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It Isn’t Kinder Morgan That’s a House of Cards

By Jim Mueller, CFA - Sep 16, 2013 at 8:04AM

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Is Kinder Morgan cutting maintenance capex? Hedgeye says yes, I say no.

On Wednesday, Sept. 4, an email sent out by research firm Hedgeye, along with the author's comments on Twitter , caused shares of Kinder Morgan (KMI 1.34%) to fall 6% . Hedgeye claimed that the Kinder Morgan pipeline companies were "a house of cards" and that a report detailing this would be released on Tuesday, Sept. 10 .

Beyond the obvious questions of why announce it this way and why the delay, the share price movement shows how silly some investors are, selling on the merest whiff of supposition without taking time to see if analyst Kevin Kaiser of Hedgeye was right or blowing smoke.

Instead of knee-jerk selling, I held the shares of KMI my wife and I own, read the report when it finally came out, and was not impressed.

The thesis 
The major point presented by Kaiser is that Kinder Morgan has very low maintenance capital expenditure (capex), presumably cuts maintenance capex upon acquiring other pipeline operators which leads to an increased incidence in pipeline accidents, and then uses replacement of the pipes (an expansion capex) instead to "catch up" on neglected maintenance. 

The reason for this is to enrich KMI (the general partner of the limited partnerships KMP and El Paso Energy Partners (NYSE: EPB)), as well as Richard Kinder, at the expense of the unit holders of the limited partnerships . This enrichment happens in part because maintenance capex is deducted from distributable cash flow (DCF) payable to all the partners, while expansion capex is not. By shifting maintenance capex to expansion capex, more DCF is available.

Kaiser also argued that KMI receives too much in incentive distribution rights , but I'm not going to address that here.

Maintenance capex and DCF
So is Kinder Morgan's definition of DCF unique? I looked at how El Paso defined DCF and where maintenance capex fit in. Prior to being acquired by Kinder Morgan, it too removed maintenance capex when calculating DCF . Magellan Midstream Partners (MMP 0.14%) and Boardwalk Pipeline Partners (BWP), two other pipeline operators, both define DCF the same way. Seems to be industry standard, so nothing apparently nefarious there.

Kaiser argues, however, that Kinder Morgan uses the "apophatic definition" that any capex that is not expansion capex is maintenance capex , and can assign dollars spent to either category. But Kinder Morgan is hardly unique here, either.

Looking again at El Paso, they define it the same way. Not in those specific words, but in context : "Our total cash capital expenditures for the year ended December 31, 2011 were $264 million, including $101 million for maintenance and $163 million for expansion." Other pipeline operators I looked at also split total capex into the same two categories.

It's industry standard, so why should Kinder Morgan be called out? However, Kaiser has more points to argue.

Maintenance capex vs. depreciation
Kaiser argues that maintenance capex should be larger than depreciation . Why? Besides an inflation argument that I found quite confusing , he points out that Chevron (CVX 0.03%) and ExxonMobil (XOM 0.71%) spend huge amounts in capex in order to keep production constant, much more than depreciation. The thought appears to be that these guys are in the oil and gas business, just like Kinder Morgan, so Kinder Morgan should also have maintenance capex at least equal to depreciation.

Pipelines are pretty static things, once they're installed. The only moving parts that would require regular replacement are the valves, the pipeline inspection "pigs," and the compressors in the compression stations . Only if a leak is found or corrosion is discovered does there need to be expensive replacement of part of the pipeline.

Chevron and ExxonMobil, on the other hand, own refineries, trucks, storage tanks, and retail outlets, and capitalize much of their well costs,  among other things. It seems reasonable that the capex and D&A issues are entirely different for these companies compared to pipeline operators. In other words, it's a huge case of apples to oranges comparison.

Kinder Morgan cuts maintenance spending
Kaiser goes to some lengths arguing that Kinder Morgan cut maintenance capex on assets obtained from Santa Fe Pipeline. (He actually addresses maintenance expenses, a different line item . It's clear, though, that he equates this with maintenance capex.) He then presents a series of pipeline accidents and implies that it was this and similar cuts to maintenance spending that led to the accidents. However, he doesn't present accident data from the time before Kinder Morgan obtained those assets, nor does he present data from other operators (who presumably keep maintenance spending at proper levels) showing a lack of accidents. In other words, he fails to connect the dots between an argued decrease in maintenance spending and an increase in pipeline accidents.

Further, the numbers do not bear Kaiser out. I looked at six pipeline operators, including Kinder Morgan and El Paso before Kinder Morgan acquired it. I was looking to see how much they all spend on maintenance capex on their pipelines. Here's what I found for 2012:

Operator

Miles of Pipeline

Maintenance Capex, 2012 (in millions)

Maintenance Capex, 2012, Per Mile

Boardwalk Pipeline Partners 

14,410

$79.8

$5,538 

El Paso Pipeline Partners 

12,900

$91*

$7,054*

Enbridge Energy Partners (EEP)

17,900

$123.8

$6,916

Enterprise Products Partners (EPD 0.74%)

50,000

$365.8

$7,316

Magellan Midstream Partners 

9,600

$64.4

$6,708

       

Kinder Morgan Energy Partners (NYSE: KMP)

46,000

$285

$6,196

*Company projection for 2012; El Paso was acquired in May 2012 . Source: Company 10-K filings for 2012 (for 2011 in the case of El Paso).

As you can see, Kinder Morgan lies right within the range of what five other companies spend per mile on maintaining their pipelines. If Kinder Morgan is purposefully keeping maintenance capex low to boost DCF, it should be reflected in much lower amounts per mile spent compared to the others. It's not.

Given that, how strong is the argument that Kinder Morgan is boosting distributable cash flow by cutting maintenance capex and hiding what should have been spent there in expansion capex?

Not very.

Summing up
• A spate of pipeline accidents after change of ownership could be due to other events or just plain chance. Kaiser does not link cause and effect between presumed cuts to maintenance capex and any increase in accidents.

• Maintenance capex does not have to exceed DD&A expense.

• Kinder Morgan is not spending less than other pipeline operators on maintenance capex on a per mile of pipeline basis.

• Kinder Morgan does not appear, therefore, to be inflating distributable cash flow.

As a result, it is my opinion that Kaiser's and Hedgeye's argument is significantly flawed and I would not let it dictate any investing decision.

Jim Mueller is an analyst for Motley Fool Stock Advisor and owns shares of Kinder Morgan. The Motley Fool recommends Chevron, El Paso Pipeline Partners LP, Enterprise Products Partners L.P., Kinder Morgan, and Magellan Midstream Partners, L.P.. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Kinder Morgan, Inc. Stock Quote
Kinder Morgan, Inc.
KMI
$17.70 (1.34%) $0.23
Exxon Mobil Corporation Stock Quote
Exxon Mobil Corporation
XOM
$89.08 (0.71%) $0.63
Chevron Corporation Stock Quote
Chevron Corporation
CVX
$153.69 (0.03%) $0.05
Enterprise Products Partners L.P. Stock Quote
Enterprise Products Partners L.P.
EPD
$25.89 (0.74%) $0.19
Enbridge Energy Partners, L.P. Stock Quote
Enbridge Energy Partners, L.P.
EEP
Magellan Midstream Partners, L.P. Stock Quote
Magellan Midstream Partners, L.P.
MMP
$50.01 (0.14%) $0.07
Boardwalk Pipeline Partners Stock Quote
Boardwalk Pipeline Partners
BWP

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