Kinder Morgan: A Promising Pipeline Play

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The pipeline will have initial capacity of 1.4 billion cubic feet per day, of which more than 1.3 billion cubic feet per day is fully subscribed with long-term binding commitments. Construction on the project, a 50/50 joint venture of KMP and Energy Transfer Partners (ETP), is expected to begin this summer.

Valuation

Kinder Morgan units have performed well in 2008 (up about 25% through late April) despite overall weakness within the pipeline MLP group. Our model assumes Kinder Morgan will reach its goal of increasing 2008 distributions by 16%, to $4.02 per unit. After achieving a first-quarter distribution coverage ratio of 1.2 times, we are increasingly confident of Kinder Morgan's ability to reach its distribution goals.

Given our view that Kinder Morgan units exhibit the strongest distribution-growth profile among its peers, we believe the units warrant a premium valuation. The units are currently yielding about 6.4% based on annualized first-quarter distributions of 96¢ per unit ($3.84 annually), compared with a peer average of approximately 7%. Our 12-month target price of $68 is based on a blend of a premium-to-peers target yield of 6% on our one-year-out distribution estimate and a target 11 times enterprise value to estimated 2008 EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple, comparable to peers.

Corporate Governance

With the privatization of Knight, which owns the general partner of Kinder Morgan, we believe there is a lack of transparency when it comes to Kinder Morgan's corporate governance. Kinder Morgan itself does not have any officers or directors and operates under Knight's corporate governance guidelines. Knight's guidelines state that the number of directors shall be established from time to time by the holders of the voting shares. On the date these guidelines were adopted, the number of directors was set at five. Three of the five board members are outside directors, and the nominating and compensation committees are chaired by the same outside director. Also negatively affecting our view is the occupation of the roles of chairman and CEO by the same person.

A positive factor we see in terms of corporate governance is the absence of a poison pill plan.

The primary risk to our recommendation and target price, in our view, is a downturn in the global economy that increases interest rates and reduces demand for energy products, leading to lower transportation volumes. Kinder Morgan is dependent on volumes running through its infrastructure, and if volumes decline, cash flow would be harmed. Kinder Morgan's business is also subject to environmental and other regulations. The general partner controls the assets of the partnership, and it is possible that conflicts of interest could arise between the interests of Kinder Morgan unit holders and the general partner.

Kaye, a chartered financial analyst, is an analyst for Standard & Poor's Portfolio Services. He is the author of The Standard & Poor's Guide to the Perfect Portfolio: Five Steps to Allocate Your Assets and Ensure a Lifetime of Wealth.