FOOL ON THE HILL
Kinder Morgan's Attraction

When certain sectors of the market fall out of favor, the stocks of good companies can get taken down with the bad ones. This is exactly what has happened to Kinder Morgan, which has been tarred with the Enron brush, making its stock a compelling buy, according to Whitney Tilson.

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By Whitney Tilson
March 6, 2002

I've recently been buying the stock of Kinder Morgan, Inc. (NYSE: KMI), a company panicky investors have falsely tarred with the Enron brush.

Kinder Morgan is actually three different stocks: 1) Kinder Morgan Energy Partners (NYSE: KMP), a master limited partnership (a legal structure with significant tax advantages; a recent Forbes article does a good job explaining MLPs); 2) the general partner of KMP, Kinder Morgan, Inc.; and 3) Kinder Morgan Management, LLC (NYSE: KMR), whose assets are almost entirely partnership units of KMP. (For the sake of simplicity, just assume that KMP and KMR are identical -- KMR was set up to primarily to allow institutions to own KMP without some of the logistical hassles, detailed in the Forbes article, of owning shares of a master limited partnership.)

Kinder Morgan, according to the company's website, "is one of the largest midstream energy companies in America, operating more than 30,000 miles of natural gas and product pipelines across the United States. It also has significant retail distribution, electric generation, and terminal assets. Kinder Morgan, Inc., through its general partner interest, operates Kinder Morgan Energy Partners, L.P., the nation's largest pipeline master limited partnership."

The Kinder Morgan companies were created by Rich Kinder and Bill Morgan, friends and seasoned industry veterans. They have built, primarily via a string of savvy acquisitions and flawless execution, a large and rapidly growing pair of companies that are focused "on stable, fee-based assets which are core to the energy infrastructure of growing markets." Consequently, during the period in which Kinder and Morgan have run the companies, the stock of KMI compounded at 80% annually from 7/99 through 12/01 and KMP compounded at 50% annually from 1/97 through 12/01 (including reinvested dividends).

Concerns about Kinder Morgan
All of this sounds great, so why is KMI down about 25% this year, and KMP by nearly as much? Primarily because investors fear another Enron (OTCBB: ENRNQ) debacle. Superficially, the parallels are ominous: the original company upon which Kinder Morgan was built was purchased from Enron in 1996, and Rich Kinder was COO of Enron until he left in late 1996 to join Bill Morgan. Both companies are/were rapidly growing energy companies utilizing acquisitions, debt and complex structures, including off-balance sheet entities. There is/was insider selling at both.

Sounds like another stock destined for bankruptcy, right? WRONG! I believe this is a classic example of the "sell-first-ask-questions-later" madness that often afflicts Wall Street -- and it is resulting in a very attractively priced stock.

Kinder Morgan's attractive business
Prior to discovering Kinder Morgan, I had never invested in any energy or natural resources companies for two primary reasons: They are generally highly cyclical, vulnerable to commodity price swings (which I have no ability to predict), and also tend to be capital intensive. Both Kinder Morgan companies have largely mitigated the former problem because their core business, operating pipelines, generates revenues based on per-unit pricing, rather than the value of the product passing by. It's like a tollbooth: Every car pays the same amount, regardless of its value.

Regarding the latter problem, there's no question that buying, building, and operating pipelines is capital intensive -- which is why I own Kinder Morgan not Kinder Morgan Energy Partners. A large and rapidly rising portion of KMI's operating income -- 35% in 2001 and 46% projected for 2002 -- is derived from KMI's interest in KMP (mainly the general partnership interest, but KMI also owns 19% of the partnership units of KMP).

KMI's general partnership interest is a truly great business. KMI has to put up little of the capital -- that's raised via KMP's debt and equity offerings -- yet it earns half of KMP's incremental profits. Of course, KMI would suffer half of any decline in KMP's profits, but I believe continued growth is likely given the stable nature of KMP's businesses and the superb execution demonstrated over many years by the Kinder Morgan management team.

One other thing I like a lot: the founders, Rich Kinder and Bill Morgan, take only $1/year in salary and receive no bonuses or stock options. I never thought anyone would make Warren Buffett look overpaid! (Buffett's salary is $100,000 annually.) Like Buffett, Kinder and Morgan only make money when the stock price rises (a lot of money at that, as they own 19.4% and 3.6% of KMI stock, respectively).

Rebutting the concerns
So what about all the parallels with Enron? Pure rubbish. A careful analysis reveals that Kinder Morgan has almost nothing in common with Enron. Here are the facts:

Enron was largely a trading company, which depended on market confidence to operate. When that confidence evaporated, the company went poof. Kinder Morgan owns and operates hard assets.

As I noted in "Lessons from the Enron Debacle," Enron's cash flows were weak and erratic. The Kinder Morgan companies generate huge, stable, and rapidly growing cash flows. In 2001, KMP generated $581 million of operating cash flow, and had $295 million of capital expenditures (more than 80% of which was for growth rather than maintenance). Similarly, KMI had $437 million of operating cash flow vs. $124 million of cap ex.

The debt levels at the Kinder Morgan companies are moderate: 47% debt-to-capital for KMI and 52% for KMP. Even if the companies cannot or choose not to raise additional capital, they can easily service their debt from internally generated cash flows.

Kinder Morgan has almost no off-balance sheet financing, but what little there is, is fully disclosed and required by GAAP.

The only significant insider selling at Kinder Morgan is from Bill Morgan, who recently announced that he is transitioning to a non-executive role over the next year. For estate planning and diversification reasons, he anticipates selling about half of his 4.5 million KMI shares over the next three years. Given the current stock price weakness, he has suspended sales and said he will not sell below $50. Rich Kinder has never sold a single share of his stake and other insiders were substantial buyers in January and February.

Even before it blew up, Enron was well known for its lack of disclosure (little wonder, given what we now know about the company). In contrast, I attended Kinder Morgan's analyst day in January and have never seen a company disclose as much detailed information about its operations. (Click here for copies of the presentations that day.)

While acquisitions have fueled the growth of the Kinder Morgan companies, they can now generate solid double-digit bottom-line growth without any further acquisitions.

Extensive investigations into Enron have revealed not a single shred of evidence linking Rich Kinder to any of the shenanigans that subsequently took place. Everything I've seen and heard indicates that his integrity is above reproach -- and no-one doubts his skills as an acquirer and operator in his industry.

Why is the stock attractive?
KMI recently announced that it was comfortable with the 2002 earnings guidance it had previously provided to investors for both KMP and KMI. The projections for KMI, $2.59 in earnings per share for the year, would represent 32% EPS growth over 2001, a remarkably high number, especially in this weak economic environment. And I think this number is conservative, as it doesn't factor in likely acquisition activity. In 2001 KMI was originally projected to earn $1.66 - $1.79/share, but ended up earning $1.96, mainly because of accretive acquisitions. Based solely on internal growth, KMI should be able to grow EPS at 18-20% annually, and with a modest level of acquisitions, 26-28% annually (for details, see pages 22-26 and 30-31 of this presentation in .pdf format).

So what's a reasonable price to pay for KMI? I'm no fan of relative valuations, but consider the S&P 500, which trades at 24x this year's expected earnings. Surely KMI should trade at a premium to this, given its mouth-watering economic characteristics and growth (earnings for the S&P 500 are projected to decline 12% this year vs. KMI's 30%+ growth). Yet at a recent price around $43, KMI is trading at less than 17x this year's estimated earnings of $2.59.

But the stock is in fact even cheaper, as KMI is one of those wonderful businesses in which true cash earnings are greater than reported earnings. Primarily because DD&A significantly exceeds maintenance cap ex on an ongoing basis, plus some one-time tax credits, KMI projects that its free cash flow in 2002 will be $3.37/share, 30% more than reported EPS of $2.59. (KMI defines FCF as net income plus DD&A minus maintenance cap ex plus the net of book taxes minus cash taxes.) This means that KMI is trading at less than 13x estimated free cash flow for 2002. For a business of this quality, that's cheap any way you cut it. (KMP is similarly cheap, and I'd recommended it for income-seeking investors.)

Conclusion
I like to buy high-quality businesses, which has made the last few years frustrating as the stocks of almost all such companies have been priced much too high for a bargain-hunter like me. Thus, I'm delighted to see the stock of a great business like KMI priced where it is today, due to the market panicking and allowing rumor and innuendo rather than facts to rule the day.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned a position in KMI at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/