December 31, 2001; Loss Aversion in 2002  

Summary and Recommendation

Our most differentiated idea for 2002 is about averting heavy loss.  Recommending Strong Sell for Kinder Morgan Energy Partners, L.P. (KMP), we stand at the opposite end of the spectrum from Wall Street analysts who, nearly unanimously, recommend Strong Buy.  According to the First Call survey, KMP appears in a small group of the most positively recommended of all stocks.   As KMP goes, so goes directly linked Kinder Morgan Management, LLC (KMR) as well as general partner Kinder Morgan, Inc. (KMI).   

Kinder Morgan Entities Overpriced, Overleveraged and Unsoundly Structured

While we see profits ahead for investors in most energy companies, we think the profits have been made, at least temporarily, in the Kinder Morgan companies.  The three KM stocks have a combined market capitalization of $13 billion and enterprise value of $24 billion.  KMP is widely recommended as an income stock for retirees.  KMR and KMI are widely held by leading institutional investors.  Rich Kinder is one of the most widely admired entrepreneurs in the energy industry, the newest energy billionaire in the Forbes 400. 

Investors familiar with the McDep Ratio will recognize that 2.04 for KMP/KMR and 1.55 for KMI are likely unsustainably high.  In more generic terms, unlevered cash flow multiples, enterprise value to ebitda, at 16.0 and 14.0 times are high for a business that trades at 9.0 times.  A more reasonable enterprise value would be one third lower.  That means a more reasonable market value would be two thirds or more lower.

The risk of owning KM stocks is multiplied by high debt.  KMP/KMR have a ratio of debt to present value of 0.54 while KMI measures 0.87, the highest of 31 large cap stocks in our coverage.  Debt normally just magnifies in linear fashion how fast a stock may go up or down with a change in the value of its business.   Too much debt introduces non-linear risk where adverse change would threaten not only stock price decline, but also corporate survival.

The complicated structure of the KM entities rests on a master limited partnership that acquires energy infrastructure.  The stock of KMP represents public limited partners, generally taxable individual investors.  The stock of KMR, essentially a derivative linked to the KMP price is owned by institutional investors who are betting on individual investors continuing to pay a high price for KMP.  KMI owns the balance of the limited partnership interests and, more important, KMI owns the general partner interest.  Our problem with the structure is first that KMP appears to be marketed as an income vehicle to investors who most likely do not understand the high risks involved.  Second there is a feature of the structure that allocates practically half the value of new acquisitions to the general partner at no cost.  That conflict of interest is likely to drive the general partner to make increasingly unsound acquisitions financed in an increasingly risky manner.

The immediate challenge to the company is to market about $450 million of new KMR stock to finance a recent acquisition.  That event may lead some investors to ask new questions in the wake of other energy infrastructure investments now more reasonably priced since the initial billion dollar KMI underwriting last spring.  If the underwriting can't be done, it is all over, in our opinion.  It appears to us that the only way the partnership can support the dilution of the general partner burden is to sell new units far in excess of their fundamental value.  In our opinion, KM keeps going because the proceeds of new financing are effectively used to repay existing investors.

Energy Infrastructure Partnership Suspends Distribution

A smaller partnership that owns oil pipelines like Kinder Morgan and gathers oil at the wellhead just suspended its distribution to unitholders.  Investors paid about $20 a unit about five years ago in an underwriting of Genesis Energy Limited (GEL).  For a couple years the partnership paid $0.50 quarterly.  About a year ago the distribution was cut to $0.20 quarterly.  Now there is no quarterly payment and the stock trades at a fraction of its initial price.

GEL also had an arrangement where the general partner would receive half the value of new acquisitions if the distribution could be increased somewhat above the initial level.  Ironically, the weakness of the structure was exposed well before the 50% compensation bomb was detonated.

We are not pointing a finger because an investment performed poorly.  Not all our recommendations have been winners either.  We do believe that the risks in some limited partnerships are not well understood by the retirees to whom they are sold.