March 25, 2002; Kinder Morgan Valuation Appears to Ignore General Partner Tax

The same technique that helps pick potential winning stocks may help avoid potential losing stocks.  In our emphasis on avoiding loss this week we describe out valuation approach to Kinder Morgan. 

One of our favorite colleagues in a past affiliation, Mr. Phil Dodge, once described the McDep Ratio as the comparison of the value of a company's securities to the value of a company's business.  For Kinder Morgan Energy Partners (KMP), let us start with the denominator - business value.  

Multiple of cash flow is a common measure of the value of energy infrastructure businesses.  Kinder Morgan speaks that language when its management points out that its recent acquisition was priced around 7 times Ebitda.  Apparently that multiple was on expected cash flow for 2002.  On cash flow for 2001, the price apparently was closer to 12 times.  We assess the business value of Kinder Morgan and related companies at 9 times our current estimate of cash flow for the year ahead.   Our estimate of cash flow is about $870 million for the partnership. 

Since we use cash flow to estimate value we allocate cash flow to limited partners in proportion to the amount of value the limited partners are expected to receive.  Thus the limited partners' share of cash flow for valuation purposes is about $440 million.  We further allocate cash flow to the KMP unitholders separate from the KMR shareholders.  That leaves about $358 million of cash flow for KMP.  Thus the denominator of the McDep Ratio or the business value, attributable to KMP unitholders, is 9 times $358 million, which equals $3.22 billion.

Now we turn to the numerator of the McDep Ratio, the value of securities including debt.  Taking the latter first we calculate debt from the year-end balance sheet and add the $750 million taken down to finance a recent acquisition.  That brings total debt to $3.72 billion of which we allocate $1.53 billion to KMP unitholders.  Meanwhile there are 136 million units of KMP outstanding at the latest closing price of $33.01 implying an equity market capitalization of $4.49 billion.  As a result the value of KMP equity and debt securities is $6.02 billion.

Finally the McDep Ratio is $6.02/$3.22 or 1.87 (see Table M-1).  That is such a high number and so unlikely to be sustained that one might ask if there is something wrong with the calculation. 

Suppose we ignored the general partner interest.  In that case the McDep Ratio would be about half the current level and roughly in line with the typical energy stock.  Thus we might conclude that KMP stock is priced as though the general partner tax did not exist.  That may be the genius of the scheme.  The general partner may ultimately get 50%, or more, of value and KMP investors ignore it.  As Lincoln apparently said, "You can fool............."