-Seven Year Revenue Growth Rate: Negative
-Seven Year Income Growth Rate: 12.4%
-Seven Year Asset Growth Rate: 15.9%
-Seven Year Distribution Growth Rate: 6.7%
-Current Distribution Yield: 6.32%
-Balance Sheet Strength: Leveraged, Stable
Based on the high distribution yield, moderate distribution growth, a strong and growing diversified asset base, I view KMP as a well-run Master Limited Partnership to purchase at the current price of around $80/unit.
OverviewSince the mid-1990′s, when under the operation of Richard Kinder, Kinder Morgan Energy Partners has grown to become one of the largest MLPs, and has produced annualized returns of over 25%.
The partnership owns interest in or operates 75,000 miles of pipelines and 180 terminals, making it one of the largest energy business, and the largest midstream business, in the United States.
The partnership has a variety of business segments:
Natural Gas Pipelines- buying, selling, transporting, storing, gathering, and processing natural gas
Segment earnings: 38%
CO2- transporting and selling CO2
Segment earnings: 27%
Terminals- transloading, storing, and delivering bulk (including steel and coal), petroleum, and chemical products
Segment earnings: 16%
Product Pipelines- transporting, storing, and processing refined petroleum products
Segment earnings: 15%
Kinder Morgan Canada- petroleum pipelines
Segment earnings: 4%
Revenue and Assets
(Chart Source: DividendMonk.com)
KMR has had volatile revenue in part due to buying and selling commodities.
(Chart Source: DividendMonk.com)
The partnership has maintained steady asset growth with consistent use of leverage.
(Chart Source: DividendMonk.com)
KMP has grown the distribution by an average of 6.7% per year over the past seven years.
A distribution yield of over 6% combined with distribution growth of over 6% can result in 12% or more annualized returns for as long as that growth continues. The distribution gets paid from incoming cash flows, as well as the continued issuance of new units to fund capital expenditures and investments.
Approximate historical distribution yield at beginning of each year:
As can be seen, Kinder Morgan has traded in a fairly tight valuation range compared to its distribution payouts. With exceptions for the stock dip in the beginning of 2009 near the market bottom and the early 2012 market rise, the units have traded at a price that results in a yield of around 6.5%.
Balance SheetLike all Master Limited Partnership, Kinder Morgan makes a large use of debt. The partnership carries approximately $17 billion in debt currently.
The interest coverage ratio is under 4x, which shows the degree of leverage that the partnership uses. Well-run partnerships can achieve above-average investment returns due to their tax-advantaged structure. Unlike many corporations that repurchase their shares, MLPs (and especially their general partners) benefit when they continually issue more units. By issuing units, they can raise capital to invest in robust long-lived assets such as pipelines that produce reliable cash flows, and they can issue debt on those assets due to their steady nature.
Investment ThesisKinder Morgan is essentially a large toll operator. By owning pipelines, terminals, and storage areas, they move various forms of energy around the country. In most of their business operations, they’re the largest in their industry in the United States. This includes being the larges transporter of natural gas, the largest independent transporter of petroleum products, the largest transporter of CO2, and the largest terminal operator. Their asset base is spread across most of the United States and into Canada, giving them access to most of the major shale plays.
Management identifies approximately $11 billion in capital investment opportunities for growth over the next 5 years. The largest area of investment is expected to be their Canadian segment, followed by their natural gas segment and CO2 segment. Their products and terminals segments are the smaller areas of expected capital investment. In addition, acquisitions can be made by the partnership or dropped down from KMI as part of their overall growth strategy.
In terms of controlling costs and producing growth, management has had strong performance. Richard Kinder owns approximately one quarter of Kinder Morgan Inc. (KMI), which is the general partner of KMP (Kinder Morgan Energy Partners) and EPB (El Paso Pipeline Partners), and represents billions of dollars of capital that aligns his interests with the interests of the unitholders of KMI.
Out of the past decade, when Kinder Morgan budgets an annual expected distribution payout, they’ve met that expectation every year except once, when they were $0.02 shy of the target. The 2013 distribution target for KMP is $5.28 per unit.
RisksMaster Limited Partnerships carry quite a bit of leverage. Low interest rates are useful for the business, whereas high interest rates can make capital more costly to acquire. More specifically, according to management’s December 2012 Wells Fargo presentation, for every 1% increase in floating interest rates, it costs KMP $55 million in additional annual interest expense. Damaging events or business downturns can result in failure to meet interest payments, which would affect the distribution to unitholders and the value of the business. It’s notable that the partnership was able to continue increasing the distribution through the 2007-2009 financial crisis.
Kinder Morgan has to pay high Incentive Distribution Rights (IDRs) to Kinder Morgan Inc. (KMI). As the general partner of KMP, KMI is entitled to a growing share of the total cash. Since the partnership has been active for a long time and has far surpassed its top IDR tier, it is paying a hefty percentage of its available cash to KMI. In 2011, this figure was 44% for the IDRs, plush distributions to the limited partnership units that KMI holds. The IDR payments approach but will not exceed 50%.
Some MLPs, when they get to this stage, are unable to continue raising the distribution. For example, ETP has been unable to grow its distribution for four and a half years, as it’s a large partnership and the cost of capital is too high. Its GP, ETE, has had to temporarily waive IDR rights on drop down assets in order to make acquisitions work out for ETP. Other large partnerships have bought out their GP so that they are no longer burdened by the IDRs.
The problem lies in the fact that the partnership has to continue issuing units to grow. It issues units to fund new investments, but in order to continue growing the distribution for the growing number of unitholders, each infusion of new capital has to provide sufficient returns to lift all distribution payments. If IDRs reach a critical point where they take too big of a chunk out of the available cash to keep issuing units to grow the partnership, then distribution growth can quickly run into a wall. Many MLPs hit that point before the 44% mark that Kinder Morgan is currently at. Strong management and capital allocation have allowed the partnership to grow the distribution for a longer period than peers, but it’s always a risk that in the future, IDRs will prove too much for distribution growth to occur at this rate.
Conclusion and ValuationUsing the Gordon Growth Model, if KMP can continue raising the distribution by 6% annually, and a 12% discount rate (the target rate of return) is used, then the intrinsic value of the units is up to $85. If the forward-looking distribution growth is estimated at 5% instead, then the intrinsic value drops substantially to $72, unless the discount rate is adjusted down to 11%, which brings the intrinsic value up to $85 again.
Overall, to justify the current price of around $80/unit, only 4% long-term distribution growth is required for low double digit returns, which I believe provides a sufficient margin of safety as part of a diversified portfolio.
Full Disclosure: As of this writing, I am long KMI. I have no direct position in KMP or EPB, but have an indirect position in them through KMI.