Kinder Morgan Energy Partners LP (KMP) is the country’s largest pipeline master limited partnership. Perhaps the clearest way to think about a pipeline MLP is as a toll road. According to their website, Kinder Morgan Energy Partners LP owns an interest in or operates approximately 75,000 miles of pipelines and 180 terminals. The company’s pipelines transport natural gas, refined petroleum products, crude oil, carbon dioxide (CO2) and store a variety of energy-related products and materials at their terminals. These would include gasoline, jet fuel, ethanol, coal, petroleum coke and steel.
Master Limited Partnerships (MLPs) were authorized in 1997 by Congress under the Internal Revenue Code Section 7704 in order to promote investment in the energy sector. The law greatly facilitated the formation of midstream MLPs such as Kinder Morgan Energy Partners LP. Midstream energy is mainly the transportation of oil and gas through pipelines. Since an MLP must by law derive 90% of their income from “sources related to income from specific sources, including dividends, rents, interests, capital gains, and mining and natural resources income identified in Section 613 of the tax code”, we believe that cash flow is more relevant than earnings as a gauge for valuation.
As we will soon demonstrate, Kinder Morgan Energy Partners LP (NYSE:KMP) has produced a consistent record of growth in distributable income. This is important, because when a master limited partnership such as Kinder Morgan Energy Partners LP (NYSE:KMP) is looked at in the traditional sense based on its record of operating earnings, a distorted picture of its performance is presented. The following F.A.S.T. Graphs™ on Kinder Morgan Energy Partners LP (NYSE:KMP) based on operating earnings produces a vivid example of what we are stating. From this perspective, we find no clear correlation between Kinder Morgan Energy Partners LP’s operating earnings and its stock price over time. In other words, the black monthly closing stock price line is disconnected from the orange earnings operating line. Consequently, it’s very difficult to ascertain whether or not this largest of all MLPs is fairly valued or not based on earnings.
On the other hand, when looked at from the perspective of distributable cash flows we discover a much more consistent view of Kinder Morgan Energy Partners LP. Consequently, we developed the Funds From Operations metric for our F.A.S.T. Graphs™ research tool which comes directly from the company’s statement of cash flows. Clearly, it is more reflective of this MLP’s ability to make distributions to its unit holders. With this iteration of fundamentals based on cash flows, we discover a lot of stability and consistency with this high-quality MLP and its cash flow generation.
In this example, we would argue that the most important lines on the graph that demonstrate fair value are the dark blue normal price/FFO line and the light purple income valuation line. Therefore, a brief explanation of each of these lines and how they relate to fair value are in order. The normal P/FFO (price to Funds From Operations) of 9.7, clearly depicts a valuation that the market has historically considered a fair value to place on Kinder Morgan Energy Partners LP. Consequently, it seems only logical to state that the best times to invest in this high-quality MLP would be when its P/FFO is below 9.7 as it is now.
We refer to the light purple line as the “income valuation line (REIT/MLP).” This overlay pertains more accurately to a REIT than it does an MLP, because it represents the total distributable cash, which a REIT is required to distribute 90% of. However, we believe it is also very useful when evaluating MLPs if looked at properly. Prior to offering this line as another proxy for ascertaining fair value, we would ask subscribers to draw a F.A.S.T. Graphs™ where they deleted the operating earnings line (orange line) and the normal PE ratio line. This would allow them to draw a graph showing distributions (dividends) only (light blue shaded area) with monthly stock prices (the black line) overlaid. The following graph depicts this iteration.
With the FFO metric added as an additional option, this measurement of valuation based on distributions (dividends) can now be revealed without having to take the F.A.S.T. Graphs™ apart. Note that when the entire graph is drawn with all of its lines, the entire complement of the distribution (dividend) is displayed on top of the green shaded area. This is because the distribution (dividend) is paid out of the green shaded area, which in this case is Funds From Operations. Consequently, the visual display of the light purple line or the “income valuation line” appears to be below the distribution (dividend) area. A closer examination will show that this actually depicts the precise amount of the blue shaded area or distributions (dividends) that are paid to unit holders.
When Kinder Morgan Energy Partners LP is looked at from the perspective of Funds From Operations, it is easy to see why this company has produced such an excellent record for shareholders. The following performance table shows that this, perhaps highest-quality of all pipeline MLPs, has produced a significantly above-average total rate of return. A one-time $1000 investment in this MLP on December 31, 1998 and held would have generated more than twice the original investment in distributions alone. Moreover, the growth of principal is also quite impressive averaging almost 12 times the capital appreciation of the S&P 500.
Kinder Morgan Energy Partners LP Business Segments
Kinder Morgan Energy Partners LP operates in five business segments. According to research from Standard & Poor’s Corp. the natural gas pipeline segment is the largest representing 29.5%, the CO2 pipeline segment comes in at 24.4%, the products pipeline segment at 21.9%, the terminal segment at 18.9% and the Kinder Morgan Energy Partners LP Canada segment at 5.3%.
MorningStar believes that the natural gas pipeline business will be a key beneficiary of drop-down assets from their acquisition of 100% of Tennessee Gas Pipeline (TGP) and a 50% interest in El Paso Natural Gas (EPNG) pipeline from Kinder Morgan Inc (NYSE:KMI). Consequently, MorningStar believes that Kinder Morgan Energy Partners LP’s business profile is moving back to its roots, and expects that the pipeline segment could increase to approximately 41% of their cash flows by the year 2016. This is important, because MorningStar also expects the important CO2 segment to slow somewhat. However, they also indicate that Kinder Morgan Energy Partners LP’s management is aware of the problem and working to rectify it in the future.
MorningStar also believes that Kinder Morgan Energy Partners LP’s other businesses should continue producing solid growth and that Kinder Morgan Canada could see major growth and expansion projects are approved. Consequently, we believe that Kinder is well-positioned and capable of continuing to produce the consistent above-average growth in Funds From Operations that unit holders have become accustomed to.
Summary and Conclusions
We believe that Kinder Morgan Energy Partners LP represents a very attractive total return play based on valuation and prospects for continued long-term growth. Strong internal growth and strategic acquisitions, coupled with a strong financial base give us high confidence as we look to the future. Perhaps