December 24, 2001; Richer Kinder, Poorer Partners  

Summary and Recommendation

In the spirit of the season, the limited partners of Kinder Morgan Energy Partners, L.P. (KMP) would give the general partner half of the value of a $750 million acquisition announced December 17.  Presuming such rare generosity cannot continue indefinitely, we strongly recommend the sale of the securities of KMP and related stocks Kinder Morgan, Inc. (KMI), and Kinder Morgan Management, LLC (KMR). 

Kinder Morgan Deal Accretive in Distribution, Dilutive in Value

Upon announcing the acquisition of intrastate natural gas pipeline, Tejas Gas, Kinder Morgan declares its intention to increase the distribution of KMP to an annual rate of $2.30 per share from $2.20.  Moreover Mr. Rich Kinder expects the distribution to reach the annual rate of $2.50 at the end of 2002.  Investors are implicitly encouraged (not by us) to capitalize the distribution at about 6%.  That implies the stock price should be about $38 on the expected $2.30 distribution, up from about $37 on the recently announced $2.20 distribution.  Indeed that is what seemed to happen in the past week.  Thus the deal seems accretive, meaning that a valuation measure is improved and stock price rises accordingly.

By our valuation measure, the McDep Ratio, the deal is dilutive by about 5%.  Debt to finance the acquisition, at least temporarily, increases the numerator of the McDep Ratio, Market Cap and Debt, or Enterprise Value, by more than 10%.  Because half the value of acquired properties accrues to the general partner, the denominator of the ratio increases by only a little more than 5%.  As a result, the McDep Ratio viewed from the standpoint of the limited partners increases, or is diluted by about 5% because of the deal.

Present value of equity is diluted even more.  The limited partners give up $1.30 per share, or 10% of estimated present value of $12.80 per unit.  Also, the ratio of debt to present value increases disproportionately for the unitholders (see Table).

Institutional Investment in KMR Sought to Restore Dilution

Dilution in value can be at least partially restored by selling new units at a price above present value of equity.  Mr. Kinder apparently intends to market new shares of KMR early next year to finance 60% of the acquisition.  An offering that nets $450 million for new shares priced at three times net present value would restore $300 million of value dilution.  Essentially, most of the money from new investors goes to pay off existing investors. 

Kinder Morgan Management, LLC is a creative means to tap the deep well of institutional funds.  Besides sparing institutions the tax complications they would normally face in a limited partnership investment, KMR has its price linked to the price of KMP by an exchange feature.  In effect, KMR is a derivative financial instrument that provides a vehicle for institutions to bet on whether individuals will continue to be willing to accord such a high price to KMR units. 

Some institutions may find it especially desirable to participate in the KMR financing.   KMR supports KMP.  In turn, KMP supports the price of KMI stock, an issue that is heavily institutionally owned.

KMP’s and KMR’s Loss is KMI’s Gain

The General Partner Burden is our term for what the General Partner calls Incentive.  It seems to us that the provisions go well beyond a reasonable incentive.  Disclosure such as it is, does not equate to general acceptance.  Enron's partnerships were "disclosed" and "approved", yet a public outcry ultimately erupted.

Here is what the Tejas acquisition does for Kinder Morgan, Inc.  By our valuation measure, the McDep Ratio, the deal is accretive by about 5%.  KMI's share of Debt to finance the acquisition increases the numerator of the McDep Ratio, Market Cap and Debt, or Enterprise Value, by about 2%.  Bolstered by half the value of acquired properties that accrues to the general partner, the denominator of the ratio increases by about 7%.  As a result, the McDep Ratio declines, or is improved by about 5% because of the deal.

Present value of equity is improved even more.  The net gain of $1.80 per share boosts estimated present value by 20% to $10.90 per share.  The ratio of debt to present value decreases slightly, but remains at an extraordinarily high level of about 0.86 (see Table).

Deal Stirs Common Sense Reservations

Why Pay a 50% Commission to Anyone?

It is a free country.  If investors admire Rich Kinder enough to pay his 21% owned company half the value of future acquisitions, should they not be able to do so?

But the GP only gets 50% on the margin, not on everything.  That is true.  One could invest with Mr. Kinder in the beginning and not worry about the high fee. Mr. Kinder through his ownership in KMI has been collecting the 50% only on recent deals. 

Now that the distribution has reached the level where the 50% fee kicks in, the general partner has a huge incentive to keep it going as long as possible.  An overpriced stock provides cheap capital to do deals.  Interest charges are almost always less than cash flow, so debt is likely to be maximized.  Shorter life deals pay more cash flow relative to purchase price.  Expect shorter life deals.

But Rich Kinder Is Not Just Anyone

When we knew Mr. Kinder as president of Enron he was always upbeat, enthusiastic, energetic, positive, and friendly.  Listening to his presentations would leave one breathless.

Mr. Kinder can add value to acquired businesses.  We would say that superior management might be worth a McDep Ratio of 1.2 on a long-term basis.  Truly superior management could be worth a lot more, but it is nearly impossible to identify in advance.  Too often what looks to be superior management turns out to be luck or hype.

Investors have made a lot of money with Mr. Kinder.  Yet, past success is no guarantee of future success.  On the contrary, past success may breed complacency.  Investors do love to extrapolate.  One can point to the trend in stock price and imagine a steep continuation.  Unfortunately, the more overpriced a stock becomes, the harder and faster may be its eventual fall.  Investors who have made good money with Mr. Kinder should be especially sensitive to the opportunity to keep those profits by selling their stock.

Why Pay 15 Times Ebitda for a Business Worth 9 Times Ebitda?

Though little detail has been disclosed, we figure the Tejas deal went for 9 times Ebitda, because that is the median for energy infrastructure companies in the stock market.  KMR and KMP are valued at 16 times and KMI at 14 times.  Perhaps Mr. Kinder can extract more Ebitda so that the deal he bought at 9 times was really worth 11 times a base that could be expanded.  It seems highly unlikely that Tejas is really worth 15 times.  Therefore it seems that stock prices at 15 times are out of line with a business that is worth 9 times.

Are Business Risks Really Low?

Yes, the KM entities own long life assets that generate steady income.  Though the assets have relatively low business risks, that source of comfort is more than offset by high financial risk as measured by KMI's ratio of debt to property at near the highest of any of the 70 stocks in our research coverage. 

Nor might the business risk be as low as it seems.  Tejas (Spanish for Texas) reminds us of its namesake, Texas Oil and Gas, a similar intrastate pipeline that was acquired by U.S. Steel for about $4 billion in the 1980s.  After the combined company became known as USX, the parts of the acquired pipeline and liquids businesses were sold for half or less than their acquisition price.  That deal was also dilutive on a value basis. 

Fundamentally, an intrastate pipeline like Tejas has higher geographic risk than interstate pipelines that dominate KM's current property mix.  Cash flow is also more sensitive to natural gas price than may appear on the surface.  The Tejas line runs through producing areas that would experience high rates of volume decline if drilling activity were to be curtailed.  We actually are optimistic on natural gas price, but skeptical that KM is a low risk investment.

Renouncing Egregious Compensation Would Be The Right Action

In our opinion, Mr. Kinder is headed down the same path as his former colleagues at Enron.  Mr. Lay ultimately saw the wisdom of renouncing his $60 million severance package, but by then it was too late.

In our opinion, excessive compensation to the promoters of partnerships is an abuse of investor trust.  In our opinion, the Kinder Morgan entities are a subtler version of the failed energy partnerships of the past.  The failures often had in common a charismatic leader driven by excessive compensation, or greed.

A drop in Mr. Kinder's net worth might accompany renouncing the GP Burden, but it would still be in the hundreds of millions.  From a more solid base he could build a positive legacy rather than risking collapse.