Kinder Morgan Inc (KMI): You sell, I’ll buy

Richard Kinder, the CEO of KMI, is a brilliant operator and a brilliant capital allocator.  He is a self-made billionaire with a net worth of roughly $9B.

This is a company with good economics, great management, and a reasonable valuation.  The company is buying back its shares and its warrants.  Kinder has come out and said that the company is undervalued.

Overview of Kinder Morgan and general/limited partner structure

There are five different ways to invest in the various Kinder Morgan-related companies:

1. KMI.  This owns general partnership (GP) interests.  It also owns assets outside of a GP/LP structure.
2. KMI warrants.  These were issued in connection with the El Paso acquisition.
3. EPB.  This owns limited partnership (LP) interests.
4. KMP.  This owns limited partnership interests.
5. KMR.  This is like KMP except that it pays dividends in stock instead of cash.  Management argues that KMR should trade in a 1:1 ratio with KMP.

Kinder Morgan’s GP/LP structures are one-sided deals that are extremely favorable to the GP.  The GP owns incentive distribution rights, or IDRs.  The GP gets a cut of each distribution.  The rate starts at 2% but ramps up to 50% as distributions increase.

KMP IDR structure

EPB IDR structure

There are a number of other aspects of the GP/LP structure that makes the deal extremely one sided.  The KMP 10-K states numerous risk factors associated with the GP/LP structure.  Here is one of them:

The interests of KMI may differ from our interests and the interests of our unitholders.

KMI indirectly owns all of the common stock of our general partner and elects all of its directors.  Our general partner owns all of KMR’s voting shares and elects all of its directors.  Furthermore, some of KMR’s and our general partner’s directors and officers are also directors and officers of KMI and its other subsidiaries, including EPB, and have fiduciary duties to manage the businesses of KMI and its other subsidiaries in a manner that may not be in the best interests of our unitholders.  KMI has a number of interests that differ from the interests of our unitholders.  As a result, there is a risk that important business decisions will not be made in the best interests of our unitholders.

It’s obvious to me that you want to be on the same side as the general partner.  Not surprisingly, Richard Kinder’s money is concentrated in KMI.  Here’s what his ownership looks like:

• KMP – Less than 1% (315,979 units according to the 10-K)
• KMR – Less than 1% (294,952 units)
• EPB – Less than 1% (28,000 units according to the EPB 10-K)
• KMI – 23.3% (240,872,511 shares according to the KMI annual proxy statement)

If he were to buy warrants, I presume that he would have to file an insider trading report.  I assume that Kinder has not purchased any warrants on the open market.

IDRs are a wonderful business

There are different ways of looking at the IDR business:

1. An asset management company with permanent capital.  This is like a hedge fund where the clients cannot leave.  Instead of charging 2% of AUM and 20% of profits, Kinder Morgan gets to eventually charge 0 and (almost) 50% of profits.
2. Warren Buffett often uses See’s Candies as an example of why buying a wonderful business at a fair price is better than buying a fair company at a wonderful price.  When See’s Candies opens a new store, it can generate excellent returns on the capital invested.  Over time, earnings growth has a powerful effect on the compounding of money.  KMI is like a See’s Candies that opens new stores without paying for them.

Here are historical KMP cash distributions to the general partner:

YE1996 – $0.268M
YE1997 – $2.280M  <– Richard Kinder becomes the CEO in Feb. 1997
YE1998 – $27.450M
YE1999 – $52.674M
YE2000 – $91.366M
YE2001 – $181.198M
YE2002 – $253.344M
YE2003 – $314.244M
YE2004 – $376.005M
YE2005 – $460.869M
YE2006 – $523.198M
YE2007 – $567.7M
YE2008 – $764.7M
YE2009 – $918.4M
YE2010 – $861.7M
YE2011 – $1161M
YE2012 – $1340M

*I have used the cash figures from KMP’s statements of cash flows.  Note that the stated income of the general partner is higher than the cash sent to KMI.  One is the reasons is because there is a lag between when income is earned and when it is paid.
(**EDIT: 5/3/2014: Note that “drop down” transactions increase IDR payments.  Some of the growth above did require capital from KMI.)

The growth in the cash payments to the GP has been 53% annualized from YE1997 (when management took over) to YE2012.  In the past decade, it has been 18% annualized.  However, I would expect growth to be lower going forward.

“Drop down” transactions

KMI can also make money through “drop down” transactions.  Basically, KMI can sell infrastructure assets to the LPs.  The LPs have no say in approving these transactions.  They are at the mercy of KMI’s limited fiduciary duties (the partnership agreement places limits on the GP’s fiduciary duties).

Did the LPs get a raw deal?

Interestingly enough, the limited partners have done pretty well.  While the typical GP/LP structure has been heavily criticized for years and years, KMP stock has outperformed relevant indexes since inception. Richard Kinder could have taken steps to enrich himself at the expense of the LPs.  However, he has voluntarily given up his salary despite being an officer at KMP.

Are huge fees unethical?

In my opinion, no.

1. Shareholders consented to the fees.  There was no coercion, fraud, or deception involved.
2. KMI can only collect massive fees if the KMP shareholders are making money.
3. KMP shareholders made a lot of money.

Seems fair to me.  KMP is not something I would buy for myself.  But if somebody else wants to buy it, who am I to judge?  I think that it’s fine if other people pay excessive fees as long as they don’t feel like they were lied to or cheated.

Management’s integrity

For a long time, Richard Kinder has received a salary of only $1.  The proxy statement goes into further detail:

At his request, Richard D. Kinder receives $1 of base salary per year from us. Additionally, Mr. Kinder has requested that he receive no annual bonus or other compensation from us or any of our affiliates (other than the Class B unit awards that he received in 2007 in connection with the Going Private Transaction). Mr. Kinder does not have any deferred compensation, supplemental retirement or any other special benefit, compensation or perquisite arrangement with us, and each year Mr. Kinder reimburses us for his portion of health care premiums and parking expenses.

The other side of the coin: why I’m a little disappointed in Richard Kinder

Kinder writes in the 2002 shareholder letter [my emphasis]:

I’m not a believer in razzle-dazzle slogans, grand corporate brand advertising programs or million dollar mission statements, but I do believe companies should be run with integrity and for the benefit of the shareholder-owners. This means management acting as if they are principals (owners of the business), not agents (managers of the business). If you’re a principal, you prefer long-term results over short-term profits, growth in underlying value over higher salaries and bonuses, and if forced to choose, would pick cash flow over earnings.

In 2006, Kinder led a leveraged buy-out to take the company private.  Unfortunately for shareholders, they approved the takeover!!  With the benefit of 20/20 hindsight, it’s obvious that shareholders should have rejected the takeover offer and held onto their shares.  Any long-term shareholders were not able to participate in the future growth of Kinder Morgan and were not able to defer the capital gains tax on their shares.  I think that taking the company private goes against what Kinder was saying in 2002.I get the sense that Kinder was very disenchanted with his shareholder base.  In the years prior, he had given investors a lot of transparency, wrote excellent shareholder letters, and had been buying stock on the open market.  He probably got sick of analysts and all of the people who doubted him.  Maybe he was disappointed that shareholders didn’t give him credit for his integrity and honesty.  He was telling the market that Kinder Morgan was undervalued and the market didn’t listen.  Maybe he wanted to prove a point.

I’m guessing that in Kinder’s mind, he was reciprocating what shareholders were dishing out to him.  I don’t think that Kinder was trying to be greedy.  Still… what he did strikes me as hypocritical.

How was Kinder Morgan able to create so much value?

The YE2003 letter to shareholders states:

At Kinder Morgan, our strategy is quite simple: 1) we own and operate quality midstream energy assets — primarily pipelines and terminals that handle gasoline, jet fuel, diesel, natural gas, carbon dioxide (CO2) and certain dry-bulk materials — which produce consistent, fee-based cash flow and earnings; 2) we run these assets in the most efficient, cost-effective way possible, with a commitment to public safety and protection of the environment; 3) we grow the top-line revenues of our facilities through internal volume growth, small rate increases, expansions and extensions, and thus convert fairly modest top-line growth into relatively strong bottom-line growth. We can do this because our assets have high fixed costs and low variable costs that we aggressively control; and 4) whenever appropriate, we own our assets in our affiliated master limited partnership, Kinder Morgan Energy Partners, L.P. (NYSE: KMP), which is the most tax advantaged method of owning these types of assets.

A miserly culture

An excellent 2003 Fortune magazine article (I’ll link to it multiple times in this post) notes that the company has a miserly culture.

When the deal closed in February 1997, the company’s name was changed to Kinder Morgan. And Kinder went to work. A mere seven months later, he doubled the business’s market cap to $475 million by slashing costs and moving significantly more volume through its underutilized pipelines. While Houston’s energy elite were indulging in lavish lifestyles–flying in private jets, naming ball fields after their companies, building ostentatious mansions–Kinder was pinching pennies. He was flying coach. He and his Morgan execs were staying at Red Roof Inns. He was laying people off. “People thought we were curmudgeons or stick-in-the-muds,” acknowledges Kinder. “But we wanted to drive home one culture here: Cheap. Cheap. Cheap. We were tightwads.”

The company’s latest proxy statement backs it up [the emphasis is mine]:

Unlike many companies, we have no executive perquisites, supplemental executive retirement, non-qualified supplemental defined benefit/contribution, deferred compensation or split-dollar life insurance programs for our executive officers. We have no executive company cars or executive car allowances nor do we pay for financial planning services. Additionally, we do not own any corporate aircraft and we do not pay for executives to fly first class. We believe that this area of our overall compensation package is below competitive levels for comparable companies; however, we have no current plans to change our policy of not offering such executive benefits or perquisite programs.

And:

Our compensation is determined independently without the use of any compensation consultants.

While most companies waste money on compensation consultants, Richard Kinder has enough sense to avoid that nonsense.

Other areas of value creation and shareholder return

Overall, I’d say that Kinder Morgan does a lot of things and it does them well.  Part of Kinder Morgan’s strategy is to only build new infrastructure when they have contracts locking in most of the revenue.  They go after low-risk projects with attractive returns.  The company tries very hard to maintain capital discipline though it makes mistakes like everybody else. What Kinder Morgan does exceptionally well is in its capital allocation.  The company understands taxes, understands when to buy back shares, and opportunistically arbitrages stock price fluctuations.  It constantly buys other companies in “accretive” acquisitions.  Richard Kinder understands that it makes sense to use overpriced stock to buy undervalued assets.  The 2001 shareholder’s letter contains the interesting phrase “strong currency”:

With its low-cost structure, strong currency and tax advantages, KMP is often an ideal buyer of these assets.

He’s talking about using pricey stock instead of cash when KMP takes over other companies.  To be fair, this is not necessarily nefarious.  Companies with good management teams tend to trade at premiums compared to their poorly-managed peers.  By using their pricier stock as “currency”, there is basically an arbitrage between good management and bad management.  Value is being created when takeovers put assets into the hands of good managers.

Accounting

In GAAP accounting, pipeline companies have to recognize a non-cash expense related to straight-line amortization.  Suppose a pipeline has an expected life of 60 years.  Every year, the company has to recognize 1/60th of the pipeline’s cost as depreciation. The economic reality is a little different.  For the first few decades of a pipeline’s life, very very little of the pipeline needs to be replaced.  There may be small leaks, fractures, or damage to the pipe due to an unmarked pipe being damaged by construction equipment.  Very small segments of the pipe will need to be replaced.  The big picture is that virtually none of the pipe needs to be replaced.  Virtually all of the asset’s replacement costs will be concentrated near the end of a pipeline’s life rather than being evenly distributed over the 60 years (or however long the pipeline will last).  If you apply a discount rate to both scenarios and discount all of the future cash flows back to the present, you will find that straight-line depreciation overstates depreciation costs.

There is a small degree of uncertainty about how long a pipeline will last.  Some pipelines installed over 60 years ago are still in operation.  Some of them don’t have protective coatings and have higher-than-normal costs in inspecting and maintaining the pipe as these old pipes are more prone to problems.  The true life of a pipeline will depend on future safety regulations and the cost of complying with them.

On the revenue side, there is some uncertainty about how much revenue a pipeline will generate in the future.  I believe that all pipelines are built with some degree of excess capacity.  Selling excess capacity is how pipeline companies can really make money and grow their cash flows.  However, this sword cuts both ways.  A pipeline asset can run at a lower utilization rate than when it first started.  This can happen when market dynamics change the price differentials (the difference between commodity prices) at different ends of the pipeline.

I don’t know what the right model for depreciation is.

Valuing Kinder Morgan

Prior to 2006, Richard Kinder wrote excellent shareholder letters which you can access on the KMI website.  He was fond of looking at free cash flow instead of GAAP earnings.  His definition of free cash flow was:

Free cash flow = earnings + DD&A – sustaining capex* + book taxes – cash taxes
*Sustaining capex is any capex that does not increase the capacity of an asset.  This is a reasonable proxy for maintenance capex.
**This is my interpretation of “Cash flow is earnings before DD&A, less cash taxes and sustaining capital expenditures”.

This metric gives a pretty good idea as to the actual cash being generated by the underlying pipeline assets in any given time period.  Because Kinder is a really good CEO, he was able to continually increase the free cash flow of the assets he managed (e.g. by increasing utilization).  To simplify things, you can simply assume that the company as a whole is throwing off an ever increasing stream of free cash flow.  To value the stock, use free cash flow as a proxy for what earnings should be without accounting distortions.  On top of that, factor in growth expectations for increases in free cash flow.  Use growth expectations to determine a correct multiple for free cash flow yield. This method of valuing the company is based on continual growth and having the assets continually become more productive.  It is overly aggressive if the cash flows were to stay constant or go sideways (e.g. if the company did not have a superstar CEO at the helm).

Otherwise, it is reasonable to assume that a pipeline will throw off less free cash flow in the future.  Free cash flow would not be a good proxy for earnings since the company won’t make as much money in the future as it does today.

On the tax front, the effect of book taxes – cash taxes is that deferred tax is given a present value of 0.  In reality, the present value is a little more than 0.  Overall, I think that free cash flow slightly overstates a pipeline business’ profitability.

When free cash flow isn’t a good metric

KMP has an oil production business where free cash flow (or free cash flow yield) is inappropriate for valuing the company.  Each individual oil-producing well will throw off less and less cash flow as time progresses.  This is not the same as pipeline assets with stable or growing cash flows. If management wanted to be transparent to shareholders, it would try to help investors value the E&P segment by providing information on reserves and estimates of its net present value (NPV).  (Oil assets are actually difficult to value, especially if there are undeveloped reserves.)

When talking about KMP, management does not take efforts to break out the oil business separately even though dividend yield is not really an appropriate way of valuing an E&P.

Distributable cash flow versus free cash flow

Here’s how I think about it: distributable cash flow simply adds more adjustments on top of free cash flow.  Over the years, Kinder Morgan’s accounting has gotten more complex due to things like:

• Joint ventures.
• Lawsuits.  I believe GAAP requires the company to set aside reserves (on paper) for expected costs of litigation.
• Impairments and remeasurement of assets to fair value.

Minor dividend shenanigans at KMP

KMP has been throwing off an ever-increasing stream of dividends that have never gone down. The cash payments from KMP to KMI actually dropped from 2009 to 2010: YE2009 – $918.4M YE2010 – $861.7M What happened with that 2010 was a bad year for KMP as it paid out a lot of money on a lawsuit.  Despite a bad year, KMP increased its dividend anyways.  From the YE2010 KMP 10-K:

On May 28, 2010, the Federal Energy Regulatory Commission, referred to in this report as the FERC, approved a settlement agreement that our subsidiary SFPP, L.P. reached with 11 of 12 shippers regarding various rate challenges.  We refer to this settlement agreement as the Historical Cases Settlement, and it resolved a wide range of rate challenges dating back as early as 1992.  The Historical Cases Settlement resolved all but two of the cases outstanding between SFPP and the eleven shippers, and we do not expect any material adverse impacts on our business from the remaining two unsettled cases.  The twelfth shipper entered into a separate settlement agreement with SFPP, L.P. in February 2011.  The FERC has not yet acted on the second settlement.  In 2010, we recognized a $172.0 million expense due to adjustments of our liabilities related to both the Historical Cases Settlement and other matters related to SFPP and other rate litigation, and in June 2010, we made settlement payments to various shippers totaling $206.3 million.  Our cash distributions of $4.40 per unit to our limited partners for 2010 were not impacted by these rate case litigation settlement payments because, from a cash perspective, a portion of our partnership distributions for the second quarter of 2010 was a distribution of cash from interim capital transactions, rather than a distribution of cash from operations;

I think that the steadily increasing dividends at KMP is an illusion that management perpetuates.  It makes sense for them to do this because they want to see their ‘assets under management’ at KMP grow.  This is more likely to occur if KMP has a high share price which it can use as a “strong currency” to buy other companies in accretive transactions.

The short thesis (AKA who wants to short a self-made billionaire?)

In the past, Kinder Morgan has had its critics.  The 2003 Fortune article states:

Still, many–including some of its own investors–are bothered by the so-called “incentive distribution” inherent in Kinder Morgan’s MLP structure. Kurt Wulff, an independent energy analyst who gained prominence in the 1980s by correctly predicting oil megamergers, calls MLPs “partnerships of greed.” He charges that MLPs allow the general partner–in this case, Kinder Morgan Inc.–to milk the partnership for huge amounts of cash even though it owns only a small stake in the MLP.

Furthermore:

Analyst Wulff points to the pipeline rupture as proof that MLPs like Kinder Morgan Energy Partners are skimping on crucial maintenance spending. “If I were the FERC (Federal Energy Regulatory Commission),” he says, “I wouldn’t let these partnerships run the pipeline companies and then take all the cash out of them.” Federal regulators said that Kinder Morgan Energy Partners didn’t commit any safety violations. Arizona state regulators, on the other hand, are seeking the maximum penalty of $25,000. It’s nonsense that his company would cut critical maintenance to keep the dividend high, says Kinder: “It is significantly more costly to repair assets or have them out of service than it is to perform preventative maintenance.”

Recently, Kinder Morgan has come under attack by Kevin Kaiser of Hedgeye for similar concerns.  Sidenote: it so happens that Mr. Kaiser liked one of my blog posts enough to tweet it:

I haven’t read Kaiser’s original piece attacking all of the Kinder Morgan companies because it seems to have been taken down.  However, Kaiser’s arguments are summarized in a Barron’s article.  Kinder Morgan hosted a conference call on Sept. 18, 2013 where they responded to (debunked) his arguments.  Seeking Alpha has a transcript of that call.  Kaiser released a rebuttal on Sept. 26 (you can put in a fake email to read it).  I don’t think that the short thesis is very good at all and I don’t think that Kinder Morgan is cutting corners on pipeline maintenance.  Otherwise KM’s safety track record would be terrible.

At the end of the day… Richard Kinder has come out to explain why Kaiser’s arguments are wrong, why KMI is undervalued, and has put his money where his mouth is by buying shares personally.  On the Q4 2013 conference call (transcript) on January 15, 2014 Kinder made the following comments [the emphasis is mine]:

Now I’d be remiss if I didn’t speak of one other topic before turning this over to Steve. While we had an excellent year at the Kinder Morgan companies, both financially and operationally, our units and stocks underperformed the market by a wide margin. Now perhaps we failed to adequately communicate our story, although we certainly tried, and maybe we did communicate it, and the message was not accepted. I don’t know the answer to which it was, but I do believe that particularly at KMI and KMP, these securities are trading at the greatest disconnect to appropriate valuation since the period in 2006, just before we took the first KMI private. Like now, back in 2006, we had an enormous backlog of projects. And like now, many experts will find that we were too big to be able to continue to grow at an acceptable rate. We proved the doubters wrong the first time around, and I anticipate the same result this time. Reflecting this belief in the Kinder Morgan companies, as many of you know, I’ve been a buyer of KMI shares. I’ve purchased over 800,000 shares in December alone. So I guess my message to those who saw the story less positively was you sell, I’ll buy, and we see who comes out the best in the long run.

Epic.

Share repurchases

Since 2012, the company has been repurchasing the warrants it issued in connection with the El Paso takeover.  In the latest quarter, the company has also begun repurchasing its common shares (press release):

KMI repurchased 5.2 million shares of its common stock during the fourth quarter for approximately $172 million.

Valuation

This part is tricky.  The most important thing is to figure out how much KMI will grow in the future. The main drivers of growth will be:

1. Internal growth at KMP.  This will come from a combination of improved productivity from its existing assets and expansion capex being deployed at high rates of return.
2. KMP/KMR raising more equity.  Both stocks have a combined market cap of around $45B.  The growth in share count will slow down compared to the past.
3. KMP using its stock to acquire other companies in accretive transactions.

On Jan 29, 2014 management gave a projection of KMI’s growth (page 21 of this PDF):

KMI – 3-year targeted dividend/share CAGR of about 8% (2013-2016)

This is lower than the 9-10% growth projected in this Nov 22 2013 presentation.  The projections assume that no major (accretive) acquisitions are made.  Such acquisitions would increase growth.  I find the differences in the projections interesting as management has guided to no growth at EPB compared to 5-6% previously.

Valuing the warrants

One way of looking at it is this:

• The warrants cost $3.16.
• They have around 3.33 years until expiration (May 25, 2017) and have a strike price of $40.
• The current KMI share price is $34.10.

Suppose that the dividends grow at 8%/year and that the dividend yield stays the same.  This is the same as saying that the shares will go up 8%/year.

• They have around 3.33 years until expiration (May 25, 2017) and have a strike price of $40.
• At expiration, the warrants should be worth 1.28X their original price.  (34.10 * 1.08^3.33 – 40) / 3.16

The break-even on the warrants happens when the growth in the share price is 6.0%/yr.  If we make more aggressive assumptions then obviously the expected return on the warrants would be higher.  I think management will likely exceed the 8% guidance because it will likely find major acquisitions.  On top of that, any multiple expansion will increase the value of the warrants.  While this can cut both ways, any volatility is good for the warrants.

In YE2002, KMI repurchased its warrants at average prices ranging from $2.01 to $3.79 according to the 10-K.

In 2013, KMI repurchased its warrants at average prices of $4.72 in Q1, $5.76-$5.78 in Q2, and $4.95-$5.60 in Q3.

Terms of the warrants

The terms of the warrants are described in this prospectus.  If dividends exceed certain levels then the dividend strike price will be adjusted.  I don’t think that this feature will ever become relevant.

EDIT (Jan 31, 2014):  The Kinder Morgan website has a merger consideration FAQ that doesn’t even mention the dividend adjustment feature.

Bottom Line

Originally, I was really excited about KMI because you have a very good CEO doing insider buying.  However, the situation is not quite as good as it first appears.  It really does look like the company’s growth is slowing down and that there is some indigestion going on with the El Paso takeover.  The way management presents the company strikes me as slightly aggressive and (at KMP) slightly promotional.

Still, this is an above-average company with above-average management.  The warrants seem to have an attractive risk/reward.  There are some other stocks out there which will likely grow faster than KMI.

*Disclosure:  Long KMI calls and warrants.

Links

KMI shareholder letters – These are a must-read for understanding Kinder Morgan and its CEO.  Richard Kinder is clearly somebody special.  The letters also contain descriptions of the business.

The Anti-Enron In 1996, Rich Kinder lost out on the CEO job at Enron. So he left to start his own energy firm. Now he’s a billionaire. Take that, Ken Lay! – I really like the writing in this 2003 profile piece on Kinder Morgan.

Rich Kinder’s Biggest Slice – Hit piece on Richard Kinder regarding the management-led buyout.  It contains a rebuttal by Kinder.