Kinder Morgan Partners (KMP) for High Yield and Solid Distributions Growth

Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. The partnership is a member of the dividend achievers index, as it has managed to boost quarterly distributions for 16 consecutive years. Over the past decade, Kinder Morgan has managed to boost distributions by 8.20%/year. The partnership operates over 75,000 miles of pipelines as well as 180 terminals.

Its main business activity involves transporting commodities such as oil and natural gas for third parties such as oil and gas companies for a fee. In essence, Kinder Morgan operates a toll-based business, which generates stable fee revenues, without having exposure to fluctuating commodity prices. The volumes of oil and gas transported in the US are very stable and move by only a few percentage points per year. In addition, as the US is experiencing a boom in shale-gas production, there is a greater need for transporting carbons in the country. Companies like Kinder Morgan are in a great position to capitalize on this opportunity, with their pipelines in Marcellus Shale, Eagle Ford, Haynesville and Barnett Shale.

The partnership is operated by Kinder Morgan Inc (KMI), which is the General Partner. The general partner has an incentive distribution rights to 50% of distributable cash flows over certain amounts as well as 11% of the partnership. As a result, future distributions growth might be limited in the limited partnership level, but much higher at the general partner level. In a previous article I mentioned that there are three ways to invest in Kinder Morgan through general partner, limited partner and LLC interests.

Kinder Morgan’s CEO, Richard Kinder, owns 24% of the general partner interests in the partnership and received an annual salary of $1/year. As a result, since most of his net worth is invested in the partnership, he has the incentive to deliver solid results to unit holders in terms of distributions and total returns. It is rare in corporate America today to see management and shareholders goals align as closely as they do in Kinder Morgan. The other major company that comes to mind, where top management has a large stake includes Warren Buffett’s Berkshire Hathaway (BRK.B).

As a master limited partnership, Kinder Morgan (KMP) is a pass-through entity. This means that it does not pay taxes at the corporate level. Instead, each unitholder pays their portion of Kinder Morgan’s income, net of any deductions. Each year, unitholders receive a K-1 form, which describes their share of income, and how to report it on their tax returns. In general, for the first ten years or so, new unitholders generally do not pay taxes on their distributions, as they are classified as “return of capital” for tax purposes. While this creates a slightly more challenging tax return than the typical dividend paying stock, any serious do-it-yourself investor or investor with an average CPA should be able to handle this aspect. Taxation also makes investing in Kinder Morgan Partners slightly more challenging in deferred retirement accounts such as ROTH IRA’s. Luckily, the option to acquire i-shares of Kinder Morgan Management (KMR) exists, which pay distributions in the form of stock. As a result, unitholders do not receive any cash, and their distributions are viewed in the eyes of the IRS similar to stock splits. This means that unitholders of Kinder Morgan Partners, who invest in I-Shares such as KMR do not have to file any information with tax authorities regarding the shares they received as distributions from KMR. The only item that has to be reported would be the taxable event of a sale. Currently, KMR trades at a discount to KMP, which is why a lot of investors have chosen it over the partnership units.

This being said, Kinder Morgan does have the distributable cash flows from its vast portfolio of fee generating assets to pay for its generous partner distributions. For the first six months of 2012, Kinder Morgan had Distributable Cash Flow of $2.44 unit, while it paid out $2.36/unit. In 2011 DCF/unit was $4.68/unit and the partnership distributed $4.61/unit for the year.

Future distributions growth could come out of the ten billion in capex that the partnership plans to invest over the next five years. Projects in the pipeline include $4 billion for Transmountain Pipeline expansion, as well as expansions in company’s Natural Gas and Products Pipelines expansions. As General Partner plans on becoming a pure play GP by 2014, there will be expected drop-downs of assets to Kinder Morgan Partners, which would fuel future distributions growth as well. The Parkway Pipeline is another major project in South-East US, which is expected to come on-line in 2013, and be accretive to distributable cash flow per unit. Another driver of growth could include tariff increases as well as organic growth in oil and gas delivered. A third driver of growth could include strategic acquisitions. The acquisition of El Paso in 2011 will lead to Kinder Morgan Partners acquiring several projects. This in turn has increased the expected growth in distributions per unit from 5% to 7% in the foreseeable future.

One of the risks for the partnership includes interest rate risk. For every one percent move in interest rates, interest expense fluctuates by $55 million. If interest rates start to increase, that could affect distributable cash flow per unit, as new projects would be more expensive to build.

Full Disclosure: Long KMR and KMI

Relevant Articles:

- Master Limited Partnerships (MLPs) – an island of opportunity for dividend investors
- General vs Limited Partners in MLP's
- MLPs for tax-deferred accounts
- Kinder Morgan Partners – One Company three ways to invest in it