pork barrel projects.

Despite those investment threats, we are recommending oil and gas producers in Canada, Russia and the U.S. The higher risk deal as we see it is that offered to investors in KMP and KMR.

General Partner Free Riding while Distribution Financed by Debt

The latest declaration of an increase in quarterly distribution to $0.88 a unit from $0.85 amounts to an additional $7 million a quarter to limited partners and an equal $7 million to the general partner who has put up essentially no capital. When we allocate projected cash flow (Ebitda) in proportion to the debt ratio we have “equity Ebitda” of $917 million for the next twelve months compared to a projected distribution of $1499 million. The excess of $582 million is that portion of the distribution we consider financed by debt and not sustainable by prudent standards.

Originally published on October 17, 2007.

Comments

[footballtaxman:]

Kurt fails to properly inform the reader of how incentive distribution rights work with many Master Limited Partnerships. The limited unit holders agree to these as a way to enhance the value of their own limited units, while giving incentive to the GP to increase the cash flow of the MLP. Kurt, why single out Kinder Morgan? This is very common in the MLP world.

2007 Nov 13 07:54 PM

[footballtaxman:]

Kurt fails to properly inform the reader of how incentive distribution rights work with many Master Limited Partnerships. The limited unit holders agree to these as a way to enhance the value of their own limited units, while giving incentive to the GP to increase the cash flow of the MLP. Kurt, why single out Kinder Morgan? This is very common in the MLP world.

2007 Nov 13 07:54 PM

[William Eic...:]

Someday KMP will have Distribution per Unit of $10.00.
At that time the GP will receive 42.375% of that amount.
The LPs will receive 57.625%. And that is the price to piggy-back
on this great company.

2007 Nov 29 08:10 PM

[William Eic...:]

The 12/11 MorningStar report on KMP notes that Enterprise Products Partners - EPD parent, Enterprise GP Holdings - EPE, reduced its incentive call on EPD's cash-flow to 25% in return for shares in EPD.

A move available to privatized KMI and KMP.

2007 Dec 26 02:56 PM

[Dan Notestein:]

Kurt is completely on target here. Anyone with a true understanding of company financials should be able to recognize this as a classic case of "cooking the books". Footballtaxman's statement that this is the way a number of MLP's operate is also true, but this is just saying that there are a number of crooks out there (no suprise to a modern investor, I hope). Anyone clueless enough to think that handing 50% of a company's profit to management to "incentivize" them to work harder, should not be investing (and definitely shouldn't be advising anyone else).

2008 Feb 24 07:30 PM

[weiwentg:]

I think the criticisms of the incentive distribution structure are way off base. The structure compensates the general partner for managing the asset. Most general partners probably also own a boatload of limited partner shares.

Folks who are really dissatisfied about the structures can either set up their own MLP without incentive distribution rights, or they can invest in one of the several publicly traded general partners. Legacy Reserves is an example of the former. Enterprise GP holdings and Magellan Midstream Holdings are two examples of the latter.

2008 Oct 16 01:02 PM

[RWRocksOn:]

actually, the price you pay to piggyback onto Knight (fka KMI) is the stock price. The stock price for KMP/KMR reflects the distribution per share not (directly) the earnings. Those buying the stock do need to look to the splits to understand how future growth will affect their cut of the dish. In addition, the leverage applied by the company and embedded in the yield for a given dish must also be understood by the investor to appropriately value the stock. If the splits were otherwise (more favorable to KMP, for example) then the stock price would be higher. The yield will be about the same no matter the split for a given interest rate, inflation and projected growth environment.


On Nov 29 08:10 PM W. Eichler wrote:

> Someday KMP will have Distribution per Unit of $10.00.
> At that time the GP will receive 42.375% of that amount.
> The LPs will receive 57.625%. And that is the price to piggy-back

>
> on this great company.

2008 Nov 02 02:42 PM