April 1, 2002; Kinder Morgan General Partner Tax: April Fool!

Last week we suggested that if we ignored the general partner tax, the McDep Ratio for KMP would be about half the level we showed.  Wrong. Let’s try again to show the impact of the general partner tax on McDep Ratio.

The first column reproduces the calculation we explained last week (see table).  That is our base case.  It assumes that the general partner gets slightly less than half (.4961) of the value of KMP’s business.  A McDep Ratio as high as 1.87 is a strong sell signal and we rate the stock accordingly. 

Now let us ignore the GP tax.  In the second column there is no value allocated to the GP.  Note that there is no debt allocated to the GP either.  Thus the McDep Ratio that ignores the GP tax is still at the high end of the range for holding a stock. 

As we looked at the issue again we note that our base case represents the middle ground.  One could make a worst case assumption and allocate no debt to the GP while crediting the GP with half of value.  That could be the case if it turns out in hindsight that payout levels were too high and value is not what it appears to be.  The GP would be under no obligation to repay the tax that was collected.   Recognizing the GP tax, but assigning no debt to the GP yields a McDep Ratio of 2.33.

If we have been fooled more than once on how to value the disguised general partner tax, chances are other investors have been fooled also. Valuation can be a powerful tool often overlooked in glowing praise heaped on stocks that have gone up in the past. 

Kinder Morgan would have investors believe that the GP tax is an incentive.  Supposedly the tax starts out low and then goes up only if the GP does a good job that justifies raising the distribution.  Here’s the rub.  The number of units outstanding when the tax was low is a small fraction of those outstanding today.  Unitholders who buy today are immediately hit with a general partner tax of about 40% on average even before any 50% tax on incremental cash flow.  What reward has the GP produced for new stockholders to justify a 40% tax out the gate?  April Fool!