FOOL ON THE HILL
Growth in the Pipeline

Guest columnist Chuck Saletta says despite a rocky history, including roots in corporate plunderer Enron, Kinder Morgan Energy Partners deserves a closer look from value-minded investors.

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By Chuck Saletta
January 31, 2003

Once upon a time, a company named Enron Liquids Pipeline, L.P., owned and operated the pipelines that shipped the fuel Enron sold to itself, while pretending to provide an energy marketplace. Even in Enron's heyday, fuel eventually transferred across those pipelines and went to customers to heat homes, cook food, and power automobiles and factories.

Despite Enron's fraud and deceit, the pipeline company still exists today as Kinder Morgan Energy Partners (NYSE: KMP). The name changed when owners Rich Kinder and Bill Morgan bought it from Enron in 1996. This, of course, was well before the big E's ultimate undoing. And though Kinder was an Enron executive until joining Morgan, the companies' corporate governance practices were far afield from one another.

To wit, Kinder Morgan still exists as a public company, while its more famous cousin does not. In fact, it has a history of growth in earnings, operational cash flow, and cash distributions. It also has decent prospects for continued growth and a solid business model that make its current, longer-term 11% profit-growth projections seem achievable. While fuel prices are volatile -- rising and falling in response to everything from the weather to Middle East tensions -- Kinder Morgan isn't in the fuel business; it's in the fuel distribution business. Big difference. It makes money based on the amount of fuel that passes through its pipelines. The price of that fuel, while a concern to the buyers and sellers at each end of the pipeline, is of no concern whatsoever to Kinder Morgan. 

The company has four distinct units: natural gas pipeline, products (liquid petroleum) pipelines, carbon dioxide pipelines, and terminals (coal and other dry materials). Diversification protects it from being slammed by relative price swings among differing energy sources. A price hike in coal that causes more people to shift from electric to natural gas heat, for example, would likely shift revenues from Kinder Morgan's terminals unit to its natural gas pipelines unit. The biggest risk for the company would be a wholesale decrease in energy usage across its portfolio of transport offerings. It has happened, but there's a greater tendency to cycle among fuel stocks.

Kinder Morgan is the largest pipeline company in the U.S., and the business offers significant barriers for new entrants that help protect it from competition. Pipeline construction costs are significant, as are right-of-way acquisitions (ROWs), and the latter of the two is a decreasing resource. Once ROWs are granted, alternate sites have declining value and increasing cost of acquisition.

Pipeline construction also requires political capital, particularly if the construction comes close to populated areas. Pipelines have statutory minimal maintenance standards to protect against catastrophes, regardless of the revenue generated by the pipeline. In other words, the ramp up of a new pipeline or a new pipeline company can get expensive in a hurry, before the pipeline has generated the first penny of revenue. Kinder Morgan's infrastructure is already in place, and it has sufficient volume through its pipelines to cover the maintenance charges. Why would a new competitor try to compete against that?

The huge infrastructure costs required for pipelines also act as financial leverage for the company. A substantial part of Kinder Morgan's costs are static and must be paid regardless of business levels. Once those costs are covered, however, the incremental margins in the company's businesses become incredibly high. As more goods travel across the company's pipelines, a large fraction of that additional revenue travels straight to the bottom line. In the company's second quarter of 2002, for example, it had an 87% boost in its natural gas pipelines' operating income. Half of that income growth came from internal growth, such as higher pipeline utilization.

The other half came through acquisitions. In the past, the partnership has benefited from acquiring assets from its affiliated company, Kinder Morgan Inc. (NYSE: KMI). There's also a third financial component company that's also publicly traded, Kinder Morgan Management (NYSE: KMR). Future acquisitions will need to take place in a more competitive environment, however. The field of possible acquisitions that would make substantial difference to Kinder Morgan's bottom line has narrowed as the company has grown. Were Kinder Morgan a smaller company, the tougher acquisition climate would look like a difficult obstacle to overcome. Since it leads the industry, however, the company can negotiate competitive deals from a position of strength.

Kinder Morgan carries some Enron baggage due to its shared heritage and similar core business model -- both being pipeline companies at their bases. However, upon closer look, Kinder Morgan bears little resemblance to the Enron that collapsed. As Enron's fraud fed on itself, its reported profits grew much faster than the money it paid to its shareholders. As a limited partnership, Kinder Morgan has an extremely high distribution payment, and thus any attempt to fraudulently boost profits would ultimately be self-defeating. Higher reported profits would inevitably lead to higher cash payments to its partners, and if these reported profits were fraudulent, the company would quickly knife through its available cash.

The Master Limited Partnership structure taken on by Kinder Morgan requires federal tax liabilities to pass through to the partners, who then pay tax on them. As such, to attract investors, the partnership must pay out high dividends (currently Kinder Morgan's yield sits at 6.8%). This eliminates the double taxation on dividends, but not without risk.

Most public companies have limited liability protection; investors cannot lose more than they invest. In this type of partnership, however, there are two classes of partners: general and limited. The general partner has unlimited liability and can lose even unrelated assets, while the limited partners have standard limited liability protections. In Kinder Morgan's case, the general partner is owned by Kinder Morgan Inc., so owners of Kinder Morgan Energy units are protected from unlimited risk.

Given the risks, very few companies are structured this way. Founders have specific goals when they form these partnerships. The first is retention of control. No matter how much limited partners invest, total control of the company is held by the general partner. This allows the partnership to finance expansion via the sale of additional units without risking a hostile takeover. Additionally, owners of such partnerships benefit when the partnership's distributions exceed its earnings. The distributions above earnings are treated as returns on capital, not dividends. That portion of the distribution doesn't get taxed when paid. Instead, it serves to lower the basis price for the investor, increasing the potential for capital gains when the units get sold. Every year since 1993, Kinder Morgan has paid distributions higher than its earnings, a trend that's expected to continue.

Kinder Morgan manages to consistently distribute more than it earns due to the accounting rules of depreciation. As it expands, through acquisitions and by growing its business organically, it gains assets. Those assets get written down, or depreciated, over their useful lifetimes. That depreciation appears as a charge against the company's earnings, but does not actually cost the company cash, leaving money to pay for the distributions.

However, the company needs to keep growing, which it intends to do. As evidence of this planned growth, Kinder Morgan is investing $450 million for internal expansion projects. Company estimates for 2003 put per-unit earnings and distributions approximately 15% higher than 2002. In 2002, the company distributed $2.36 per unit, which would put projected distributions for 2003 at around $2.71. At its recent price of $36.85 per unit, Kinder Morgan's yield for 2003 is estimated to be about 7.35%. This puts its forward-looking price-to-distribution ratio below 14, on estimated growth of around 15%.

It's hard to fake cash payments to shareowners. The high distributions required by Kinder Morgan's corporate structure enforce financial discipline, which protects investors from the outright fraud that destroyed its ancestral home, Enron. That history is known and already priced into the partnership.

With a commitment to growth, a corporate structure that directly rewards owners, a market-leading position, a high yield, and a price weighed down by a historical connection to Enron, Kinder Morgan Energy Partners definitely deserves a closer look for value-minded investors.

Fool guest contributor Chuck Saletta posts on the boards as babyfrog. He currently holds no financial stake in any of the companies mentioned in this article. He lives in Cincinnati, Ohio, where he believes that the coldest winter in a decade is greatly benefiting the companies involved in heating his apartment. The Fool has a disclosure policy.