Kinder Morgan: Energy Infrastructure Fee Machine

Sell-recommended Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management LLC (KMR) reported another quarter of rich fee payments to the general partner after the market close on January 16. Quarterly distributions approximated $163 million in fees to owners of the general partner, $158 million in cash to KMP unit holders and $55 million in new units to KMR holders. Exceeding cash distributions, the fees are neither reported as expenses, nor as long-term dilution of KMP equity.

The general partners responsible for the misleading accounting include Goldman Sachs (GS), the firm that has provided two Secretaries of the Treasury; Carlyle Group, the Washington buyout operator populated with ex-government officials; and AIG (AIG), the insurance company. Mr. Arthur Levitt, former chairman of the Securities and Exchange Commission [SEC] and an outspoken advocate for small investors, is a paid advisor to Carlyle Group and AIG as well as a board member of Bloomberg, a data provider that passes along the misleading accounting information. The investors in KMP are predominantly small investors seeking income. In addition to underperforming other energy investments on a debt-adjusted basis, there remains a high risk that the stock market values in KMP and KMR would melt away should the deceptive accounting be exposed.

Controversial Incentive Distribution Rights (IDRs)

Cleverly created by Enron before its collapse, the general partner structure of KMP is codified with IDRs, a mechanism that now pays the general partner 50% of the present value of all new investment by the partnership. The IDR deal is that the general partner gets a dollar of cash for every dollar distributed to limited partners. The distribution to limited partners consists of about 74% in cash to KMP holders and about 26% in units to KMR holders.

The incentive distribution rights that give the general partner 50% of incremental cash flow distort the valuation of publicly-traded units of KMP and KMR. Starting innocuously years ago at a lower level, the misnamed IDRs give the general partner 44% 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 used unlevered cash flow multiple (EV/Ebitda) for valuing energy investments. 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 thereby computes an unlevered cash flow multiple that is too low by practically a half. When we calculate a more representative EV/Ebitda ratio, the securities appear to be overpriced by a factor of two.

Though we refer to Bloomberg, the same observation applies to other financial services and to the sales literature provided by the investment bankers regularly promoting KMP and KMR securities. The bond rating agencies paid by Kinder Morgan also err on the side of the general partner in going along with misrepresentation, we think.

Financing Fiction

During the past quarter, KMP holders reinvested $343 million in new units for a net investment of $185 million. In the same quarter the general partner took out $163 million and underwriting commissions on the new units may have been near $20 million. The approximate $800 million increase in total assets was matched by about an $800 million increase in debt. It seems fair to conclude that practically all the new investment that facilitates payment of general partner fees and limited partner distributions is financed by debt.

Booming Energy Investments

The need for new energy infrastructure provides abundant opportunities for the partnership to put more borrowed funds to work. Because the partnership has been aggressive in pursuing such opportunities, the general partner has much to talk about that appears interesting to investors who overlook the underlying financing fiction.

Yet if there were no Kinder Morgan, the energy projects would still be built. Natural gas producers have a keen interest in new pipelines. Buy-recommended Encana (ECA) initiated an early leg of the Kinder Morgan Rocky Mountain pipeline and buy-recommended ConocoPhillips (COP) is an equity investor in the line.

Who Cares?

History teaches us that potential blowups can sometimes be postponed a long time. The highly levered energy transportation business in which Kinder Morgan operates goes through periodic cycles of financial failure. Investors lose in old companies and new companies are formed. Kinder Morgan was practically insolvent in the last cycle as we calculated at the time. Usually only the most exposed companies fail in a particular cycle. KMP may be more prominent in the next cycle as it is now more dominant and it has carried the IDR ruse further than any competitor.

We can’t promise that KMP will collapse soon. As long as Wall Street has found new debt and equity investors for KMP, investors as well as the regulators at the SEC and Federal Energy Regulatory Commission have shown little concern. Yet, investors need not own an energy stock among the most exposed to risk when other stocks offer less risk and more reward.

Originally published on Jan. 17, 2008.

Comments

[Jason Alexander]

Using the name of Enron in the discussion implies guilt by association. Additionally, the general tone of the article makes it sound like something underhanded is going on that no one knows about. How KMP/KMR manages its financials is fairly unique but no secret.

[Jake2]

The conspiratorial tone of the article is disturbing. All any reader of these pages wants here are the facts. Opinion is ok if kept to a minimum and supported with rigourous analysis.

[Tony Soprano]

It's the same story warmed over each time. You need to come up with a new recipe. You have been zapping KMP/KMR for over a year (Jan 9 , 2007, Richly Valued Kinder Morgan Completes Canada Deal) and your story doesn't seem to stick. Also, why would S & P give KMP a 5 STAR rating? This is their highest rating. You have a Sell-recommended.

[globalmacro]

If you're looking for an alternative, there are plenty of other suitable ways to play in this space -- Boardwalk Partners (BWP) and Holly Energy Partners (HEP) just to name two.

[jjason]

Thanks for the article pointing out that the General Partners receive as much as the unitholders with no assumption of risk. I would not invest in anything that is so unfair to the small investor. Those of you who say "who cares" are inconsiderate of the plight of the small investor looking for income from a well run company. Also, the appointment of wall street executives to high positions in the US government just allows the rich to get richer at the expense of us middle class Americans. Hopefully, Senator Barack Obama wins the election and cleans house in Washington.

[Tony Soprano]

In their recent report, Standard & Poors does not think that there is any misleading accounting regarding Kinder Morgan and their partners. In addition, Standard & Poors gives Kinder Morgan a strong buy recommendation - 5 stars and they go on to say that their long term growth looks promising.

As Mr Alexander says above the way they manage their accounting is fairly unique but NO SECRET.

[Dan Notestein]

Secret's are always relative. It's an EXTREMELY non-standard practice (yes, a number of MLP's do it, but that's a drop in the bucket compared to the number of stocks and the history of the stock market). The average investor using normal valuation methodologies will easily get mislead by this practice and will dramatically overvalue the stock. My personal involvement with this stock began when my mom invested in this stock, then later asked me to look into it. It was really more luck than anything else that I decided to read thru the whole annual report and managed to spot the IDR payments in their. This stock will collapse eventually, it's only a matter of how long before it goes down, it could last a few more years, unfortunately, and cost a lot more people money. I don't feel too sorry for the investors who are fully informed on the IDRs and still think it's a price worth paying because they get the "incredible management" abilities of KM (these guys just make me laugh), but do feel sorry for the the investors who just don't know of this deceptive practice. So this information is worth repeating as often as possible, to limit the number of such investors.

[Tony Soprano]

It's nice to know that Mr. Dan Notestein cares so much about his mother's investment in KMP. However, if she had purchased the stock in 1992 at 6 she would have increased her value by nearly TEN FOLD (not including dividends). If she had purchased KMP in 1998 at 18 she would have increased her value by THREE FOLD (not including dividends).

Also, Mr. Dan Notestein states that "Secret's are always relative." There is no secret here, so how can it be relative? He goes on to back up this statement with the idea that "It's an EXTREMELY non-standard practice (yes, a number of MLP's do it'. How can extremely non-standard practice and yes, a number of MLP's do it make any sense. There are not that may pipeline MLP's to begin with so this comparison makes no sense. How KMP handles its accounting and IDR payments is built into the price of the stock.

FIRST CALL has a buy recommendation for KMP. Out of 13 analyst 6 are strong buys, 3 are buys and 4 are holds. S&P gives KMP five stars, a strong buy.

Yesterday KMP had a public offering of 5 million shares. Most of those shares sold for $57. This proves to me that KMP can raise capital successfully. If there was a concern about deceptive accounting procedures or their IDR payments it did not impede their effort to raise nearly 300 million dollars.

[Dan Notestein]

Ah, the classic argument of Ponzi schemes: if you had just invested x numbers of years ago, you would have made 10 times your initial investment. This works fine up until the point where the Ponzi scheme collapses, then you lose all your money. KMP is a relative new form of ponzi scheme and it's successfully cloaked this aspect of it's financial structure using a legitimate underlying business, unlike most ponzi schemes.

Mr. Wulf may be too eloquent in his description of the nature of the problem with KMP, so I'm going to try to simplify it:

For every billion dollars of new money that goes into KMP (which is happening yearly now), the profits for 50% of that money go to the general partner. This means there's an effective toll of 50% on the earning power of all new investment (this costs existing limited partners as well as the new equity). In other words, when new equity is issued, KMP shareholders get diluted, but the general partner doesn't. And KMP is massively diluting and taken on huge amounts debt for extremely rapid expansion. This makes perfect sense for the general partner, since he's truly using "other people's money" to make a killing. If the doesn't make the problem clear, let me know, and I can go into more detail on how this works.

As for the argument about analyst recommendations, analysts have missed many such boondoggles. I suggest as a starting point reading Ben Graham's The Intelligent Investor to see just how wrong they can be. And this case it's even worse, since one of the most commonly cited reccommenders of this stock is Goldman Sachs, who just happens to own a huge portion of general partner shares (as Wolf mentions in his article).


On Feb 28 11:53 AM Tony Soprano wrote:

> It's nice to know that Mr. Dan Notestein cares so much about his
> mother's investment in KMP. However, if she had purchased the stock
> in 1992 at 6 she would have increased her value by nearly TEN FOLD
> (not including dividends). If she had purchased KMP in 1998 at 18
> she would have increased her value by THREE FOLD (not including dividends).
>
>
> Also, Mr. Dan Notestein states that "Secret's are always relative."
> There is no secret here, so how can it be relative? He goes on to
> back up this statement with the idea that "It's an EXTREMELY non-standard
> practice (yes, a number of MLP's do it'. How can extremely non-standard
> practice and yes, a number of MLP's do it make any sense. There are
> not that may pipeline MLP's to begin with so this comparison makes
> no sense. How KMP handles its accounting and IDR payments is built
> into the price of the stock.
>
> FIRST CALL has a buy recommendation for KMP. Out of 13 analyst 6
> are strong buys, 3 are buys and 4 are holds. S&P gives KMP five stars,
> a strong buy.
>
> Yesterday KMP had a public offering of 5 million shares. Most of
> those shares sold for $57. This proves to me that KMP can raise capital
> successfully. If there was a concern about deceptive accounting procedures
> or their IDR payments it did not impede their effort to raise nearly
> 300 million dollars.
>

[weiwentg]

This is a lot of caterwauling over a non-issue. The general partner is getting 50% of KMP's -incremental- cash flow, not 50% of all cash flow. The partnership has to achieve a certain (quite large) amount of distributions to hit the high splits, where 50% of incremental cash flow goes to the GP. This provides incentive for the GP to run the partnership to maximize cash flow.

If you think this is unfair to small investors, first, most MLP investors are institutions. Second, there's many worse cases of Wall Street being unfair to small investors.

If you're really dissatisfied, you have three options. One, pony up the cash and start your own MLP. Two, find an MLP that doesn't have incentive distributions for general partners. Legacy Holdings LP (LGCY) is one which I recommend. Three, there are publicly traded general partners, like Enterprise GP Holdings (EPE) and Magellan Midstream Holdings (MGG), both of which I recommend.