Kinder Morgan Promoted by the Folks Who Brought Us Enron

All Enron, all the time.  We are only beginning to hear the details of how this tragedy unfolded.  Because Enron and Kinder Morgan have a common history, many of the same analysts who got to know Ken Lay got to know Rich Kinder.  We are among them though we couldn't recommend Enron when it had a high McDep Ratio.  Some of the most prominent promoters of Enron are now promoting Kinder Morgan.  We are recommending Strong Sell.

Up to this point nearly everyone who has invested in Kinder Morgan has made money.  It is hard for investors to sell when a stock has been good to them.  It is human nature to be lax on questioning a success and to hope for more of the same.  The bankers and analysts who have made money with Kinder Morgan so far are looking forward to more of the same.

Wall Street seems to be promoting Kinder Morgan as the buyer of choice of energy infrastructure.  By persuading retirement investors to overpay, in our opinion, for Kinder Morgan stock, Wall Street empowers Kinder Morgan to make winning bids for pipelines, storage tanks and energy terminals. 

Kinder Morgan, in turn, is driven by confiscatory compensation.  Here is an example.  Assume Kinder Morgan borrows a million dollars to buy an oil tank that generates $120,000 a year in storage fees after expenses.  At today's low interest rates the loan costs only $40,000 a year.  Out of the remaining $80,000 the limited partners get cash distributions of $40,000 and the general partner keeps $40,000.  After 17 years, the tank rusts out and no longer has any value.  The annual cash generated for interest and distributions would equate to a 10% per year discounted cash flow rate of return.  The limited partners would get cumulative distributions of $680,000 and the general partner the same.  The limited partners are the effective borrowers and thereby obligated to repay the loan of $1,000,000.  Effectively the limited partners would have to give back all their distributions and more to repay the loan.  The general partner essentially has stripped the limited partners of the value of their ownership in the oil tank.

The bulls on Kinder Morgan would have us believe that 1) the asset would never wear out, 2) the loan would never have to be repaid and 3) the rate of return with smart management is much higher.  That requires that we also believe there is little competition to invest in oil tanks and other energy infrastructure.

Petro-Lewis Experience Illustrates Risks

Remember Petro-Lewis?  As we recall investors would pay something like a 10% sales commission up front on a drilling partnership commitment.  Petro-Lewis would take another 20%.  Wall Street got the sales commission and it might have earned more fees helping Petro-Lewis overpay for oil and gas properties.  When oil and gas turned down, asset value declined and the weakness of the whole effort was exposed.  Investors lost most of their principal.

But Kinder Morgan isn't Petro-Lewis.  Right, Kinder Morgan takes even more from investors than Petro-Lewis.  Kinder Morgan's nominal take has reached 50%, not 30%. 

But those Petro-Lewis partnerships failed because production is a risky business.  Kinder Morgan is in infrastructure, a safer business.  Perhaps, but Kinder Morgan uses a lot of debt that increases risk.  Moreover infrastructure has high operating leverage.  It may be that a little more revenue means a lot more profit.  The reverse is also true; a little less revenue means a lot less profit. The combination of high financial leverage and high operating leverage compounds risk.

Is The Whole Greater Than the Sum of the Parts?

Bear in mind that the three Kinder Morgan entities represent claims on essentially the same assets.  Each security is designed to appeal to different investors.  The limited partnership is commonly marketed as an income security.  Some suggest a target price for limited partnership units of KMP by projecting a distribution and capitalizing it at a "yield".  The same source may then compute a target price for the general partner, KMI, by projecting earnings and capitalizing at a price/earnings multiple.

It is a wonderful bit of alchemy.  Supposing we tested it by reversing the calculation.  KMP earnings capitalized at the same price/earnings multiple would imply a lower price.    KMI's nominal distribution, which capitalized at the same yield, would imply a much lower price.

Kinder Morgan maximizes the distribution on one security and some analysts oblige by applying a measure that gets the highest valuation for that security.  On the other security earnings are maximized with the help of 50% asset stripping and some analysts apply a measure that gets the highest price for that security.  When we apply our valuation standard, present value, to both securities, we conclude that both are grossly overvalued.

Where is the Securities and Exchange Commission?

We think it requires audacity to take 50% of investor's principal for little in return.  Maybe the fact that the confiscatory compensation was set up by Enron helps explain how we got where we are.  Enron formed Enron Liquids Pipeline, which became Kinder Morgan.  Why doesn't anyone protest Kinder Morgan's 50% take? 

Where Are the Auditors?

We question that the accounting statements present "fairly" the financial position of Kinder Morgan.  We have previously explained how accounting standards do not handle contingent interests well.  As a result users of KMP's accounting disclosures are prone to overstate the asset position for the limited partners. 

Where is the New York Stock Exchange?

How can our symbol of capitalism allow retirement investors to be deceived?