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Tap Kinder Morgan Energy Partners for High Yield and Growth

Numerous projects could light a fire under KMP distributions

   

Kinder Morgan Energy Partners, LP (NYSE:KMP) operates as a pipeline transportation and energy storage company in North America. The partnership is a member of the dividend achievers index — it has boosted quarterly distributions for 16 consecutive years, and improved payouts by 8.2% per year for the past decade.

KMP operates more than 75,000 miles of pipelines, as well as 180 terminals. Its main business activity involves transporting commodities such as oil and natural gas for third parties such as oil and gas companies for a fee.

In essence, Kinder Morgan operates a toll-based business, which generates stable fee revenues, without having exposure to fluctuating commodity prices. The volumes of oil and gas transported in the U.S. are very stable and move by only a few percentage points per year. In addition, as the U.S. is experiencing a boom in shale gas production, there is a greater need for transporting carbons in the country. Companies like KMP are in a great position to capitalize on this opportunity, with its pipelines in Marcellus Shale, Eagle Ford, Haynesville and Barnett Shale.

The partnership is operated by Kinder Morgan Inc. (NYSE:KMI), the general partner. Because of the general partner’s incentive distribution rights, future distribution growth might be limited at the LP level, but much higher at the general partner level. Previously, mentioned that there are three ways to invest in Kinder Morgan — through general partner, limited partner and LLC interests.

CEO Richard Kinder owns 24% of the general partner interests in the partnership and receives an annual salary of $1 per year. Since most of his net worth is invested in the partnership, he has the incentive to deliver solid results to unitholders in terms of distributions and total returns.

It is rare in corporate America today to see management and shareholders goals align as closely as they do in Kinder Morgan. The other major company that comes to mind: Warren Buffett’s Berkshire Hathaway (NYSE:BRK.B).

Taxation

As a master limited partnership, KMP is a pass-through entity, which means it does not pay taxes at the corporate level. Instead, each unitholder pays their portion of Kinder Morgan’s income, net of any deductions.

Each year, unitholders receive a K-1 form, which describes their share of income, and how to report it on their tax returns. In general, for the first 10 years or so, new unitholders generally do not pay taxes on their distributions, as they are classified as “return of capital” for tax purposes. While this creates a slightly more challenging tax return than the typical dividend-paying stock, any serious do-it-yourself investor should be able to handle this aspect. Taxation also makes investing in Kinder Morgan Energy Partners slightly more challenging in deferred retirement accounts such as Roth IRAs.

Luckily, you also can acquire I-shares of Kinder Morgan Management (NYSE:KMR), which pay distributions in the form of stock. As a result, unitholders do not receive any cash, and their distributions are viewed similar to stock splits in the eyes of the IRS. This means unitholders of KMP that invest in I-Shares such as KMR do not have to file any information with tax authorities regarding the shares they received as distributions from KMR. The only item that must be reported would be the taxable event of a sale.

Currently, KMR trades at a discount to KMP, which is why a lot of investors have chosen it over the partnership units.

Distributions

This being said, Kinder Morgan Energy Partners does have the distributable cash flows from its vast portfolio of fee-generating assets to pay for its generous partner distributions. For the first six months of 2012, KMP had distributable cash flow of $2.44 per unit, while it paid out $2.36 per unit. In 2011, DCF was $4.68 per unit, and the partnership distributed $4.61 per unit for the year.

Future distributions growth could come out of the $10 billion in capex that the partnership plans to invest over the next five years. Projects in the pipeline include $4 billion for Transmountain Pipeline expansion, as well as expansions in company’s Natural Gas and Products Pipelines expansions. The Parkway Pipeline is another major project in South-East U.S.; it is expected to come online in 2013 and be accretive to DCF.

As the general partner plans on becoming a pure-play GP by 2014, there will be expected drop-downs of assets to Kinder Morgan Energy Partners, which would fuel future distributions growth as well. Another driver of growth could include tariff increases as well as organic growth in oil and gas delivered.

A third driver could include strategic acquisitions. The acquisition of El Paso in 2011 will lead to Kinder Morgan Partners acquiring several projects. This in turn has increased the expected growth in distributions per unit from 5% to 7% in the foreseeable future.

One risk for KMP is interest rate risk. For every 1% move in interest rates, interest expense fluctuates by $55 million. If interest rates start to increase, that could affect DCF, as new projects would be more expensive to build.

Full Disclosure: Long KMR and KMI.

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Article printed from InvestorPlace Media, http://investorplace.com/2012/10/tap-kinder-morgan-energy-partners-for-high-yield-and-growth/.

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