Barron's Warns on Kinder Morgan

On Saturday, Barron’s ran a front cover piece that was negative on Kinder Morgan (“Yield of Dreams”). Andrew Bary has written many thoughtful pieces for Barron’s over the years. In this case he basically reproduced a negative report written by Hedgeye’s Kevin Kaiser from last year. Kinder Morgan Inc (KMI) was down yesterday because evidently some readers of Barron’s haven’t heard of Kevin Kaiser.

The issue Kaiser raises is whether Kinder Morgan Partners (KMP) and El Paso (EPB) skimp on maintenance in order to increase their Distributable Cash Flow (DCF) of which close to 50% goes to the General Partner, KMI. We like KMI for this reason as we’ve noted before. They benefit from increased assets and cashflows at KMP and EPB without having to put up any capital. Rich Kinder does too, since he owns $8BN of the stock.

As for whether they do skimp on maintenance cap ex or not, the evidence would seem to suggest they don’t. Kinder Morgan’s safety record is at least as good as their peers; their return on invested capital has been consistent and above their cost of capital; their leverage ratios have also remained stable.  From these perspectives, we feel comfortable with their management of these assets. As the development of shale oil and gas creates the need for investments in energy infrastructure, Kinder Morgan will be a significant player (they have a current project backlog of $14BN against an enterprise value of about $100BN). KMI should see growth in cashflows from the increased DCF at the MLPs it controls. Its forward dividend yield is 5%, and expected to grow at 8% over the next several years. Kinder Morgan issued a response to the Barron’s article yesterday.

No doubt KMI has performed poorly in recent months, partly because they lowered their forecast dividend growth from 9-10% last year but also due to negative sentiment caused by Hedgeye’s analysis. We continue to think it’s an attractive investment at current levels.

The Power of the MLP GP

Kinder Morgan Partners (KMP) announced a secondary offering of 6.9 million shares last night at $78.32, raising $540 million. KMP is predictably weaker this morning as is usually the case when an MLP sells stock unexpectedly. For Kinder Morgan Inc., (KMI), the math is somewhat different. KMI owns the General Partner (GP) of KMP, and as such is entitled to 50% of the distributable cashflow generated by KMP. Simplistically, without considering any additional debt that KMP might raise, KMI will  earn the return on 50% of the equity capital KMP has raised. In effect, the value of the assets on which KMI earns a return has gone up by $270 million, without KMI having to put up any money. KMI investors should thank the KMP investors for making this possible.

Kinder Morgan Lawsuit Highlights Who's In Control

Last week an investor in Kinder Morgan Partners (KMP) filed a lawsuit against its general partner, Kinder Morgan Inc. (KMI), alleging that KMI (which runs KMP) had directed excessive cash distributions to itself to the detriment of investors in KMP. The suit (filed by Jon Slotoroff) highlights a seldom noted feature of MLPs, which is that investors have far less power than conventional equity investors in a corporation. MLP GPs are extremely hard to displace, enjoy preferential rights with respect to distributable cashflow (DCF) and can organize the capital structure of their MLP in such a way as to benefit the GP at the expense of the MLP unit holders (by, for example, causing the MLP to issue dilutive equity that increases distributions to the GP).

These features are disclosed to those who read the documents. KMP’s 2013 10-K for example notes in its Risk Factors that, “The general partner can protect itself against dilution”, that conflicts of interest of the GP may be resolved in ways that are unfavorable to LP unitholders and various other issues of control. Removing KMI as the GP takes a two thirds vote of the LPs but no one holder may vote more than 20% of the units even if they own more.

Simply put, the value proposition for an MLP is for its GP to manage its distribution yield and capital structure such that it’s just sufficient to maintain demand for new units as they’re sold but not overly generous. Too much abuse of LPs will drive up the required yield to sell additional equity, impeding the GPs ability to continue growing the MLP and the DCF it receives. But there’s little point in running an MLP to be overly generous to its unitholders, unless the GP also owns healthy percentage of the MLP’s units (and some do).

Suing KMI under such circumstances seems to be a waste of time, although America is a litigious country and any lawyer will tell you that in court anything can happen. But the fact of the lawsuit highlights the stronger position of GPs versus LPs in the MLP structure. The sensible move would seem to be to invest in GPs and therefore avoid the need to sue as a disgruntled LP. Evidently, not everybody reads the SEC filings before they invest.

Kinder Morgan's Analyst Day, Part 2

The meeting concluded with a financial review and Q&A. Overall the impression is one of numerous projects to grow and add to their energy infrastructure assets. Many seemingly attractive opportunities are available.  The shadow of Kevin Kaiser, the HedgeEye analyst who criticized their accounting last year, was present even though Kaiser himself did not ask any questions (he was actively tweeting though). The maintenance capex figure for Kinder Morgan Partners (KMP) received some scrutiny, up as it was from $327MM last year to $438MM this year. The series of presentations also offered a lot of detail, and although today’s market vote was a negative (KMI is -4%) we are comfortable with our investment. We are long KMI, but also short a substantially smaller amount of KMP as a hedge in one particular strategy.

Kinder Morgan's Analyst Day, Part 1

So far we’re half way through Kinder Morgan’s analyst day. It opened with a summary by Rich Kinder who repeated his oft-stated thoughts that the stock price of all four Kinder entities is too low. We agree with him at least in the case of Kinder Morgan Inc (KMI) which we own. We much prefer the position of General Partner over Limited Partner, although so far the presentations haven’t been able to draw in too many new buyers of the stock, with KMI currently -3.4%. Everything we’ve heard is consistent with a solid long term growth story in U.S. energy infrastructure. Kinder Morgan (KM) is involved in numerous ways, and the development of shale resources is causing many new opportunities and incongruous developments that the company is involved in. These include:

1) Increased capability to export coal, since domestic demand is being displaced by natural gas. In spite of the developed world’s focus on clean energy, coal use is forecast to exceed crude oil in consumption by 2020, on an energy-equivalent basis.

2) Regulatory uncertainty over the Keystone pipeline as well as the increasing variability of liquids produced is increasing the need for flexible supply systems. Crude by rail has grown enormously, to the benefit of firms like Burlington Northern (owned by Berkshire Hathaway, BRK, another holding of ours). KM is investing in infrastructure to support more movement of crude oil by rail.

3) Distillate is being transported from the Marcellus shale in Pennsylvania to the Canadian tar sands in Alberta, where it is used as a diluent mixed in with the heavy crude produced there to ease its subsequent transportation.

There were many projects aimed at increasing existing pipeline capacity, reversing pipelines and creating additional infrastructure to move  product from where it’s produced to refiners and end users.

So far a very interesting session, with no doubt more to come.

An Activist Chooses an MLP

We’ve written before about the benefits of being the General Partner (GP) in a Master Limited Partnership (MLP) rather than a Limited Partner (LP). MLPs are a great asset class; the more stable, midstream businesses that invest in energy infrastructure operate a toll-type of business model with fairly predictable cashflows. Their 5-6% distribution yields are largely tax-deferred and generally grow anywhere from 4-5% and higher, annually. One of the disadvantages of investing in MLPs (beyond the K-1s) concerns the very weak corporate governance afforded LPs. The GP runs the business on behalf of the LPs, and it’s virtually impossible to fire an underperforming GP no matter how many LP units you hold. You don’t see activist hedge funds buying LP units for that reason. The GP potentially has substantial power to act in ways that are not always in the interests of the LPs. For example, since the GP earns a chunk of the Distributable CashFlow (DCF) an MLP generates (often as much as 50%) they benefit from increasing the DCF. LP unitsholders want that too, but acquisitions funded by a secondary offering of LP units and debt will always benefit the GP. They’ll benefit the LP only as long as the return on the new capital exceeds its cost (i.e. is not dilutive). The GP can benefit even from a dilutive offering, since he never gets diluted. The trick is to treat the LPs just well enough that the price of LP units stays high enough to support that next secondary offering of stock.

Which brings us to hedge fund managers, whose role is in many ways similar to that of a GP in an MLP. New assets raised by a hedge fund manager may not hurt returns for existing investors if sufficient investment opportunities exist to deploy the additional money. New assets will ALWAYS benefit the hedge fund manager though, because he’ll earn fees on those assets. No doubt many hedge fund managers look in awe at the economic enjoyed by an MLP GP. Hedge Fund managers, with their 20% incentive fee and limited ability to abuse their LPs, can look in envy at the 50%” earned by an MLP GP.

This has not escaped the attention of Keith Meister, manager of Corvex Management LP, a hedge fund manager. Corvex filed a 13D this morning disclosing an investment in Williams Companies (WMB), in partnership with another hedge fund manager called Soroban Capital Partners run by Eric Mandelblatt. WMB is the GP for Williams Partners, LP (WPZ). Corvex and Soroban together own 8.8% of WMB through shares and unexercised options. The 13D includes a list of issues they’d like to discuss with the board of WMB, most interestingly, “…participating in strategic combinations given the rapid pace of consolidation in the midstream energy industry.”

WMB’s investor presentation includes a forecast of 20% annual growth in dividends from over the next few years, driven in no small part by their GP stake in WPZ (they expect the Incentive Distribution Rights, or IDRs, to grow at 30%). WPZ itself is forecasting 6%. But this need not even be the Upside Case; WMB could, for example, sell the 279 million units of WPZ it owns and use the cash to buy back WMB shares. They could use their WPZ units to acquire other assets and then drop them down into WPZ. They could even buy an MLP that had no GP and then drop the underlying assets into WPZ where their cashflows would then be subject to the 50% IDR split. There are numerous other, possibly more imaginative steps.

We have no idea what Meister and Mandelblatt have in mind. We have long owned WMB because we like their prospects. The involvement of an activist raises the possibility of faster wealth creation for WMB at the expense of WPZ.

Quite recently, Keith Meister abruptly sold his position in ADT, a company we owned. We wrote about the “Corvex Discount”. Based on his past, Corvex could switch gears and dump WMB. It may be an obvious statement, but following other investors into positions is not a great model. In our case we’ve owned WMB a long time, since we much prefer the GP side of the MLP story to the LP one. We are also short WPZ. We think it’s vulnerable to wealth creating moves at the WMB level as described above.

The Economist Writes About MLPs

This weekend’s Economist discussed Master Limited Partnerships (MLPs). Their Leader article primarily focuses on the different forms of corporate structure that are developing both to minimize corporate taxes as well as in response to legislation such as Sarbanes-Oxley which raised the cost of compliance (disproportionately for smaller firms) for many traditional corporations.  It’s interesting to see The Economist probing a relatively unknown segment of the capital markets, but as usual they bring their clear-headed analytical skills to bear and pose some thought-provoking questions such as the absence of a public policy debate over a shift away from the traditional corporate, or “C-corp” structure widely used.

MLP investors have done well, and the requirement that profits be substantially distributed to owners rather than accumulate via retained earnings as management’s piggy bank hardly seems a bad idea. Investors in Microsoft (MSFT) and Apple (AAPL) might well wish that those companies were structured as MLPs (since they’re not involved in natural resources they don’t qualify). If MSFT had to raise capital every time they make an acquisition they’d probably find their investments in Skype or Nokia rather less well supported by the investors in the secondary equity offerings whose sponsorship they would need.


Hedgeye's Third Time Lucky?

I’d never heard of Keith McCullough until today when we noticed that Kinder Morgan (KMI), a stock we own, was down 4%. MLPs are weak but KMI and its cousins KMP and KMR are certainly leading the way. The driver appears to be a bearish report on Kinder Morgan to be released to clients of Hedgeye next week. We like KMI for its 4% yield, long history of stable growth and management guidance of 12% dividend growth. KMI owns the IDR’s for Kinder Morgan Partners (KMP) which we also own, and around 50% of distributable cashflow from KMP now goes to KMI. In effect, KMI is a hedge fund manager charging 2 and 50. It seems like a decent investment.

Keith McCullough has in the past made some bold calls. In 2010 he apparently advised clients that France and Italy would both crash as the Euro crisis unfolded, and also at around the same time recommended that they sell all U.S. stocks. I must confess that we didn’t read about those forecasts as the time because we weren’t then (and aren’t now) subscribers. In fact we didn’t hear about them at all until reading about Kevin McCullough today.

Two spectacularly wrong calls don’t tell you anything about whether the KMI call will be right or wrong (and in any case there may have been hundreds of correct calls since 2010). We still like KMI, although we haven’t read Hedgeye’s report. We bought a little more today. He obviously has the ability to cause short term moves in stocks, so we’ll be watching what he has to say (though not as a subscriber).

Annual MLP Conference

Yesterday I attended the National Association of Publicly Traded Partnerships’ (NAPTP) annual conference in Stamford, CT. It was well attended as is normal, and it provided a welcome opportunity to see presentations by several of our portfolio names. The long run prospects remain attractive although we’ve had two years’ worth of return in less than five months of 2013.

Given the strong performance of MLPs so far this year, not surprisingly there was a certain amount of chatter about taxes. Buy and hold MLP investors have certainly seen their unrealized gains grow and consequently so has their associated tax liability. A high class problem no doubt.

Earlier this year I heard of an MLP asset manager who was advising clients that they should cut back their exposure because the market was overextended. With the benefit of hindsight it was poor advice, but even at the time it was of dubious value. Few money managers publish or even care about their clients’ after tax returns. But consider an MLP investor holding a portfolio worth $100 and a cost basis of $40 (believe me, there are many). Liquidating the portfolio to profit from an anticipated near term decline in prices results in a $60 taxable gain. Some of this gain will be subject to ordinary income tax (coming as it has from the tax-deferred nature of the distributions). The Federal Capital Gains tax rate is now 20%, while the top marginal ordinary income rate is 39.6%. Many states impose taxes as well, and investment income tax in support of Obamacare can also apply, so let’s assume that the mix of taxable income is approximately evenly split between ordinary income and capital gains, and it subject to a 30% Federal tax plus 5% state. The $60 in taxable income will throw off a $21 tax bill.

What this means is that the liquidated portfolio needs to be reinvested at prices of 79% (i.e. $100-$21) of its pre-tax value just in order to break even. The manager needs to accurately forecast a 25%+ drop in prices and be sufficiently nimble to get back in to justify such a move.

However, performance is normally reported pre-tax, since everybody’s tax situation is different.  The tax drag from this attempt to time the market doesn’t show up. If the market does drop 10%, the manager may look good even though he has left his clients poorer. MLPs are a great example of inaction often being more profitable than action. Although there is invariably liquidity to sell what you want, staying with a diverse set of names you’d like to own for years is the best way to maximize the after-tax wealth creation that is possible from the sector.