By Ephraim Juskowicz
Kinder Morgan Inc. (KMI ) owns Natural Gas Pipeline Co. of America (NGPL), a major participant in the "midstream" energy sector, connecting the "upstream" producers to "downstream" end-users such as local distribution companies. And Kinder Morgan also owns a utility that provides approximately 225,000 customers in Colorado, Nebraska and Wyoming with natural gas. Both of these businesses are typically tightly-regulated, with little prospects for significant growth.
Then how was Kinder Morgan able -- at a recent analyst conference in Houston -- to reiterate that earnings per share this year would grow 30%-40% and long-term EPS growth would be 20%-30%?
The answer: the company is also the general partner of Kinder Morgan Energy Partners (KMP ), which owns fee-based businesses such as refined petroleum products pipelines, liquids and bulk terminals and CO2 pipelines for enhanced oil recovery. And it's the company's intricate relationship with KMP that is the key to its growth potential.
TAX BENEFIT. Under the Tax Reform Act of 1987, master limited partnerships (MLPs) that are engaged in natural resources activities, such as KMP, are exempt from corporate taxes. As a result, an investor in an MLP avoids double taxation, unlike an investor in a "C" corporation who is taxed both at the corporate level -- the company pays taxes on its earnings -- and at the investor level, where any dividends paid are also subject to taxation.
The advantage? With its favorable tax treatment, KMP has a lower cost of capital than traditional "C" corporations, such as the company. KMP exploits this competitive advantage by paying relatively high multiples to earnings before interest, taxes, depreciation and amortization for assets in acquisitions that are, nonetheless, accretive to distributable cash, the primary objective and performance measurement for MLPs.
KMP has made 19 acquisitions in the past 3 years for a total $4.7 billion and intends to make at least $1 billion a year of additional accretive acquisitions. As with its previous purchases, KMP is targeting fee-based businesses.
PARTNER PAYOUTS. The company, in turn, benefits from the higher cash distributions in several ways. First, as the general partner, the company is entitled to a 2% general partnership interest. More importantly, pursuant to an incentive distribution tier system, Kinder Morgan receives a larger percentage of the distributions as they increase. Specifically, the company receives its 2% general partnership interest on the first $1.21 of distributions per unit (DPU), 15% of the next $0.22, 25% of the next $0.44 and 50% of anything greater than that.
With current annualized DPU of $3.80 and based on 67.5 million common units, the general partner - Kinder Morgan -- receives 36% of total distributions. The remaining 64% goes to the limited partnership interests.
But the buck doesn't stop there. Kinder Morgan owns approximately 21% of KMP's limited partnership units, too. Some of these units resulted from the transfer of assets from the company to KMP in exchange for cash and newly issued units. As we said previously, KMP has a lower cost of capital than traditional "C" corporations and can thus afford to pay out more distributable cash. As a result, the company has transferred approximately $1 billion of assets to KMP. With KMP distributing more cash, Kinder Morgan gains because of its above-described general partnership incentive arrangement, as well as through its limited partnership unit ownership. Taken all together, the company receives approximately 49% of KMP's total cash distributions.
ROOM TO GROW. With most available asset transfers complete, we believe that the partnership will look elsewhere for acquisitions. Some analysts have questioned whether the company will be able to continue finding potential acquisitions. KMP pointed out to analysts at its recent presentation that it only had a 7% share of the petroleum pipelines market. It expects major integrated oil companies, which own 33% of the market, to divest their pipeline assets in order to focus on core businesses and comply with merger-related antitrust issues. In addition, much of the remaining 60% is owned by independent operators. This highly fragmented industry is ripe for consolidation. Finally, KMP noted that there are still significant acquisition opportunities in the bulk and liquids terminals businesses.
While best known for its acquisition strategy, KMP is growing internally as well. First, the company strives to operate its assets because it is efficient at controlling costs and increasing asset utilization. With the pipeline business having little variable costs and with no taxes, some 90% of incremental revenues associated with working the assets harder flows to the bottom line. Second, after a pending acquisition is completed, the company's pipelines will serve virtually all of the fastest growing population markets in the U.S., including California, New Mexico and Arizona. Coupled with current expansion initiatives, we expect throughput volumes to increase at rates in excess of 3% a year into the foreseeable future.
Third, in addition to growth of its refined petroleum products pipelines, KMP plans to increase EBITDA at its CO2 business in 2001 by 20% through new sales and expansions of existing projects. With the maturing of many U.S. production fields, and with a strong commodity price environment making CO2 flooding more economical on a per-barrel cost basis, we believe the 20% target may be conservative.
UPSIDE POTENTIAL. How does this all translate into bottom line results for KMP and the company? KMP's annual cash distribution per unit for 2000 was $3.43. S&P expects DPU to be $3.90 this year, a 14% rise. The increase should be derived evenly through internal and external growth. With rising equity earnings for Kinder Morgan from its interests in KMP, coupled with a doubling of earnings at the company's burgeoning power business, we expect Kinder Morgan to increase EPS by 39% to $1.78. Our estimate, which is in line with management-stated objectives, may prove conservative, just as Kinder Morgan exceeded its own forecasts for 2000.
Longer-term, we think that the company can grow EPS by 25%, which is also in line with management's guidance. The stock was recently trading at a p-e to growth rate (PEG) of just 1.2, compared with a 1.9 PEG for Kinder Morgan's peers. Assuming the company achieves a 1.5 PEG, consistent with normal industry levels, the stock would be worth $66.75, a 27% appreciation from the current quote.
If that were not reason enough to invest in these companies, management has indicated that it may be filing in a few weeks with the SEC for the establishment of "I-shares." Short for institutional shares, this financial instrument may allow institutions to more flexibly own KMP. Under current regulations, mutual funds can have only 10% of invested funds in "non-qualifying sources," such as a master limited partnerships (MLPs) due to their tax exempt status. Although management was unable to go into specific details about the filing, it is possible that they found a loophole in the current legislation that, through I-shares, would allow institutional investors to indirectly own KMP. In addition, the energy-friendly Bush administration may reverse a Clinton veto of a bill that sought to ease institutional ownership of MLPs. These developments would tap a huge pocket of institutional money, which may result in further price appreciation for KMP.
Shares of Kinder Morgan carry S&P's highest investment ranking, 5 STARS (buy), while Kinder Morgan Energy Partners is ranked 4 STARS (accumulate).
Juskowicz is an equity analyst covering the oil and gas industry for Standard & Poor's