Hedgeye/Barron's take on Kinder Morgan

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Hedgeye Risk Management today released its written case against U.S. energy pipeline operator Kinder Morgan and its related entities.

In a nutshell: Hedgeye says investors should worry more about Kinder’s pipeline maintenance and spending therein. And it says Kinder’s exploration and production business, while small, is NOT a pipeline enterprise and valuation should reflect that. Moreover, Hedgeye says it thinks Kinder Morgan’s strategy is to “starve its pipelines and related infrastructure of routine maintenance spending” so that it can maximize distributable cash flow and payments to the general partner, Kinder Morgan (KMI). As a structure, MLPs pay out most of their cash flow as tax-deferred distributions to investors in their “units,” as shares are called.

But KMI’s structure is more complex, and the general partner is collecting some hefty distributions from limited partners in the form of “incentive distribution rights.”

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Hedgeye thinks that by cutting or deferring the limited partner maintenance spending, the general partner KMI is getting more payments — incentive distribution rights — than it deserves. Hedgeye essentially is pointing to Kinder Morgan founder Richard Kinder, the current chairman and CEO, who bought $18 million in KMI stock as it sold off recently. Richard Kinder doesn’t collect a salary, but he already owned 23% of KMI units as of March 31, according to StreetSight.net.

Continuing the report’s first bullet point, Hedgeye’s allegation is that:

“… after years of under-spending, Kinder Morgan will replace an asset, while simultaneously increasing the asset’s nameplate capacity, a technicality that allows the company to classify the entire budget of a replacement project as “expansion CapEx.” Essentially, it is our opinion that Kinder Morgan defers LP maintenance expenses and CapEx, and when the large bill eventually comes due, books 100% of it as expansion CapEx, leaving distributable cash flow unimpaired. In the meantime, any environmental or legal expenses due to poorly-maintained assets are considered “certain items,” which are added back to distributable cash flow .”

The caveat is that Kinder Morgan didn’t respond to requests from Analyst Kevin Kaiser to speak about his assumptions. Hedgeye is a relatively small and unknown investment advisor, based in Connecticut. None the less, Kaiser recommends a short on Kinder Morgan, the general partner, which reaps distributions from underlying businesses; Kinder Morgan Energy Partners (KMP), the main pipeline MLP enterprise; Kinder Morgan Management (KMR), which pays distributions in shares rather than cash; and, finally, El Paso Pipeline Partners (EPB).

There are some fair points in the report. But as Kaiser aptly points out, they haven’t mattered until now and may not constitute downside catalysts for any of the Kinder tickers. A few of those fair points:

- Kinder’s corporate structure is complex and “may distort underlying economics and valuation.”

- To wit, investors should realize “Kinder Morgan is one of Texas’ largest oil producers” and should realize that roughly a quarter of KMP distributable cash flow, before general partner accounting, is from exploration and production.

- ”KMP’s E&P business will require ~$450 million of annual CapEx to keep production and reserves flat from 2013 levels [but this business] is allocated zero sustaining CapEx, [accounting for ~20% of limited partner distributable cash flow. .... [This] may be misleading …”

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