"Sell" recommendation from Hedgeye pushes Kinder Morgan yield to 6.75% and I say "Buy"

09/17/2013 7:37 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

The run up in U.S. interest rates and worries in the weeks leading up to tomorrow’s Federal Reserve decision on whether or not to begin reducing the central bank’s monthly purchases of $85 billion of Treasuries and mortgage-backed securities hasn’t been kind to dividend stocks, REITs (real estate investment trusts) or MLPs (master limited partnerships.) In fact pretty much anything that trades on yield has tumbled.

For example, units of Kinder Morgan Energy Partners (KMP), a member of my dividend income portfolio http://jubakpicks.com/ , had fallen from $83.35 on August 28 to $81.32 on September 10. That’s a pull back of about 2.4%.

But the damage has gotten a lot worse in the last few days. On September 11 an analyst with Hedgeye Risk Management told Fox Business Network that Kinder Morgan was a house of cards,” that “Kinder Morgan’s issues are very concerning,” and that “there are some very misleading statements with some of the non-GAAP financials.” Investors should sell Kinder Morgan. (The analyst, Kevin Kaiser, seems to have been talking about all the Kinder Morgan companies: Kinder Morgan (KMI,) the general partner; Kinder Morgan Management (KMR), which pays distributions in shares rather than in cash; and Kinder Morgan Energy Partners (KMP), the cash-distributing MLP.)

On that blast the units of Kinder Morgan Energy Partners have dropped to $78.17 at the close on September 17, a drop of another 3.9%.

Since I was about to recommend buying Kinder Morgan Energy Partners on the drop—since the yield has climbed to 6.75%--I thought it would be a good idea to dig into the report and Kinder Morgan.

My conclusion: I’m still recommending that you buy the units at this yield.

If I wanted to be really cynical, I’d say the report from Hedgeye is an effort to profit—if you sell short—by playing on general fears of a decline in yield assets in light of the possibility of rising interest rates and that Morgan Kinder Energy Partners in particular and MLPs in general make a good target because relatively few of the retail investors who own MLPs understand all of the ins and outs of this financial instrument. If I wanted to be less cynical, I’d say that the report dredged up “issues” that really aren’t issues to those of us who have followed or owned Kinder Morgan Energy Partners for a long time. (I’ve owned Kinder Morgan Energy Partners off and on in one portfolio or another since 2005.)

What kind of issues? Well, how about the charge that there are “some very misleading statements with some of the non-GAAP financials?” If I’m reading the Hedgeye report correctly, this refers to the way that Kinder Morgan Energy Partners reports maintenance capital. The report argues that the MLP is over-distributing cash flow because it under reports maintenance capital. This argument isn’t new—you can argue about what constitutes maintenance capital and growth capital. But importantly for investors Kinder Morgan has been consistent in how it treats this accounting over the years. I don’t see any evidence that the MLP has been shifting accounting treatments year to year in order to pump up cash flow from this source. Nor do I see signs that Kinder Morgan is starving its existing assets of maintenance capital in order to pump up cash flow. The report’s argument gets pretty convoluted here with charges that the company keeps maintenance capital spending low—either in fact or through accounting—to increase the distributions flowing to Kinder Morgan, the general partner, and Richard Kinder, the CEO of Kinder Morgan and cites accidents at Kinder Morgan’s pipelines as evidence of underspending. (The accounting here is interesting—if you’re an accounting geek since maintenance capital spending is deducted from distributable cash flow while growth or expansion capital spending isn’t.) But Kinder Morgan’s accounting practice and accident record seems within industry norms.

One of the telltale flaws in the Hedgeye report comes here when the analyst pulls in a comparison with Chevron (CVX) and Exxon Mobil (XON) to argue that Kinder Morgan’s maintenance capital spending should be larger than it is. Kinder Morgan Energy Partners shows way less in capital spending than those oil companies, which, the report argues is a clear sign that something is wrong with Kinder Morgan Energy Partners accounting. Or, it could be, that Chevron and Exxon Mobil are oil companies with huge budgets for finding oil and developing oil fields and Kinder Morgan Energy Partners is mostly a pipeline company.

Apples and oranges. If the report knows that, the argument is intentionally deceptive. If it doesn’t, then we don’t need to pay attention to this report.

I think the report is aware of this problem because it tries to haul in Kinder Morgan’s energy production revenue—about 30,000 barrels a day right now—so that it can argue that Kinder Morgan Energy Partners is actually like Chevron. And then to bring in the argument that you shouldn’t invest in Kinder Morgan Energy Partners because oil prices could fall and that would endanger cash flow. And the report tries to find something sinister in the MLP’s oil production revenue by arguing that 1) most people don’t know about it, and 2) the company hasn’t disclosed the danger of falling oil prices. I can’t speak to what most people know about Kinder Morgan Energy Partners’ revenue from energy production—it’s pretty clear in its financials—but I do know that management has been upfront about the possibility that oil prices could fall. If Kinder Morgan Energy Partners is a “house of cards” on these grounds, then so is Exxon Mobil. Kinder Morgan management has, in fact, pursued a strategy of investing in natural gas pipelines, in order to reduce its exposure to a possible decline in oil prices and slowing growth in its CO2 unit, once the big growth driver.

I think there are important questions to ask about Kinder Morgan Energy Partners before you invest. The key ones in this environment are can the company continue to raise capital to invest in new assets (since that’s what drives growing cash distributions) at a reasonable price and is the company able to find investment opportunities that generate a high return on investment? Historically, Kinder Morgan has been able to do both of these tasks very well and it looks like the company should be able to continue meeting those challenges for the foreseeable future.

My only knock on Kinder Morgan Energy Partners is that, as a investor favorite in the pipeline MLP space, the units can get pricy. Thanks to the report from Hedgeye Risk Management that’s not a problem right now, however.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any company mentioned in this post as of the end of June. For a complete list of the fund’s holdings as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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