The "Kinder Morgan Is a House of Cards" Theory and the Pros and Cons of Going Short (KMI)

Companies that engage in great amounts of financial engineering are always worth looking at as potential shorts. A lot of skullduggery can occur when the razzamatazz really gets going.

This week both Barron's which has been skeptical for a while, and FT Alphaville which has, until today, been neutral take a look at all the moving parts.

Regarding a short on KMI, I hate paying dividends on short positions.
Hate it, hate it, hate it.
But I might be tempted in this case. And the rate of ascent on the stock is definitely rolling over.

First up, FT Alphaville:
Kinder Morgan, MLPs and the sell case

The $44bn self-acquisition of Kinder Morgan has been heralded by some as a great deal for shareholders.

But is it? Is it really? At least for the ordinary investors?

We’ve already wondered about the motivation for the deal.

Among our initial thoughts: Kinder Morgan MLP units trading under the KMP ticker had got expensive due to the heavy promotion of MLP structures as a safe-ish and yieldy investment at a time of low interest rates.

But we now think there may be more to it than that.

First, there’s the Master Limited Partnership (MLP) structure itself, which was pioneered and popularised for use in the energy infrastructure sector by Kinder Morgan’s chief executive, Richard Kinder, in the 1990s. It’s certainly not your average run-of-the mill equity instrument.

Instead of owning shares in energy companies, investors in MLPs receive units that entitle them to the cash-flow from partnership-owned assets. They’re tax efficient because depreciation on the assets becomes tax deductible on a partner level.

To us, MLPs evoke the Production Sharing Agreements (PSAs) used by oil-rich foreign countries to incentivise private investment by non-residents.

Under these structures, if the investor-led projects strike oil and achieve cash-flow, their capital in the form of “cost oil” is returned to them before any profit share is subjected to tax. The host country, meanwhile, takes a royalty payment from the beginning (a share of the flow) and is provided with an extremely low cost of capital — because all the risk is borne by the foreign investors doing the oil hunting. It also retains the right to tax the foreign entity’s remaining “profit oil” generated by the project.

Foreign investors don’t tend to mind the structure because asset depletion or depreciation becomes the host country’s problem while the ongoing cash-flow remains theirs. Indeed, once their capital is returned they can simply transfer it into further cash-flow generating investments while retaining their rights to the now (taxable) cash-flow from depreciating assets.

But with MLPs the depletion and depreciation remains a real cost which must be capital accounted. While it is true that the charge is tax deductible, it must be remembered, taxes are never avoided just deferred until the units are sold.

Some independent analysts, such as Kurt Wulff, have been critical of the MLP structure for years, claiming it only works for shareholders during the growth phases of a partnership.

Due to capital depreciation costs (so-called depreciation, depletion and amortisation, known as DD&A) the investor can in the long run, he believes, end up paying the company in question more (via the cheapness of the capital provided) than what they defer in tax over the period.

That’s considered okay in the MLP marketing spiel, however, because a tax deferred is a tax not paid.

Furthermore, as Kevin Kaiser, an analyst at Hedgeye, explains to us investors are simply encouraged to never sell their units....MUCH MORE

And from Barron's:
Tax Breaks -- For Whom?

Two big deals in the world of tax-advantaged income investments -- MLPs and REITs -- signal that change is afoot. But don't be fooled by corporate maneuvering: These deals are tax-advantaged for the companies themselves.

Two tax-advantaged income investments have gained attention by way of two unusual transactions. One raises questions about the sustainability of its growing asset class, while the other expands its asset class' reach.

Last week, Kinder Morgan (ticker: KMI) said it will unify its energy empire within a single company, abandoning the master-limited-partnership structure it helped popularize. Kinder will absorb its subsidiaries -- Kinder Morgan Management (KMR), El Paso Pipeline Partners (EPB), and Kinder Morgan Energy Partners (KMP), the latter two both MLPs -- into a traditional C corporation structure under the KMI ticker. (See related story, "Treading Gently With Kinder Morgan.")

In a common MLP setup, a parent company, known as the general partner, helps run the underlying limited partnership, which typically owns pipelines that transport natural gas and other fuels. In return, the general partner receives a growing share of the cash stream the MLP produces. But Kinder Morgan Inc. got to the point where it was siphoning off 45% of the cash from its underlying MLPs, which still had to pay investors and fund projects. 

These payments to the general partner, known as incentive distribution rights, encourage growth in an MLP's early years, according to Brian Watson, director of MLP research at Oppenheimer SteelPath MLP funds, but over time, they can become a burden. Kinder attained a size and longevity that tested the model. 

No other MLP pays more than 34% of its distributable cash flow to a general partner; Watson would like to see MLPs keep that to 25% or less. "Solving this issue is something that's been talked about for years," he says. "At some point, [Kinder] crossed a line where it was no longer just an incentive mechanism but instead became a drag on performance."...MORE

This isn't the first time Barron's declined to wear the cheerleader uniform.
Back in February they ran a cover story:
Kinder Morgan: Trouble in the Pipelines?

The $500 billion master-limited-partnership sector is the sausage maker of the investment world. Buyers love the yields -- now averaging about 6% -- but many know little about how the yields are generated. And Kinder Morgan, the country's largest energy-infrastructure company, may be the biggest sausage maker of them all. The publicly traded companies in the Kinder Morgan family own or operate 80,000 miles of pipelines carrying natural gas and petroleum products, and 180 terminals that store oil and other commodities. The company also produces oil from mature fields in Texas. 

In all, the Kinder Morgan complex -- Kinder Morgan Energy Partners (ticker: KMP), Kinder Morgan Management (KMR), Kinder Morgan Inc. (KMI), and El Paso Pipeline Partners (EPB) -- has an enterprise value (market value plus net debt) of over $100 billion, ranking it third behind only ExxonMobil (XOM) and Chevron (CVX) in the entire U.S. energy business. Last year, the company distributed more than $4 billion to public shareholders. 

The bull case for the Kinder Morgan companies is that they offer a high-yielding way to participate in the booming U.S. energy infrastructure build-out. Bulls invoke the toll-road analogy, saying Kinder Morgan and its peers generate the bulk of their revenues from stable, government-regulated returns on their pipeline assets.

With a motto of "run by shareholders, for shareholders," Kinder Morgan has generated superior returns since 1997, when CEO Richard Kinder took over. Those gains could be difficult to sustain.

The largest piece of the Kinder Morgan complex, Kinder Morgan Energy Partners, is a master limited partnership that is widely owned by retail investors. It trades for about $79 and yields 6.9%. Its twin, Kinder Morgan Management, which is structured as a corporation for tax purposes, pays a comparable dividend, but in stock not cash. Kinder Morgan Inc. is the general partner, which controls the Kinder Morgan MLP and El Paso Pipeline Partners. It's headed by Rich Kinder, whose 23% stake is worth $8.1 billion. It trades at about $33 and yields 4.9%....MORE

After the Barron's piece a Seeking Alpha contributor called his post "Kinder Morgan Energy Partners: Still Not A House Of Cards" which defense I thought was pretty funny and from which I purloined the headline for our post.

For those interested here is the KMI response to the February Barron's story, (6 page PDF)

All that being said the stock is showing its first real weakness day since the announcement:

On Aug. 8 the stock closed at $36.12, opened the following Monday at $42.41, shook out a couple hundred million shares over the course of that week and closed Friday at $41.43. Today it is off 1% at $41.00 on a 1% up day for the larger market.

Via Yahoo Finance: