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Questions Remain at Kinder Morgan: Jefferies

NEW YORK (TheStreet) -- Richard Kinder, the billionaire co-founder of pipeline giant Kinder Morgan (KMI), has not put to rest concerns about the firm's sharply falling capital expenditure, according to a research report from investment bank Jefferies.

In a Wednesday morning conference call, Kinder Morgan provided investors with a line-by-line explanation of ita falling capital expenditure in the wake of its acquisition of El Paso in 2011, including an account of merger-related synergies. In spite of the call, Jefferies said questions remain about the firm's capital reported expenditure.

"While we appreciate the added detail provided on the call, we do not believe the issues have been fully explained/resolved," Jefferies analyst Christopher Sighinolfi wrote in a Thursday research note.

Those lingering questions underscore a wave of confusion that has gripped the energy master limited partnership (MLP) sector since Kevin Kaiser, a 26-year old Hedgeye Risk Management energy analyst, called Kinder Morgan a "house of cards" in a recent research note report and questioned the accounting of Linn Energy (LINE) and Breitburn Energy Partners (BBEP). In particular, those firms' reliance on 'maintenance capital expenditure,' a non-GAAP accounting metric that drives dividend payouts across the MLP sector, has come into question.

On Wednesday, Linn Energy said in a filing with the Securities and Exchange Commission that it will no longer report maintenance capital expenditure or distributable cash flow (DFC), another non-GAAP accounting metric. Linn Energy said in the filing that its partnership agreement didn't provide for the use of maintenance capital expenditure or DCF, and some analysts speculated the company's decision to change its accounting definitions may have been pushed by the SEC amid an informal review.

Now, lingering concerns raised by Jefferies about Kinder Morgan center on how the company's El Paso Pipeline Partners (EPB) business characterizes its maintenance capital expenditure relative to MLP industry peers. Reliance on non-GAAP reporting of capital expenditure also appear to have been done in a non-standard fashion across the entire energy MLP sector and firms such as Kinder Morgan are now working hard to alleviate investor uncertainty.

It remains to be seen whether there will be any financial impact. Linn Energy's changing definitions had no material impact on its finances, however, the company is now left with uncomparable non-GAAP accounting metrics relative to industry peers, according to Wells Fargo analysts.

Richard Kinder, meanwhile, said on his firm's conference call that many of Hedgeye's calculations were "flat out wrong" and he spent the better part of the hour-long investor call providing an itemized detail of Kinder Morgan's reported capital expenditure.

Much of Kinder's focus centered on what Kinder Morgan describes as capital expenditure versus what it describes as operating expense. For instance, in 2011 El Paso spent $73.9 million on anomaly repairs to its pipeline infrastructure and just $33.9 million in expense. After acquiring El Paso, however, Kinder Morgan plans to spend $96.8 million in anomaly repairs, with just $5.3 million in capital expenditures this year.

Overall, Kinder Morgan noted that a $222 million variance between El Paso's 2011 capex of $354 million and its projected $132 million in 2013 capex could be explained by the expense items versus capex items and various merger synergies. Jefferies, nevertheless, said it would like to see more detail on Kinder Morgan's falling operating expense, even as much of legacy El Paso capex has become an expense item.

Jefferies' biggest issue centered on Kinder Morgan's pipeline transportation business, Kinder Morgan Energy Partners (KMP), and capex the unit reports for its CO2 enhanced oil recovery (EOR) business by way of what is called "sustaining capex," a measurement of the spending needed to keep the business operational. While Kinder Morgan Energy Partners reporting of its sustaining is consistent with the definition featured in its partnership agreement, it is different than the definition used by other MLP's.

"As Kinder Morgan Energy Partners has operated EOR assets for some time, many investors & analysts appear comfortable with this treatment - we are not," Jefferies wrote. "[There] are 16 upstream MLPs who largely derive cash flows from the production of hydrocarbons and their existence and collective approach to maintenance capex makes KMP's treatment."

Part of the problem is Kinder Morgan's longtime use of accounting definitions that have changed as other industry competitors have grown. The other problem is a lack of clear definitions of what is and what isn't maintenance or sustaining capex, a point underscored by the changes Linn Energy made to its accounting on Wednesday.

"In the absence of a formally-established definition for maintenance capex and recognizing that all MLPs have an incentive to spend only what is necessary (maintenance capex reduces DCF), investors have no better option than to compare companies' practices against one another," Jefferies wrote.

The energy MLP sector has become a favorite of dividend-seeking investors who are weary of the headaches of equity market volatility. Unfortunately, it appears that because the once steady dividend-yielding energy MLP sector relies on non-GAAP accounting metrics and non-standard definitions, there is much due diligence left for investors to consider.

Whether a possible rationalization of accounting metrics used by MLP's like Linn Energy and Kinder Morgan impact any of their financial results or dividend payouts is still to be seen. What is clear is that firms now face a more skeptical investor base that will have to work much harder to derive industry valuations.

Kinder Morgan shares rose over 3% on Wednesday, while Kinder Morgan Energy Partners (KMP) shares rose over 1%. Both firms opened up in early Thursday trading.

--Written by Antoine Gara in New York

Stock quotes in this article: KMI, KMP, EPB, LINE, LNCO 

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