Yesterday was D-day for investors in newly embattled pipeline kingpin Kinder Morgan Partners (KMP).
However, as opposed to mass chaos, investors were mostly greeted with a big yawn when it came to Hedgeye Risk Management’s report on the firm, as well as its operating subsidiaries — Kinder Morgan Inc. (KMI), Kinder Morgan Management (KMR) and El Paso Pipelines (EPB).
The previous week, a series of tweets from Hedgeye’s energy analyst Kevin Kaiser sent shares of Kinder Morgan plummeting around 6%, promising that his report would show that the midstream firm was actually a “house of cards” worthy of a short position.
It seems that the market is brushing aside the young analyst’s assumptions, with shares of the firm only dropping 1 or 2%. So, was Kaiser full of hot air, or should investors really be concerned?
Capex Spending Problem
The crux of Kaiser’s argument against Kinder Morgan has to deal with the firm’s spending on capital expenditures and maintenance. In the report, Kaiser details how KMP had reduced maintenance spending to boost distributed cash to investors in its partnerships. According to Hedgeye, Kinder Morgan will “starve” an asset of required maintenance, then after a few years replace the pipeline to increase its capacity.
This allows Kinder Morgan to book those replacement project costs as expansion capex, rather than maintenance expenditures. By booking these costs in such a manner, Kinder Morgan can avoid deducting these costs from its distributable cash flows and is able to raise capital easily to fund the replacement projects.
The kicker is, by doing this, Kinder Morgan Inc. — which is the general partner — is entitled to higher incentive distribution rights. IDRs are basically payments in many MLP/GP agreements that help ensure that management is doing right by the partners. (If you make us better and earn us money, then we’ll pay you more.) The downside is that KMP has a high cost of capital, all while inflating KMI’s IDR payments. That can be an issue over the longer-term, but so far this hasn’t played out at Kinder, as the firm is still very profitable.
Kaiser also took issues with Kinder’s treatment of capex for its E&P business — the same story Hedgeye had with pure upstream MLP Linn Energy (LINE). The report showed that KMP’s oil production business — which is declining as an overall piece in the KMP empire — will require nearly $450 million of annual capex spending to keep production and reserves flat. However on KMP’s balance sheet, E&P has allocated zero sustaining capex.
These factors, according to Hedgeye, make the stocks worthy of a short position for investors. However, the rest of analyst community and market doesn’t think so.
As for capex spending and the concept of replacement, Kinder seems to be doing just what every other MLP and pipeline firm does these days. According to analysts at Morningstar, KMP’s “maintenance CAPEX is broadly in line with MLP industry” and there are no irregularities.
Kinder Morgan’s official response to the Hedgeye report: “Our business units perform a bottom up review of maintenance capital needs and operating expenses, with the objective being to increasingly reduce risk and improve safety for the benefit of the public and the environment …”
This isn’t accounting fraud, and if the firm finds it better to simply replace a pipeline after several years of service — with expanded capacity — ultimately, shareholders win on both ends. Meanwhile, Kinder Morgan continues to rely less and less on its E&P operations and some speculate that the division could be sold or spun off to investors in the future.
The IDR issues aren’t unique to KMI. Kinder Morgan is just structured in a way that benefits KMI more than KMP because the GP’s profits are mostly from IDRs and distributions from the units it owns. However, KMP benefits from asset drop downs and cheap capital. This is essentially a model built with two kinds of investors in mind — current high-yield investments and a dividend-growth investments. That’s not a recipe for disaster.
At the end of the day, it seems that Kaiser’s arguments have done little to create the aura of a “house of cards.” CEO and founder Richard Kinder didn’t think so either, as he bought another 500,000 shares of KMI to add to his huge stash.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.