As I posted on seeking alpha, the issue of underspending on pipeline maintenance is a red hearing. I work for a public utlities commission. and the only way these entities (KMI/KMP pipelines are FERC regulated) can make a profit is through CAPEX spending. They are allowed a regulated rate of return of about 13% (varies with utility) on any CAPEX investment. Mainenance costs are a past through, and that can't earn anything on these expenses. So what does this mean, they CAPEX any cost they can (some expense in non regulated industries are capitilized in regulated industies) and they are incentivies to make investments and discard old investments. KMI understand this very well and plays the game very well. I laughed when I read that.
The most humorous part of the report is this caveat:
" The key risk to our thesis (from an investment perspective) is the lack of an identifiable catalyst. We are confident that we are right, but we do not know when the market will prove us right. Kinder Morgan has been a fantastic investment for many years, and consensus opinion could be stubborn and slow to turn."
"Lack of identifiable catalyst" translates to KMI continuing to increase revenue, income and dividends, Kinder and other insiders buying more shares, other more well-respected analysts recommending KMI, etc. Anyone who sold Kinder on the tweet should call Vanguard and put all their money in the S&P index fund.
We believe that Kinder Morgan’s high-level business strategy is to starve its pipelines and related infrastructure of routine
maintenance spending in order to maximize Distributable Cash Flow (DCF), IDR payments to the GP, and acquisition
accretion. Then, 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 DCF unimpaired. In the meantime, any
environmental or legal expenses due to poorly-maintained assets are considered “certain items,” which are added back to
DCF. We believe that this is exactly what played out in the years after KMP acquired SFPP in 1998 and CALNEV in 2001, and
we believe that Kinder Morgan is employing the same strategy with the recently-acquired El Paso assets today.
2. In our view, Kinder Morgan cuts, defers and eventually finances the LPs’ maintenance spending. This could result in the LPs
paying KMI IDR payments that it otherwise may not be entitled to. Cutting and deferring maintenance spending really
benefits KMI, because it increases LP DCF and IDR payments, but the eventual replacement project is classified as
“expansion” CapEx, and is financed with new LP capital (which also increases the IDR fee).
3. A broader, more important concern is the reliability and safety of Kinder Morgan’s pipelines. In 2012, Kinder Morgan
acquired El Paso, then the largest natural gas pipeline company in the US, in a +$30B deal; Kinder Morgan has already cut
maintenance expenses by 70-90% and maintenance CapEx by ~60% on most of those assets. In our view, it is alarming that
Kinder Morgan supporters believe that this is sound business practice.
4. Many Kinder Morgan bulls liken KMP’s cash flows to a “toll road.” We believe that this is inaccurate. What they don’t seem
to acknowledge is that Kinder Morgan is one of Texas’ largest oil producers, and that ~20 – 25% of KMP’s pre- GP take DCF
comes from producing oil from legacy fields in the Permian Basin. While near-term cash flows are protected with hedges,
the cash flows from an E&P operation are fundamentally different from a pipeline or terminal, and should be valued as such.
5. We estimate that KMP’s E&P business will require ~$450MM of annual CapEx to keep production and reserves flat from
2013 levels, though, inexplicably, KMP–E&P is allocated ZERO sustaining CapEx. This issue alone represents ~20% of LP DCF.
All else being equal, the incremental return on E&P expansion CapEx that doesn’t expand production is ZERO. In our view,
classifying this CapEx as expansion CapEx may be misleading, as well as a major source of IDR payments to KMI that it
otherwise would not be entitled to.
6. In our view, the GP, KMI, is enriched at the expense of the LPs, KMP/KMR and EPB. The IDR appears to misalign KMI and its
LPs; at the current distribution, KMI collects an additional ~$4.5MM in IDRs from KMP with every 1MM units that KMP
issues. When Kinder Morgan cuts, defers, and eventually finances maintenance spending, it maximizes DCF and IDR
payments, while all the financing is done at the LP level, which leads to additional IDR payments. The fact that KMP
unitholders continue to fund this stream of cash to the GP – which is now ~$2B per year – leads us to believe that KMP
unitholders (~70% retail) don’t fully understand it.
7. KMP has taken more than $1B of legal and environmental reserve charges since 2005, including a $166MM charge in 2Q13
due to another adverse rate decision in its west coast Products Pipelines segment. All of the charges are considered
“certain items,” and are added back to DCF. We question whether these add-backs are appropriate.
8. The complex corporate structure of KMI/KMP/KMR/EPB may distort underlying economics and valuation. We consolidate
the implied market valuations and financials of KMI, K MP, and EPB for a clearer picture of current valuation. Kinder
Morgan has combined market cap of ~$76B and enterprise value of ~$108B. By our estimates, Kinder Morgan trades at
24.8x P/2014E earnings, 16.0x EV/2014E EBITDA (ex. E&P), 2.7x book value, and 48.5x tangible book value. Kinder
Morgan’s organic growth prospects and returns may not justify these multiples.
9. The key risk to our thesis (from an investment perspective) is the lack of an identifiable catalyst. We are confident that we
are right, but we do not know when the market will prove us right. Kinder Morgan has been a fantastic investment for
many years, and consensus opinion could be stubborn and slow to turn.
10. In our view, the bull case for Kinder Morgan rests largely upon the logic that ‘this has not mattered in the past; therefore it
will not matter in the future.’ That could turn out to be a dangerous way of thinking. We urge Kinder Morgan investors to
consider our research in their expectations for the future, not the rearview mirror.