Kinder Morgan: A Promising Pipeline Play

With $7 billion in natural gas projects coming on line within four years, this limited partnership earns S&P's highest investment ranking

by Michael Kaye From Standard & Poor's Equity Research

Kinder Morgan Energy Partners (KMP; recent price, 60) carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy) based on total return potential. One of the largest publicly traded pipeline limited partnerships in the U.S., Kinder Morgan has a long-term growth profile that is favorable, in our view. With more than $7 billion in capital projects beginning to come on line over the next four years, the company should benefit from increased natural gas production in the Rocky Mountains and from the growing importance of liquefied natural gas (LNG). Kinder Morgan has among the most visible organic growth and lowest-risk profiles of any master limited partnership (MLP) in our coverage universe.

We expect Kinder Morgan's gas pipelines and terminal operations to be the main earnings drivers, benefiting from the first segment of the Rockies Express Pipeline now in service and terminal operations being helped by expansions and acquisitions. They will benefit from the completion of the East Line expansion project and the increase in ownership to 100% (from 50%) of the Cochin NGL Pipeline from Canada to the U.S.

Kinder Morgan's MLP structure means that income is allocated among all partners in the form of distributions in proportion to their ownership interest. We see Kinder Morgan increasing earnings per unit (EPU) by 34% in 2008, to $2.31, and 7% in 2009, to $2.48, on the addition of pipeline capacity, through expansion of existing facilities, new pipelines, or acquisitions. In 2007, Kinder Morgan declared distributions of $3.48 per unit, up 7%. Kinder Morgan declared a cash distribution of 96¢ per unit for the 2008 first quarter, up 16% on an annual basis. For 2008, we see distributions of $4.02, a 16% rise, well ahead of MLP pipeline peer averages of 6%.

Company Profile

Houston-based Kinder Morgan was formed in August, 1992. The partnership is one of the largest publicly traded pipeline limited partnerships in the U.S. in terms of market capitalization. In total, it transports refined petroleum products and natural gas through more than 25,000 miles of pipeline. In addition, it operates approximately 165 terminals handling refined products, coal, and other materials.

Knight Inc., one of the largest U.S. midstream energy companies, and its subsidiaries, owned, through its general and limited partner interests, 13.9% of Kinder Morgan on Dec. 31, 2007. Knight was recently privatized, and, given certain tax benefits, we expect this to be a positive for Kinder Morgan.

Kinder Morgan's objective is to expand its portfolio of fee-based energy transportation and storage assets, while increasing the utilization of its existing assets. As a result, we believe it does not face significant risks relating to the short-term movement of commodity prices.

Kinder Morgan has established what we view as an impressive history of increasing cash distributions to common unit holders. Over the past 10 years, the payout has increased at about 17% annually. The 2007 payout of $3.48 represented an estimated 1.0 times distributable cash flow. Reflecting its diversified operations, Kinder Morgan maintains coverage somewhat lower than the average MLP. We also note that as a relatively mature partnership, Kinder Morgan pays 50% of incremental cash flow above a certain threshold as incentives to the general partner, a higher level than most of its peers. Knight, through its ownership of the general partner and limited partnership units, received a total of 40% of all quarterly distributions in 2007.