Kinder Morgan: A Promising Pipeline Play
Kinder Morgan Energy Partners (KMP; recent price, 60) carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy) based on total return potential. One of the largest publicly traded pipeline limited partnerships in the U.S., Kinder Morgan has a long-term growth profile that is favorable, in our view. With more than $7 billion in capital projects beginning to come on line over the next four years, the company should benefit from increased natural gas production in the Rocky Mountains and from the growing importance of liquefied natural gas (LNG). Kinder Morgan has among the most visible organic growth and lowest-risk profiles of any master limited partnership (MLP) in our coverage universe.
We expect Kinder Morgan's gas pipelines and terminal operations to be the main earnings drivers, benefiting from the first segment of the Rockies Express Pipeline now in service and terminal operations being helped by expansions and acquisitions. They will benefit from the completion of the East Line expansion project and the increase in ownership to 100% (from 50%) of the Cochin NGL Pipeline from Canada to the U.S.
Kinder Morgan's MLP structure means that income is allocated among all partners in the form of distributions in proportion to their ownership interest. We see Kinder Morgan increasing earnings per unit (EPU) by 34% in 2008, to $2.31, and 7% in 2009, to $2.48, on the addition of pipeline capacity, through expansion of existing facilities, new pipelines, or acquisitions. In 2007, Kinder Morgan declared distributions of $3.48 per unit, up 7%. Kinder Morgan declared a cash distribution of 96¢ per unit for the 2008 first quarter, up 16% on an annual basis. For 2008, we see distributions of $4.02, a 16% rise, well ahead of MLP pipeline peer averages of 6%.
Houston-based Kinder Morgan was formed in August, 1992. The partnership is one of the largest publicly traded pipeline limited partnerships in the U.S. in terms of market capitalization. In total, it transports refined petroleum products and natural gas through more than 25,000 miles of pipeline. In addition, it operates approximately 165 terminals handling refined products, coal, and other materials.
Knight Inc., one of the largest U.S. midstream energy companies, and its subsidiaries, owned, through its general and limited partner interests, 13.9% of Kinder Morgan on Dec. 31, 2007. Knight was recently privatized, and, given certain tax benefits, we expect this to be a positive for Kinder Morgan.
Kinder Morgan's objective is to expand its portfolio of fee-based energy transportation and storage assets, while increasing the utilization of its existing assets. As a result, we believe it does not face significant risks relating to the short-term movement of commodity prices.
Kinder Morgan has established what we view as an impressive history of increasing cash distributions to common unit holders. Over the past 10 years, the payout has increased at about 17% annually. The 2007 payout of $3.48 represented an estimated 1.0 times distributable cash flow. Reflecting its diversified operations, Kinder Morgan maintains coverage somewhat lower than the average MLP. We also note that as a relatively mature partnership, Kinder Morgan pays 50% of incremental cash flow above a certain threshold as incentives to the general partner, a higher level than most of its peers. Knight, through its ownership of the general partner and limited partnership units, received a total of 40% of all quarterly distributions in 2007.
Through its general and limited partner interests, Kinder Morgan has leveraged the resources of Knight to enable it to evolve into a leader in several core business segments, in our opinion. It is the largest independent U.S. owner and operator of pipelines transporting refined products as well as the largest independent operator of terminals. Its pipelines transport more than 2 million barrels per day of gasoline and other petroleum products and up to 7 billion cubic feet per day of natural gas. Kinder Morgan's terminals handle more than 90 million tons of coal and other dry bulk materials and have liquids storage capacity of about 70 million barrels for petroleum products and chemicals. In addition, Kinder Morgan is a leading provider of carbon dioxide used for enhanced oil recovery projects in the U.S.
We believe Kinder Morgan's size and financial resources have enabled it to distinguish itself from most other MLPs through a balanced program of acquisitions and internal expansion projects. During 2007, the partnership spent $1.7 billion for additions to property, plant, and equipment, including expansion and maintenance projects. Kinder Morgan's total capital expansion program in 2007 was about $2.6 billion, and including acquisitions totaled $3.3 billion.
Since 2005, KMP has laid the groundwork for three new capital projects—the Rockies Express Pipeline, the Louisiana Pipeline, and the Midcontinent Express—that offer significant long-term growth potential, in our view. In total, we believe that Kinder Morgan's $3.3 billion share of investments in these three projects will add at least 15¢ to 20¢ per unit in distributable cash flow by 2010.
In August, 2005, KMP announced a 66.7%/33.3% joint venture with Sempra Energy (SRE) to pursue the development of a new natural gas pipeline called the Rockies Express Pipeline (REX), providing needed take-away capacity from producing areas in the Rocky Mountains. The planned 1,675-mile pipeline would originate in Wyoming and extend to eastern Ohio at an estimated total construction cost of $4.4 billion. The February, 2006, acquisition of Entrega Gas Pipeline added two connecting pipelines in Colorado and Wyoming. In February, 2006, binding commitments were secured from shippers for all of the 1.8 billion cubic feet per day of capacity. In June, 2006, ConocoPhillips (COP) joined the joint venture with a 24% share, reducing Kinder Morgan's and Sempra Energy's shares to 51% and 25%, respectively. The first segment of the project, REX-West, was placed into service in January, 2008, and construction is scheduled to begin in June, 2008, on REX-East, with completion anticipated by yearend. The entire REX project is expected to be fully operational by June, 2009, subject to regulatory approvals. After completion, it will be one of the largest natural gas pipelines in North America.
In September, 2006, Kinder Morgan requested government approval for its proposed Louisiana Pipeline, expected to provide 3.2 billion cubic feet per day of natural gas take-away capacity from the new Cheniere Sabine Pass LNG terminal in Cameron Parish, La. At an estimated cost of $514 million, the pipeline would provide access to new supplies of imported LNG. The pipeline's capacity is fully subscribed with long-term commitments from Chevron (CVX) and Total (TOT). Construction is under way and is expected to be completed in 2009.
The Midcontinent Express Pipeline is expected to be in service by March, 2009, subject to regulatory approvals. The $1.3 billion project will extend from southeastern Oklahoma, across northeastern Texas, northern Louisiana, and central Mississippi to an interconnection with the Transco Pipeline near Butler, Ala. Midcontinent Express has put in place a $1.4 billion, three-year bank facility to be utilized for construction of the project.
The pipeline will have initial capacity of 1.4 billion cubic feet per day, of which more than 1.3 billion cubic feet per day is fully subscribed with long-term binding commitments. Construction on the project, a 50/50 joint venture of KMP and Energy Transfer Partners (ETP), is expected to begin this summer.
Kinder Morgan units have performed well in 2008 (up about 25% through late April) despite overall weakness within the pipeline MLP group. Our model assumes Kinder Morgan will reach its goal of increasing 2008 distributions by 16%, to $4.02 per unit. After achieving a first-quarter distribution coverage ratio of 1.2 times, we are increasingly confident of Kinder Morgan's ability to reach its distribution goals.
Given our view that Kinder Morgan units exhibit the strongest distribution-growth profile among its peers, we believe the units warrant a premium valuation. The units are currently yielding about 6.4% based on annualized first-quarter distributions of 96¢ per unit ($3.84 annually), compared with a peer average of approximately 7%. Our 12-month target price of $68 is based on a blend of a premium-to-peers target yield of 6% on our one-year-out distribution estimate and a target 11 times enterprise value to estimated 2008 EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple, comparable to peers.
With the privatization of Knight, which owns the general partner of Kinder Morgan, we believe there is a lack of transparency when it comes to Kinder Morgan's corporate governance. Kinder Morgan itself does not have any officers or directors and operates under Knight's corporate governance guidelines. Knight's guidelines state that the number of directors shall be established from time to time by the holders of the voting shares. On the date these guidelines were adopted, the number of directors was set at five. Three of the five board members are outside directors, and the nominating and compensation committees are chaired by the same outside director. Also negatively affecting our view is the occupation of the roles of chairman and CEO by the same person.
A positive factor we see in terms of corporate governance is the absence of a poison pill plan.
The primary risk to our recommendation and target price, in our view, is a downturn in the global economy that increases interest rates and reduces demand for energy products, leading to lower transportation volumes. Kinder Morgan is dependent on volumes running through its infrastructure, and if volumes decline, cash flow would be harmed. Kinder Morgan's business is also subject to environmental and other regulations. The general partner controls the assets of the partnership, and it is possible that conflicts of interest could arise between the interests of Kinder Morgan unit holders and the general partner.