Apparent Vulnerability in High McDep Ratio, High Greed Gauge Stocks

For the stocks with high McDep Ratio and high on the Greed Gauge, the risks seem compounded (see Chart below).  The stocks are drawn from the Mid Cap and Small Cap Infrastructure Groups (see Tables M-1, S-1).

When the Greed Gauge exceeds 1.0 the general partner gets half of the incremental cash distributed by the partnership.  For Kinder Morgan at a Greed Gauge reading above 2.3 the general partner's share of all cash flow is about 40%.

A high Greed Gauge reading indicates a heavy handicap in cost of capital.  New investments must exceed a high hurdle in order to earn the cost of capital (see Chart).  Considering the high level of competition in the energy infrastructure industry and the moderate historical returns, we are skeptical that there are few, if any, large scale industry investments that will return enough to justify a high Greed Gauge reading.  Investors who buy high greed gauge stocks are taking on an unnecessary handicap in giving the general partner half of incremental cash distributed.

Our suggestion that the cost of capital to a high greed gauge entity is high contrasts to what a general partner might advertise.  Low cost of capital is supposedly an advantage to investors in limited partner units of KMP, for example. The common observation equates cost of capital to the distribution yield, about 6.7% for the next twelve months (see Table M-2).

It seems obvious that investors are also looking for growth in the distribution.  Kinder Morgan feeds those expectations by projecting 12% growth in the annualized rate at the end of 2002 compared to the end of 2001.  The dividend discount value model holds that rate of return equals dividend yield plus growth.  Thus we suggest, at least for purposes of illustration, that limited partners are expecting 10% per year return, not 6.7%.  If KM were to announce that there would be no further growth in the distribution, stock price would probably decline and the current distribution yield would rise.

One might also consider that short-term interest rates are currently low thereby promising lower debt costs than 7.5% that we use for illustration.  Perhaps, but we prefer to take a longer-term point of view.  

Most important, any cost of equity capital needs to be doubled to support the incremental take of the general partner.  Even to meet the average current general partner take at Kinder Morgan, the combined equity return would have to be 16.7%, if not 20%.

The irony is that it is not too hard to meet a 15% return on investment on a one-year basis.  Apparently Kinder Morgan buys assets for about 6 times Ebitda.  Turn that upside down and the asset returns 16.7% the first year if projections are met.  Allow a generous 50-year life for the asset and deduct 2% of return for maintenance capital.  That leaves almost 15% to cover interest and distributions. 

The problem is that something almost always happens that keeps companies from truly earning the 15% returns managers think they see when they invest.  Moreover, sellers are not stupid.  Few would knowingly sell an asset that had a true 15% rate of return potential.  At the same time, there is competition to buy assets.  Though no infrastructure partnership is as large yet as Kinder Morgan, many are being formed.  Those with a low Greed Gauge reading have a competitive advantage over those with a high Greed Gauge reading.

As a result, the odds are stacked against new investors in high Greed Gauge stocks, in our opinion.  Compound that risk with a high McDep Ratio and the odds of earning a substandard return rises even further.