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Kinder Quibbles No Cause for Concern

Research firm's claims don't change our opinion of this wide-moat group of companies.

Kinder Morgan fared poorly Wednesday following a press release from research firm Hedgeye, which said Kinder "may be a mere house of cards, completely misunderstood and mispriced." Hedgeye won't release its research until next week, but cited a handful of topics it will discuss. For the most part, we view these topics as old news and stress that we're talking about a group of companies that operate the nation's largest pipeline network, generating north of $5 billion in EBITDA from tangible physical assets. While we always welcome critical analysis and questions to the give-and-take debate over master limited partnership valuation, we're skeptical of the claims Hedgeye is making. For more detail, see our Sept. 5 note, "Wide-Moat Kinder Morgan Under Attack; Looks Like a Buying Opportunity to Us."

Three Kinders and a Limited Partner
 Kinder Morgan Energy Partners  is one of the largest master limited partnerships, engaged in the transportation and storage of energy commodities. It operates more than 37,000 miles of pipelines for oil and natural gas transport. It also owns 180 terminals that can handle and store liquids, gases, and dry-bulk materials, such as coal. As a partnership, the company pays no corporate income tax, but its tax burden flows through to individual unitholders.

Mathematically,  Kinder Morgan Management  shares should trade in lockstep with KMP units. One share of KMR gives its owners essentially the same rights, ownership interest, and partnership distributions as one KMP unit. The only difference is that KMR holders receive their distributions in additional shares of stock instead of cash. Think of KMR shares as KMP units with a built-in dividend reinvestment plan.

 Kinder Morgan Inc. (KMI) owns the general partner, incentive distribution rights, and an approximate 11% interest in the limited partner units outstanding of KMP and the general partner, incentive distribution rights, and 40% interest in the limited partner units of  El Paso Pipeline Partners . It also owns a 20% stake in NGPL, a major interstate natural gas pipeline. As a C corporation and not an MLP, investing in KMI presents fewer tax complications for investors and may appeal to a broader investor pool.

Bigger Asset Footprint Means Greater Opportunity
KMP's operations span all of midstream energy, with a network of pipeline and storage assets that crosses the continent and is capable of transporting and storing natural gas, natural gas liquids, crude oil, refined product, and ethanol. Kinder even does a fair amount of business handling coal and steel for export in its terminals segment. With its presence in many segments and dominance in some, Kinder routinely earns well in excess of its capital costs, supporting its wide moat rating. In this business, the bigger the asset footprint, the greater the opportunity set for new investment, allowing firms like Kinder with competitive advantages to maintain their competitive position.

Kinder's two largest segments are its natural gas pipelines business and its tertiary oil recovery operation, the carbon dioxide segment. The former will be the key beneficiary of drop-down assets from the former El Paso, as the drop-downs of Tennessee Gas and EPNG have demonstrated. The natural gas pipelines segment now generates more than $1.3 billion in cash flows annually, and we think this will nearly triple by 2017 as KMP's general partner, Kinder Morgan Inc., looks to complete drop-down sales. As a result, we project that natural gas pipelines will go from accounting for 24% of KMP's cash flows in 2011 to 50% in 2017, shifting Kinder's profile back toward its roots.

It's a good thing the gas pipelines business will see so much growth, because Kinder's other major growth engine, its CO2 segment, looks set to slow. This business has benefited extraordinarily over the past decade from rising oil prices. In fact, production has actually declined since its peak in 2005, so rising prices account for the overwhelming majority of cash flow growth here (Kinder also makes money in this segment by transporting and selling CO2 to third parties, which accounts for roughly 25% of segment cash flows). Since 2008, KMP has increased earnings before depreciation and amortization by $1.4 billion. Fully $700 million of that can be attributed to rising oil prices. As we look toward the future, in which we project fairly flat oil prices, we are concerned that this segment will not be able to generate the cash flow growth we've seen over the past decade. Management is not unaware of this and is working to develop additional projects to transport and sell CO2, increasing fee-based revenue, and to develop new fields for CO2 floods, to attempt to keep volumes flat to rising. And oil prices may continue to climb, allowing Kinder to lock in price gains (KMP hedges its production aggressively to provide some stability to CO2 cash flows, given the volatile nature of oil prices). But based on our current forecast, the CO2 business will shift from being the fastest- to the slowest-growth segment at KMP, dropping from a 34% contribution to KMP cash flows in 2011 to 20% in 2017.

Kinder's other major businesses, refined products and terminals, look poised to continue steady growth, and Kinder Morgan Canada, which owns the Transmountain oil pipeline, may see major growth if the expansion project gets approved. In total, we think Kinder's mix of business, including the impact of likely drop-downs from KMI, can deliver average annual EBDA growth around 18% and distributable cash flow growth of about 15% a year. These are very respectable growth rates. The problem, as with all master limited partnerships, is that to fund growth Kinder must raise new debt and equity capital, which means, among other things, increasing unit count over time. On a distributable cash flow per unit basis, Kinder will only deliver 7% growth. That means that in order to afford to increase distributions by 6% or better over the long run, KMP will either have to cut into already thin distribution coverage or increase cash flows at a more rapid clip.

Wide Moat Comes From Asset Portfolio, With Natural Gas Pipelines the Stars
Over the years, Kinder Morgan has assembled a set of energy infrastructure assets that we believe would be nearly impossible to replicate. We tend to think pipelines have wide economic moats, as the challenges of constructing a competing pipeline confer near-monopoly status on pipeline operators. Kinder Morgan's extensive natural gas and refined products pipelines consistently generate returns in excess of the firm's cost of capital, and continued investment in major projects looks set to extend the company's asset footprint, cash flows, and economic returns. In our minds, the crown jewels of Kinder's asset portfolio are its natural gas pipelines, which provide transportation from most of the country's gas plays. Continued investment in new pipes are likely to generate returns in the mid- to high teens, consistent with historical performance. These returns are especially noteworthy given that the majority of new investment is deployed in projects backed by long-term fixed contracts.

Kinder Morgan's other segments also enjoy economic moats, in our view. The company operates one of the largest products pipeline networks in the country, and inflation-adjusted tariff structures provide some uplift in the face of reduced demand growth for refined products, which we anticipate to continue. Kinder's CO2 business also deserves recognition, given that it consistently generates returns on capital north of 22%. While we generally would not assign a moat to oil production, we think the CO2 business on its own deserves a narrow moat. By controlling the source and transportation of CO2 and oil production from three fields using CO2 floods, Kinder has created a minimonopoly in the Permian that would be impossible for a competitor to replicate. While this segment's results are exposed to commodity price fluctuations, a disciplined hedging strategy that locks in project economics helps to mitigate this exposure.

MLPs Do Hold Regulatory and Legislative Risks
Pipeline tariffs are based on regulated rates, and regulations can change, which could alter cash flows to the company. MLPs are a tax-advantaged structure, and changes to the tax code could limit or reduce Kinder Morgan's ability to generate qualified income, and the company could be subject to greater taxation in the future. Also, managing project costs and in-service dates can become challenging, and cost overruns can undermine pipeline project economics. Finally, Kinder Morgan is controlled by chairman Rich Kinder and affiliates, and individual investors have little say in the management of the firm.

However, we think Rich Kinder is the rarest kind of visionary. Not only did he see the potential for a hard-asset business within Enron's asset-light culture, but he has a focus on execution that has enabled him to build one of the largest pipeline companies in the country, bit by bit. Kinder Morgan Energy Partners is still managed by its founder, who took the company's general partner private in 2007, only to bring it public again in early 2011. Under the MLP structure, unitholders in Kinder Morgan have limited rights and effectively zero voting control over the company, negatives from a traditional corporate governance perspective. However, we think Kinder's record and performance demonstrates that common unitholders have been well served, in terms of stable and rising quarterly distributions and outstanding unit price appreciation. Also, Kinder Morgan's executives are rewarded by the performance of the company's stock more than in cash, aligning management's and unitholders' interests, in our minds. The largest negative in our minds is the drag that high-splits incentive distributions place on limited partner distribution growth.

Jason Stevens does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.