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Peters: Not Buying the New Kinder

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He's the editor of Morningstar DividendInvestor and also our director of equity income strategy. We'll look at the Kinder consolidation and see what it could mean for dividend investors.

Josh, thanks for talking with me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with the basics here. Why is Kinder going forward with this transaction? What's the motivation behind it--exactly what's happening here?

Peters: Part of the way Kinder has structured its organization in the past is you have a general partner, Kinder Morgan, Inc., or KMI, at the top of the heap. It, in turn, is collecting incentive distributions from several subsidiary partnerships--Kinder Morgan Energy Partners (KMP) and El Paso Energy or probably El Paso Pipeline Partners (EPB). Effectively, with each new unit that these two partnerships issue in order to fund their growth, that distribution is being paid to the new unit holder and an additional distribution, almost as large, is being upstreamed back to KMI.

It's certainly been a very lucrative arrangement for the general partner, but it makes it very expensive and very cumbersome to try to grow these organizations when their cost of capital is so high. So, the biggest benefit of this transaction is that by buying in the subsidiary partnerships--consolidating everything into just one entity--you get rid of those incentive distribution rights. You do, in exchange, consolidate into a taxpaying entity, so the pretax cost of capital is going to be higher than, let's say, just an ordinary [master limited partnership] consolidation.

But it's still going to be much lower, much more competitive for Kinder going forward than it has been over the last couple of years.

Glaser: It sounds like Kinder Morgan Management ends up being a winner here. Are there any losers? How should people who own, say, KMP or El Paso really think about this transaction?

Peters: Since all of the securities in the group went up dramatically the day after this was announced, who is a loser is, of course, a matter of opinion. I prefer to look at the income that different classes of equityholders are receiving, and what we find is that for KMP and EPB, the two limited partnerships, the income that those investors are going to receive is going to drop, even if you assume that a cash portion of the consideration is reinvested in KMI shares and starts earning income again.

You are still looking at income for those investors next year that is 15% roughly lower than it would have been. And that's only because KMI is actually able to increase its dividend faster as a result of this transaction; that does get back to the point where it benefits KMP and EPB, but you're still looking at the income being reduced. Second--and just as important as the tax aspect of this arrangement--for KMI shareholders, they won't really see any change; for shareholders of Kinder Morgan Management, which is sort of a pass-through tax-bypass vehicle that was structured to attract KMP, it's going to merge into KMI, apparently, with no tax consequences. But for KMP and EPB--again, the limited unit holders who put a lot of capital into the organization over the years--they are going to have their exchange of those limited partner units for KMI shares and cash treated as a sale. It's not going to be a tax-free merger. So, not only are they going to pay a capital gains tax on whatever profit they may have recorded, but you are also looking at--for these unit holders--having a catch up of all of the past deferrals of income recognition, which is one of the benefits of investing in a partnership in the first place. So, for longtime holders of KMP and EPB, they are looking at suffering both a loss of income and some pretty impressive tax liabilities potentially as well.

The third key to making all of this work is an additional slab of debt in the capital structure. Debt is cheaper than equity, and that helps facilitate the buy-in of the subsidiary partnerships. But even though Kinder has indicated in its conversations with the rating agencies that it expects to be an investment-grade company, its leverage is going to be much, much higher than peers like Enterprise Products or Magellan Midstream. With that additional leverage comes additional risk.

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Glaser: You sold out of some of these Kinder names in March. After this transaction, do you look at that sell and wish that you hadn't done it? Does it change your opinion on the investment thesis around Kinder Morgan's assets?

Peters: Well, if you've sold something and later it goes up 20% to 25%, you tend to regret at least the timing of your decision. However, I have a hard time regretting the logic. The incentive distribution rights and the complexity of the capital structure for the Kinder Morgan organization was only one of several reasons. It wasn't even the main reason that I decided to sell.

The real trigger point was the fact that Kinder--both KMI and KMP as well as EPB--have been paying out essentially one hundred cents on the dollar of their cash flow. And that cash flow is, frankly, computed on kind of an aggressive basis. You don't have really any margin for error. You don't have room for any material piece of the organization's cash flow to become impaired before the distribution is no longer covered by operations.

Back in March, I just felt as though I tolerated that situation for a long time, and it was one of those things that would work until it didn't. And I didn't want to be around for some unforeseen problem to crop up or, worse, for a foreseen problem to crop up--mainly that Kinder Morgan Energy Partners relies on oil extraction, oil wells in Texas, for a big chunk of its cash flow. It's not strictly a toll road; it's not just an energy-transportation company with an annuity-like cash flow stream. The cash flows from these oil wells are finite.

Now with this transaction, Kinder expects to covers its dividend, once everything is said and done, with about a 1.1 times coverage ratio--so, about a 90% payout ratio as opposed to 100%. But I still think that is too thin. That is running the organization too aggressively, especially in light of that ongoing exposure to oil, where someday the well will be dry. And unless you pour more and more capital into that business, the cash will stop coming out; that plus the additional debt, I still don't feel that this is really in the wheelhouse for conservative investors.

Now, there's no doubt there is some upside potential here; the company expects now, with that cost-of-capital handicap mitigated, to be able to raise its dividend 10% per year through the end of the decade. On that basis, our fair value for KMI is now $40; that's around where it's trading at now--yield 5% on what they project to pay for dividends next year. That's certainly a good, attractive income component. But you have to draw the line on risk somewhere.

For me, nobody is going to play a meaningful role in my portfolio if they're paying out hundred cents on the dollar. There needs to be some margin of safety because no business is perfect; no management team is perfect. And it's very much the risks that you take in the good times that define how you're going to do in the bad.

So, I'm still going to stay out of the Kinder Morgan story here. We made money owning the securities the first time through, and I felt like that was a fortunate outcome; but the risks here are still easily understated, and that's not the kind of approach that you want. You want to have a full reckoning with the financial risks of this or any other midstream business no matter how stable you might think that the cash flows are at any point in time.

Glaser: With that in mind then, are there better options in the midstream space that might be attractive right now?

Peters: I like Magellan Midstream Partners. To me, they are conservative on every point where Kinder is aggressive. They bought in their general partner and, with it, those incentive distribution rights several years ago. They run with relatively little debt. They very rarely issue new equity. They're funding a very good expansion program just with internally generated resources and incremental borrowing power that comes along as their cash flow grows.

It also really does have that annuity-like aspect to it. Since it is predominantly a refined petroleum products pipeline, they are not depending on oil wells or natural gas wells continuing to produce for decades into the future to have that annuity-like aspect. All they need is for people to continue burning gasoline and diesel fuel and jet fuel. It's really a consumption-driven system.

It doesn't mean it's perfect. And eventually--in fact, already, consumption of refined petroleum products is stagnant to slightly declining. But they get automatic tariff increases that are linked to inflation. So, that's a very attractive asset that management has complemented with some very sound and prudent, conservatively financed and high-return growth projects.

So, yes, yield is relatively low. I'd have been surprised 5-10 years ago if you had said they were pitching an MLP that only yielded a little over 3%. But with a 20% target for distribution growth this year--15% next year and I think 12% a year on average over the next five years--that low yield makes some sense in the context of that growth rate as well as just the conservative, very defensive and even hedge-like nature of the business itself.

Another name I like, in brief, is Spectra Energy Partners, which is a little more similar to Kinder in having a very broad base of operations and a lot of exposure to natural gas pipeline. But virtually all of its cash flow is fee-based and contracted; it is a very stable and sound base of cash flows to pay a generous distribution from. And they run with a higher coverage ratio than Kinder does; it might only be 1.1 or 1.2 times, but it's also a more stable business, and you still have that margin for error.

So, the yield is a little bit lower, but even when you're looking for dividends--and I think this is a very important observation--sometimes you have to think about them the same way you would think about junk bonds. When you have something yield 6%, 7%, or 8%--just like a bond that might yield 6%, 7%, or 8% as opposed to a Treasury bond that yields 2.5%--you have to think very carefully about the incremental risks you are taking in order to get that income return. I would rather have the bigger margin of safety as well as the higher return growth that goes along with some retained earnings in addition to a good yield than to press all the pedals to the floor and just hope nothing bad happens.

Glaser: Josh, thank you so much for your thoughts today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

 

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