February 4, 2002; Wall Street and Financial Media Overstate Value and Understate Risk in Kinder Morgan

Some investors may be willing to pay more for Kinder Morgan Energy Partners stock than would otherwise be the case because of interpretations of financial disclosures published by Wall Street underwriters and by the financial media.  In our opinion those interpretations are confusing, to use a term more innocuous than misleading or a stronger word.  If that is the case we would think the sources that contribute to the confusion would want to clear it up as soon as possible, particularly before any new securities are offered.  If some investors do pay more than they would otherwise, the stock price of KMP and by extension KMR and KMI might fall somewhat when the confusion is cleared up.  Conceivably some limited partners might seek compensation from KMI, its auditor or its underwriters.

The sources of confusion we see concern reported values for cash flow per unit and book value per unit.  In both cases, the research sources appear to overlook the economic interest of the general partner.  As we have pointed out, the general partner, KMI, gets half the cash flow from any new investment on behalf of the limited partners, KMP, and indirectly, KMR.  We have suggested that half the cash flow ultimately is likely to be more than half the value.  

Cash Flow Per Unit Overstated

Cash flow is both an indicator for determining value and for sizing up risk.  Last year KMP reported net income of $443 million and depreciation, depletion and amortization (DD&A) of $142 million.  The total of $585 million might be considered cash flow.  We would say that the limited partners have access to half or less of that cash flow.  Half of $585 is $292 million.  Divide that by 154 million average units outstanding for the year and we get $1.90 per unit.  Applying a multiple of 6.1 times would produce our present value of $11.60 per unit.  Comparing cash flow to stock price of  $34 implies a cash flow multiple of 18 times, rather high valuation by the standards of the energy industry.

As a measure of risk an investor might compare cash flow to distribution.  In the sample calculation above cash flow comes out less than the distribution of $2.15 per unit declared for last year.  That is an indicator of high risk that the distribution may be reduced in the future.

Investors who were persuaded to invest in KMP by the underwriter of the securities may get a different picture.  We have seen recent research, for example, from Broker M and Broker U that show on the front page of multi-page analyses cash flow per unit of $3.61 and cash flow per share of $3.71 respectively.  Broker M further displays Price/Cash Flow of 10.3x, apparently calculated using a stock price of $37.31.

Thus, the marketers of Kinder Morgan securities are displaying cash flow per unit results  almost twice what we calculated above.  Apparently the analysts ignore the fact that half of incremental cash flow goes to the general partner.  Investors persuaded to buy units by Broker M and Broker U may have thought that they were getting twice as much value as they were actually getting.  On the risk side a large excess of cash flow per unit compared to distribution per unit makes the ability to pay the distribution look much stronger than it really is.

Book Value Per Unit Overstated

Book value is also an indicator for determining value and for sizing up risk.  Last year KMP reported limited partner's capital at the end of the third quarter of about $3.1 billion.  The term refers to the value of assets minus liabilities figured roughly at cost.  We would say that the limited partners have access to half or less of that ongoing cost-based value, or about $1.55 billion.  Divide that by 165 million units at the end of the quarter and we get $9.40 per unit.  Comparing book value to stock price of  $34 implies a Price/Book ratio of 3.6x, rather high valuation by the standards of the energy industry.

Broker M presents book value at $18.84 per unit and Price/Book at 2.0x when the stock price was $37.31.  Broker L presents a front-page book value of $20 per share.  Investors who do their own research, or want an independent check, might turn to the websites of The Wall Street Journal, Forbes or Yahoo, for example.  There the investor would see book value featured as a valuation measure and stated to be about $24 per share. 

Thus, Wall Street and the financial media are telling investors that book value per unit is twice or more as high as a more realistic number.  Apparently the research sources are again ignoring the general partner interest.  Some investors may have thought that they were getting twice as much value as they were actually getting.  On the risk side a smaller gap between stock price and book value makes the valuation risk look much less than it really is. 

Issuer's Dilemma: Act Now or Ignore Confusion Over Accounting

Kinder Morgan, its auditor, underwriters and the financial media can act now to clear up confusion in Kinder Morgan's accounting or continue to ignore it.  Acting now might have an adverse stock price impact.  Instead ignoring the confusion may work for a while longer.  If the confusion is as significant as we believe it is, confused investors may eventually catch on and the stock price may go down later.  In that case the potential liability for failing to act now may be greater than the consequences of acting now to clear up confusion.  Either way investors in Kinder Morgan stocks are at high risk, in our opinion.  In this market, who needs to take those risks?