KMI's IPO provides investors with a way to invest in KMP's general partner.
With the IPO of Kinder Morgan Inc., investors can now choose between three stocks that derive their value from the same set of cash flows. Kinder Morgan Energy Partners
Before we get into the structure of each of these stocks, it's important to understand the core assets that generate cash flows underlying all three investment opportunities. At its heart, Kinder Morgan is a pipeline company. The original partnership was created in 1997 by Rich Kinder and William Morgan, when the two got together to purchase a pipeline from Enron. Back then, Enron was busy inventing fabulous--and later fraudulent--business models that focused on "asset-lite" strategies. Enron just didn't see the value in old-fashioned hard assets. Kinder did.
Through a series of acquisitions, Kinder Morgan Energy Partners quickly became one of the major pipeline operators in the country. Today it operates refined products, natural gas, and carbon dioxide pipelines; liquids and bulk storage terminals; rail and truck facilities; and produces crude oil in three West Texas fields. It spearheaded the Rockies Express pipeline, one of the largest natural gas pipelines built in the United States, and has built out a strong position in gas gathering and transportation in most of the major shale plays in the country. In 13 years, Kinder Morgan has increased its enterprise value by more than 900% and has managed to grow distributions to limited partners at a compound average annual rate of 12.6%.
In our view, three factors helped facilitate such rapid growth. First, Kinder recognized the inherent value of wide-moat pipelines and terminals and acquired several at very attractive prices. By focusing on franchise assets with high utilization, attractive regulated rates of return, and opportunities to expand, Kinder built a strong platform for stable and growing cash flows. Second, the MLP structure made financing attractive projects and acquisitions cheaper for Kinder Morgan than c-corp competitors could afford. The fact that Kinder did not pay entity-level taxes meant it could pay more for an asset and still realize higher returns. Third, in this industry size begets size. Cash flows increased as Kinder Morgan built or acquired additional assets, which enabled increasing distribution payments. In turn, the combination of above-average yields and well-above-average distribution growth helped to guarantee an active market for new equity issues, making it easier to finance new growth.
While we think the days of 12% annual distribution growth are a thing of the past for Kinder Morgan, largely due to its size, we continue to think the partnership will be able to increase its limited partner distributions at a healthy 4%-5% a year. This growth, combined with a yield around 6%, adds up to very attractive total return prospects, particularly in this market.
Kinder Morgan has a long history of multiple investment options. The partnership created KMR in 2001 as a way to provide access to KMP's growth without the hassles of owning MLPs. And of course, despite the term "initial public offering," KMI is nothing new. KMI first went public in 1999, when Kinder acquired a gas distribution company in Kansas. In 2007, Rich Kinder and a group of private equity backers took the company private. Now, four years later, it is returning to the public market.
The key differences between the three stocks are captured in Table 1. Kinder Morgan Energy Partners, or KMP, is a master limited partnership. As a partnership, it pays no entity-level taxes, instead passing taxable income and depreciation through to partners on a pro rata basis. Stockholders own units representing limited partnership interest rather than shares of a company. Common units pay cash distributions quarterly, and the partnership sends out K-1 forms instead of 1099s. Until 2004, mutual funds could not own partnership units, and many mutual funds do not to this day.
Partly in response to the limits to institutional ownership, Kinder formed Kinder Morgan Management. KMR is a company that solely owns i-shares, a class of limited partner units of KMP. When KMP pays distributions to its unitholders, KMR pays its shareholders in additional shares. A KMR shareholder receives additional shares instead of cash, where the number of shares is equal to the equivalent cash distribution from KMP. What this structure does is allow shareholders to avoid partnership tax accounting, and shareholders receive standard 1099s instead of K-1s at tax time. Because of the way the entity is structured, shares of KMR should be worth exactly the same amount as units of KMP.
Like KMR, KMI helps investors avoid MLP tax complications. KMI is a standard corporation; it pays income tax and pays cash dividends instead of cash distributions, like KMP, or stock dividends, like KMR. At tax time investors will receive a 1099. What sets KMI apart from KMP and KMR is its structure. While KMP and KMR both derive their value from cash flows that accrue to KMP's limited partners, the bulk of KMI's value stems from its ownership of KMP's general partner.
KMI owns the general partner (GP) and incentive distributions of KMP, 7% of KMP's outstanding limited partner (LP) units, and 4% of KMR's outstanding shares. It also owns 20% of NGPL, a major natural gas interstate pipeline, but the vast majority of KMI's cash flows come from its ownership interests in KMP. By our calculations, KMI's general partnership stake provides about 85% of its cash flow.
The reason that the general partner stake contributes so much lies in the incentive structure common to most master limited partnerships: incentive distribution rights. IDRs grant the general partner an increasing claim on the partnership's total cash distribution as the level of distribution payment to limited partners increases. This can be confusing, so we'll get specific. Table 2 illustrates KMP's incentive distribution structure.
If KMP declared a distribution less than $0.15125 per limited partner unit, limited partners would received the declared distribution and the general partner would receive 2% of the total cash paid out. Assume for a moment that KMP has 100 LP unitholders and declared a $0.15 distribution per unit. LP unitholders would, in aggregate, receive $15, and the GP would receive $0.31. The total cash payout of $15.31 would go 98% to the LP unitholders and 2% to the GP.
That doesn't amount to much, but incentives kick in as the LP distribution increases. As the distribution level reaches $0.17 per LP unit, the LP unitholders receive $17 in aggregate, while the GP gets $0.64. Again this isn't much, but look at the percent increase: the LP distribution increased 13.3%, while the GP distribution increased by 106%, and the GP now receives 4% of the total cash payout.
Moving up the splits, the same math plays out until you get to the high splits. For KMP, any LP distribution above $0.23375 is in the high splits. Let's assume KMP declared a $0.34 distribution, twice the level of the last example. LP unitholders would get $34, a 200% increase, while the GP would receive $13.25, nearly 20 times as high a payout.
You can see how this math works out against KMP's actual distribution history in the chart below. As the LP distribution increased each year, the GP's share of total distributions increased very rapidly at first, and since about 2002 it has been asymptotically closing on 50%. Currently the GP's share of total distributions is about 44%.
The other variable to consider is that the incentive is based on total cash payout. In the example above we kept KMP's hypothetical units outstanding set at 100. But as the unit count increases, the total cash payout also increases. This means that the GP's cash distribution increases whenever KMP issues more units, even if the LP's distribution does not.
In our view, high distribution splits create a real drag on LP distribution growth. Deep in the high splits, IDRs burden an MLP with a high claim on the cash flow it generates. By our calculations, KMP must increase its distributable cash flow by around 10% annually to be able to raise LP distributions at a 5% clip. Since it's challenging for a partnership as large as KMP to grow cash flows by 10% or more, year after year, high splits translate into lower LP distribution growth over time. We think we're seeing that play out now.
As you can see in the chart below, we anticipate KMP will be able to increase its LP distributions by around 4.5% a year over the next five years. But based on the math we've just walked through, the general partner's distributions will grow a little bit more than twice as fast.
This math underscores the great strength--and the potential weakness--of KMI as an investment option. Clearly, KMI's ownership of KMP's general partner and incentive distribution rights provides for strong cash flow growth, which in turn should allow KMI to grow its own dividend payments at a healthy clip. However, high incentive splits place a sizable burden on KMP's ability to raise its LP distributions over the long run. Over time, we would not be surprised to see a move to reduce or eliminate KMP's incentive distribution rights, as several other MLPs have done in the recent past. We see this as the greatest risk to KMI's long-term growth story. As the old saying goes, if something can't continue forever, it won't.
Jason Stevens is a stock analyst with Morningstar.