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Edited by Adam Isaac

Kinder Morgan Energy Partners (KMP) is one of the largest partnerships in the U.S. The company operates primarily in the energy storage and pipeline transportation business. The pipelines segment distributes diesel fuel, gasoline, natural gas liquids and Jet fuel to a range of markets. The company also possesses 60 associated product terminals and petroleum pipeline processing facilities. In the natural gas segment, KMP operates a total of more than 16,000 miles of natural gas distribution pipelines.

Kinder Morgan has a healthy dividend yield of 5.90%. For any dividend paying company, it is extremely important to generate enough cash to distribute to the shareholders. In case of Kinder Morgan, it is even more important as the partnership makes heavy cash distributions to its unit holders. In my previous articles about the partnership, I have deeply analyzed the capital structure and distribution stability of the partnership. In this article, I have looked at the cash flows and the balance sheet of the business and analyzed the company's ability to generate enough cash flows.

Earnings quality:

While assessing the earnings quality of any firm, it is extremely important to look at the revenue recognition regime the firm has adopted. In the case of Kinder Morgan, the firm mainly offers services, and resells gas. As a result, the firm has most of its agreements in the shape of long term contracts, and the revenue is recognized as the service is provided. However, having long term contracts provide the firm with a solid base for revenues, but it can also affect the cash flows if the firm has a less than ideal quarter. While making financial statements, most firms follow accrual-based accounting as it provides better timely information. Here, I have analyzed the accruals and cash flows components of Kinder Morgan. That analysis will give us a better idea about the cash generating ability of the company.

Common size analysis:

Before going into accruals, I take a look at the components of the income statement and how these components have been changing during the last three years.

2011

Common Size

2010

Common Size

2009

Common size

Revenues

Natural Gas Sales

$3,335.80

40.63%

$3,614.40

44.75%

$3,137.20

44.80%

Services

$3,108.70

37.86%

$3,024.70

37.45%

$2,739.10

39.11%

Product sales and other

$1,766.70

21.52%

$1,438.60

17.81%

$1,127.10

16.09%

Total Revenues

$8,211.20

100.00%

$8,077.70

100.00%

$7,003.40

100.00%

operating expenses

$6,540.70

79.66%

$6,472.60

80.13%

$5,488.30

78.37%

operating Income

$1,670.50

20.34%

$1,605.10

19.87%

$1,515.10

21.63%

Operating Margin

20.34%

19.87%

21.63%

EBIT

$1,314.20

16.00%

$1,361.70

16.86%

$1,339.50

19.13%

Net Income

$1,257.80

15.32%

$1,316.30

16.30%

$1,267.50

18.10%

Net Profit Margin

15.32%

16.30%

18.10%

General Partner's Interest

$1,175.00

14.31%

$884.90

10.95%

$935.80

13.36%

Limited Partner's Interest in Income

$82.80

1.01%

$431.40

5.34%

$331.70

4.74%

Limited Partner's Net Income per unit

$0.25

$1.40

$1.18

Per Unit Distribution

$4.61

$4.40

$4.20

Source: SEC filings

KMP revenues are composed of three segments: natural gas sales, services and product sales and other. Over the last three years, natural gas sales have been fluctuating. More recently, it experienced a decline. Natural gas still contributes the most to the total revenues, in 2011, it contributed a little above 40% and more than 44% in 2010. On the other hand, services segment as a percentage of total revenues has decreased from the levels of 2009. Meanwhile, other product sales have been contributing more towards the total revenue. KMP was able to decrease operating expenses and boost its operating margin in 2011 to 20.34% from 19.87% in 2010. However, net profit margin has been decreasing over the period of three years and currently stands at 15.32%. Although, the firm has shown a declining net profit margin, cash distributions have seen a steady upward trend. Cash distributions in 2011 were $4.61, up $.41 from the levels of 2009.

Accruals:

Accruals

Balance Sheet accruals

2011

2010

2009

2008

Operating Assets

$23,693.40

$20,730.20

$19,198.30

$17,822.50

Operating Liabilities

$2,622.60

$2,423.90

$2,613.20

$2,254.60

Net Operating Assets

$21,070.80

$18,306.30

$16,585.10

$15,567.90

Accruals

$2,764.50

$1,721.20

$1,017.20

Accruals Ratio

14.04%

9.87%

6.33%

Cash Flow Based

Net Income

$1,257.80

$1,316.30

$1,267.50

N/A

CFO (Operating Cash flow)

$ 2,873.80

$ 2,416.80

$ 2,109.10

CFI (Investing Cash Flow)

$ (2,416.90)

$ (2,311.60)

$ (3,450.10)

Accruals

$800.90

$1,211.10

$2,608.50

Accruals Ratio

4.07%

6.94%

16.23%

Source: SEC filings

In this segment, I look at the accruals component of earnings. As I mentioned above, we are more concerned with the cash component of the earnings. For the purposes of determining earnings quality, ratio of accruals can be very helpful. Here, I have taken balance sheet accruals ratio as well as cash flows accrual ratio. A lower ratio is better for the business. Balance sheet accruals ratio has shown an increasing trend over the last three years and currently stands at 14%. KMP is in a healthy position as balance sheet ratio is not incredibly high, most of the earnings are still in shape of cash flows although, and the firm has seen a big leap in operating assets in the year 2011.

On the other hand, cash flow accruals ratios paint a completely different picture. Cash flow accruals ratio has been decreasing over the previous three years and have come down from 16.23% to 4.07%. However, balance sheet and cash flows accruals ratios can give conflicting results sometimes, as is the case here. It is particularly the case with the companies which have been making acquisitions, divestitures or making heavy capital expenditures. It is evident from the cash flows statement, that KMP has been making heavy capital expenditures during the past three years. The company has also been active in the acquisitions front, hence the contrast in both accruals ratios. However, both ratios indicate that the firm converts most of its earnings to cash flows.

Summary:

Both Kinder Morgan Partners and Kinder Morgan Inc. (KMI) are recently upgraded to Overweight by Barclays. I think, the premium price paid for El Paso (EPB), is well justified given the potential cost savings in the future. The acquisition is likely to change the balance sheet and accruals analysis for future, but the current analysis suggests that Kinder Morgan provides one of the safest dividends in the market.

Analysis of accruals for KMP augments my belief that the firm will be able to hand out healthy cash distributions in the foreseeable future. As I have mentioned before, the firm has a strong business model and derives most of its earnings from the services business. Moreover, improving natural gas prices should also boost the business and cash distributions of the company. KMP offers excellent dividends yield, and it is a perfect stock to hold in the dividends portfolio. For those willing to receive dividends in the form of additional shares, Kinder Morgan Management (KMR) can also be a good option. As KMR pays dividends as additional shares, it offers an automatic dividend re-investment plan to interested investors.

Source: How Safe Is Kinder Morgan's Dividend?