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December 7, 2009

Is KMP too Big to Grow?


As this title implies, I set out to make the case that Kinder Morgan Energy Partners (KMP) is too big to sustain its annual per unit distribution growth rate.  I invest in and focus on smaller MLPs that distribute much less of their overall cash flow to their general partner.  As a result of incentive distribution rates, KMP’s general partner receives 44.5% of all distributions, or $979.5 million annually at its current distribution rate.  That’s a fairly large bonus!

I believe the best returns in the industry come from younger, smaller MLPs who benefit from the law of small (or smaller) numbers.  Aside from watching segment operating results from KMP as a signal of the health of similar businesses, I don’t pay much attention to KMP, which may seem counterintuitive given that it is the most well known and second biggest MLP with equity market cap of approximately $16.1 billion.


After running the numbers, I am here to say I was wrong.

KMP can grow its distribution per unit 4.8% annually over the next 5 years.  Coupled with a 7.3% yield, KMP could generate total returns of more than 12% annually.

While there are better total returns to be made in other MLPs, KMP is operationally diverse and has an excellent management team, with a proven track record of consistent distribution growth.  The partnership practically invented the industry as it exists today, by showing how the MLP structure could effectively be used a growth vehicle.  KMP has grown its distribution on average 12.8% annually in the past 10 years and 7.5% annually in the past 5 years.  Additionally, KMP’s unit price held up very well relative to other MLPs over the last 18 months, the lowest close for KMP in the past 2 years was $38.75, roughly 33% off its current price, compared to the MLP index whose low was approximately 44% lower than today’s value.

Now, on to the numbers.  My goal was to determine how much capital KMP would have to invest in acquisitions and growth projects (at assumed rates of returns) to generate the requisite distributable cash flow to grow per unit distributions 4.8% per year.  This growth rate was the magic number because management recently announced that KMP would grow its distributions per unit 4.8% in 2010 to $4.40.

For projections, I assumed a small consensus of analyst estimates (4 analysts to be exact) for 2010 through 2014, which already includes growth capital spending numbers of approximately $4.0 billion over those 5 years, including $1.6 billion in 2010.

Assumptions for Organic Growth Projects:

  • 5.0x EBITDA multiple
  • Maintenance capital expenditures of 6.5% of EBITDA

Assumptions for Acquisitions:

  • 8.0x EBITDA multiple
  • Maintenance capital expenditures of 10% of EBITDA

Financing Assumptions:

  • 50% of growth capital spending on organic growth projects and 50% on acquisitions
  • Acquisitions and projects financed 50% equity and 50% debt
  • Equity issued at 7.0% yield
  • Long term debt issued at 6.5% interest rate
  • 1.02x distribution coverage

By my estimations, KMP would need to spend a total of $6.6 billion in growth capital over the next five years, or an average of $1.325 billion per year.  These numbers may seem big, but in the 5 years prior to 2009 (2004-2008), KMP averaged $1.8 billion in growth capital spending (including acquisitions, growth capital expenditures and joint venture contributions).  In 2009, KMP is on pace to spend approximately $3.3 billion in growth capital spending in 2009, including $27.5 million in acquisitions, $1.6 billion in JV contributions and $1.7 billion in growth capital expenditures.

One acquisition that has been discussed recently is the potential for KMP to buy out ConocoPhillips’ 25% stake in the $6.8 billion Rockies Express Pipeline project, of which KMP already owns 50%.  If that acquisition were to happen, it would likely come at a price lower than construction cost, effectively cost averaging KMP’s position in that project down.

While the 4.8% distribution growth going forward is achievable, what these numbers do indicate is that the days of 8-12% annual distribution growth are behind KMP.  To grow at those rates, the partnership would need to spend roughly $12.2 billion in the next 5 years on growth.  While this is not out of the realm of possibilities, it would likely require that KMP gobble up some whole MLPs.  Taking on such a challenge would require KMP to go to the capital markets multiple times to issue large amounts of equity, which would be difficult given the limited ability of the sector to digest large equity issuances.  Lastly, with large projects come larger sensitivities to cost overruns and missteps (see KMP’s Rockies Express Pipeline).

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