RICH KINDER’s Long Con

Summarized Analysis

The title says it all. After months of analysis, discussions with lawyers, and industry experts, we have come
to a stunning conclusion about Kinder Morgan Energy Partners (KM). Engineered 13 years ago by Rich Kinder, this
entity exists for one purpose alone…to enable the General Partner (GP) to systematically loot the Limited Partner
investors (LP) of KMP and KMR.
Ponzi allegations at Kinder Morgan are nothing new. A lot of people have smelled the stink on this stock over
the years, but none have quite figured out how they do it, and thus, the market has summarily rejected these claims.
With the aid of a few key insights overlooked by the “experts” we can say with certainty that we have cracked the
Kinder Morgan code. What we have discovered is probably the most brilliant and complex large scale investment scam
the world has ever seen. All perpetrated in broad daylight, under the noses of Wall Street’s best and brightest
professional analysts, including perhaps not so surprising… Mad Money’s Jim Cramer.
Here is how the scam works. Rich Kinder, the General Partner of KM offers above market, but at 6.5%, still
somewhat realistic dividend yields to LP investors, primarily retirees, struggling to live off historically low CD rates.
They market the stock as an opportunity to invest in a safe company with strong cash flows, and a remarkably
consistent, (almost Madoff-like) record of performance. It sounds very good, but not too good to be true. Under the
guise of funding profitable expansion projects like the high profile Rockies Express pipeline, the GP sells a large
amount of new shares per year, typically around 15-20M. This “new money” is then levered to obtain a 50/50
debt/equity ratio, and invested in unprofitable, but cash generating assets like pipelines and oil wells. Of that cash flow,
the GP keeps about half, then uses the remaining to satiate the “old money” investors and lure more into the pool. It’s
clever… in that rather than running a straight ponzi and just skimming the raw cash, they go the extra step to launder it
first through unprofitable pipeline and drilling projects, but the result is the same. Once the market gets wise and
funding dries up, maintaining the above market dividend will be impossible, the share price will collapse, and billions
will be lost as investors race for the exits. If there is justice, Rich and his management team will join their old Enron
buddies, Bernie Madoff, and Allen Stanford in jail.
The analysis that follows will prove this hypothesis using the companies 2009 10k, some relatively basic
math, and some common sense from two old oil industry veterans. For a more detailed analysis, please read the detailed
analysis write up.
(http://www.scribd.com/doc/47274818/Kinder-Morgan-Detailed-Analysis-Draft)
Right off the bat, there are some huge red flags for the stock of KMP (and sister stock KMR). A sky high price to
earnings ratio of 57, and even more confusing, a dividend coverage ratio that is off the charts. Looking at the 3Q 2010,
KMP paid a $1.11 dividend on only $0.17 of earnings. This, it so happens is the critical question that unraveled the
entire scheme. While it’s not impossible for a company to have a dividend payout ratio above 1:1, 6.5:1 is pretty much
unheard of. Still, they obviously had the cash flow to fund the dividend…those checks weren’t bouncing. The income
statement provided further clues. Though earnings were $332M, they were showing a depreciation expense of $851M.
So we sat down and thought about it for a while….”What kind of scenario could lead to a company having very little
earnings, and a huge DD&A expense?” Only one situation fit the facts…they must be investing a lot of cash into
money losing investments. By funding the projects with equity capital, the losses would get lost in the dilution and the
cash flow from depreciation could be used to fund generous, but unsustainable dividends.
The key to unlocking the scam is to understand the Incentive Distribution Rights (IDR) on a micro level,
rather than the macro level the market seems to fixate on. The IDR is basically a bonus for the GP. The logic behind it
seems innocent enough…lets give the GP a little bit of an incentive to run the business efficiently and increase
distributions, thus aligning the interests of the GP and the LP. Set up as a tiered system, the more cash flow the GP can
generate, the higher his bonus, with a highest (and current) tier at a full 50% of marginal cash flow. While there is
occasional chatter about how high this is, as far as we can tell, no analyst has ever dug into the details of this
arrangement. If they had, they would found that there are two fatal flaws.
Number one, this burden makes it almost impossible for any expansion capital project to be profitable for the
LP. How do we know? We’ve been running project economics in this industry for 25years each. Trust us, the numbers
simply don’t work. If I put up 98% of the capital, but am only entitled to half the cash flow, it’s going to take a hell of a
project to even pay out, much less meet a hurdle rate of 15%. Any college freshman with a copy of excel should be
able prove this out in just a few minutes. Thus, because of the IDR, the LP loses money on every single dollar of
expansion capital spent. Clearly this is not desirable or sustainable.
The second flaw is that by incentivizing cash flow, rather than profits, you give the GP the tools he needs to
rob you blind. Imagine a $100 project that generates $10 of cash flow per year for 10 years. The project is clearly
unprofitable, barely even paying back the initial capital, much less covering cost of capital and overhead. If you had
tied the incentive to profit, the GP would get nothing for this boondoggle. However, at KM the IDR isn’t tied to profit,
it is tied to cash flow, so the GP gets $5 per year on his $2 investment. After 10 years, we see that the GP has made
about a 250% annual return, while the LP has lost about half of his initial investment.
As it turns out, this is pretty much exactly what the GP has been doing. They took it easy at first, setting the
groundwork for a huge payout down the line by building credibility, a good reputation, and essentially training the
apparently incompetent analysts that follow them. However, after taking the GP private in 2006, they kicked the
scheme into overdrive. A look at the financials will prove out our hypothesis beautifully. Between 2005 and 2009, KM
spent roughly 10B on expansion capital projects. One would think that spending 10B, roughly doubling the size of the
company would result in higher income. In fact, it was virtually stagnant, dropping from 335M in 2005 to 332M in
2009. Since shares outstanding increased from 220M to nearly 300M over that time, that same amount of income is
now shared with 36% more shareholders. NI went from ~$1.5 per share down to ~$1.10. Shareholders are being diluted
by additional shares issued to finance projects with apparently no additional income.
Also concerning, debt increases from $8.3B in 2005 to $13.6B in 2009 and while income was stagnant over
the period, DD&A increase from ~$350M to ~$850M, a 150% increase. Not surprisingly, given the mechanics of the
IDR, the GP’s take nearly doubled over 2005-2009 from $480M to $930M. When you incentivize cash flow over
profits…that’s exactly what you get.
All of this supports our hypothesis… the GP is effectively laundering cash through the capital accounts,
investing in crappy projects that lose money for the LP, and then pocketing half of the marginal cash flow. Further
proof lies in the 2009 10k, which gives us earnings from 2 recent high profile projects, Midcontinent Express and
Rockies Express pipelines.
The Rockies Express had 2009 Earnings of $98.5M… this on what is roughly a $7B pipeline of which KM
owns half. To be fair, lets add back in DD&A to get an approximate cash flow. Using straight line, a $3.5B investment
with a 35 year life has DD&A rate of about $100M. So gross, the project is yielding around 5.7%. This is, of course
before the IDR…so back that down by half again, and we are under 3% return on the LP’s investment. In this industry,
10-15% would be required to interest a straight player, 3% doesn’t even come close to covering the LP’s cost of
capital. One project does not make a trend, lets keep looking.
The Midcontinent Express had 2009 earnings of $14.7M, though it was only online for about half of the year,
so lets just assume annualized it would have been $30M. This pipeline had a cost of around 2.2B, again which KM
owns 50%. Using the same DD&A assumptions as with Rockies Express, we come up with an annual DD&A rate of
30M, we’ll call it a 5.5% gross return, adjusted for the IDR, under 3% . Not so good.
Honestly we were expecting to see gross returns in the 10-15% range and net returns for the LP around 7%,
still not enough to cover cost of capital and overhead, but not blatantly obvious. However, These two high profile,
projects aren’t even in the ballpark of marginal profitability. This suggests to us that the GP trying to goose their
distributions as they prepare to cash out and go public again. Granted, the upcoming offering is small, but they are
laying the groundwork for their big payout.
So that’s the simple summary. The GP of KM is actively defrauding it’s limited partners, with the cumulative
tab likely in the $5-10B range. For a more analysis that really digs into the details, please read the detailed analysis
which can be found at:

http://www.scribd.com/doc/47274818/Kinder-Morgan-Detailed-Analysis-Draft

*This is not investment advice. It is a hypothesis put forth to the investing community for further analysis. Sources of
data include the 2009 10k, various finance sites, hundreds of articles on KM and other MLP’s, and thousands of
message board post. We can not vouch for the accuracy of any of these.
This work is based on SEC filings, current events, interviews, corporate press releases, and what we've learned in our
research. It may contain errors and you shouldn't make any investment decision based solely on what you read here.