March 18, 2002; Kinder Morgan Leaps from the Credit Crunch Fire to the Long Term Debt Frying Pan

It wasn't supposed to happen this way.  When management announced its $750 million acquisition late last year we got the impression that it would be financed by now with a new equity issue.  Some large investors apparently balked at the equity issue and the company was forced into debt financing.

Along the way it became necessary to renegotiate covenants to bank loans to permit more debt than previously contemplated.  When the acquisition closed it was financed with commercial paper.  We became concerned about a credit crunch, as we could not see how Kinder Morgan could be a viable borrower in the commercial paper market.  Apparently our concerns were well founded.  After only a few days Kinder Morgan floated a $750 million long-term debt issue.  Some of the same banks instrumental in approving the debt change apparently were also involved as underwriters in that financing. 

Now that the long term financing is in place, the Kinder Morgan entities are more highly leveraged than management was suggesting only a few months ago.  Bank covenants have had to be renegotiated.  Following the "smoking gun" we found earlier, those are signs of a deteriorating investment situation.  One need look no further than the high debt power companies AES and Calpine for examples of how a loss of confidence progresses. 

Ironically, the new Kinder Morgan debt is a better investment, in our opinion, than Kinder Morgan stock.  The yields are higher for the time being and the debt holders theoretically get paid before the general partner extracts its tax.  We expect the credit ratings to be lowered eventually thus implying that there is likely to be a loss in market value of principal, but less of a loss than we expect in the stocks.

Because the general partner tax takes so much of the upside, if any, KMP stock is more like debt in that the distribution is like the interest on a bond that doesn't go up.  In contrast to a bond, there is much less asset coverage for the stock.  Thus KMP stock is more like a low rated junk bond where the risk of default is high.  Such bonds have yields on the order of 12% or more.  The distribution yield on KMP and KMR is currently about 6.5%.