KMP (IL/N), KMR (OP/N): 3Q05 results exceed expectations; maintain ratings, continue to prefer KMR for 'new money' - Goldman Sachs - October 20, 2005
We continue to recommend KMP/KMR, rated In-Line/Outperform, as core holdings in a diversified MLP portfolio following 3Q05 earnings results and sequential distrib increase of 1.3%. We prefer KMR to KMP due to its 55 bps yield discount over KMP, which is the basis of our rating differential. We continue to view KMP as a top In-Line-rated name, along with VLI, MMP, SXL, and ETP, despite unit price outperformance YTD (18% vs 4% group avg), resulting in a return of KMP's historical yield premium to the pipeline MLP peer group. KMP's 3Q05 operating income exceeded our est in three of its business segments, with the Product Pipeline's disappointing performance resulting from hurricane-related downtime. We are increasing our 4Q05 EPU/DCF est to $0.57/$0.77 from $0.54/$0.78, increasing our 2006 ests to $2.40/$3.45 from $2.35/$3.45 and 2007 ests to $2.55/$3.60 from $2.40/$3.50, detailed below.
RECOMMENDATION: PREFER KMR ON RELATIVE DISCOUNT; KMP IS A TOP IN-LINE-RATED NAME. INCREASING 2006/2007 ESTIMATES AS 3Q05 SEGMENT EARNINGS EXCEED EXPECTATIONS.
WHAT TO WATCH FOR: PROGRESS ON LONG-TERM 'TRANSFORMING' CAPITAL PROJECTS, OIL PRODUCTION TRENDS, ALJ RULING. KEY RISK: HIGHER INTEREST RATES.
RECOMMENDATION: PREFER KMR ON RELATIVE DISCOUNT; KMP IS A TOP IN LINE-RATED NAME.
We view both KMP/KMR as core holdings in a diversified MLP portfolio as we expect the partnership to continue to generate above-average distribution growth rates (7% in 2006 vs 2005 vs a pipeline group average of 5%) due to its high quality, well-diversified asset base and management's focused internal growth and acquisition strategy. KMR's 9.2% unit price discount (55 bp yield discount) provides investors with superior total return potential, and is the basis for our Outperform rating. The unit price discount occurs despite (1) representing virtually identical ownership in the partnership and (2) generating equivalent quarterly distributions with additional tax advantages. The KMR discount is currently in line with its historical average (since Oct '02). However, EEQ's unit price discount of 0.4% to EEP (vs its 7% average since Oct '02) suggests that a compression in the discount is possible.
INCREASING 2006/07 ESTIMATES AS 3Q05 SEGMENT EARNINGS EXCEED EXPECTATIONS.
Third quarter EPU of $0.57 exceeded our forecast of $0.51 as operating income across three of KMP's business segments exceeded our estimate. We expect strong operating performance to continue and are raising our 4Q05 EPU estimate by $0.03 to $0.57. We are also increasing our EPU/DCF estimates to $2.40/$3.45 from $2.35/$3.45 for 2006 and to $2.55/$3.60 from $2.40/$3.50 for 2007.
REFINED PRODUCT PIPELINES.
We are modestly lowering our 4Q05 volume expectation driven by lower 3Q05 results. As expected, Hurricane-related downtime on the Plantation Pipeline, which experienced an estimated 6-7% decline in year over year volumes, resulted in the Refined Product Pipeline segment operating income falling short of our expectation. Lower propane demand also impacted volumes on the Cochin Pipeline and North System. For 4Q05, we are modeling a 2% sequential increase in volumes (though volumes remain 3% below our prior forecast) with 6% volumetric growth in 2006 to levels in line with our prior estimate as KMP is leveraged to high growth population centers.
NATURAL GAS PIPELINES.
We are maintaining our 4Q05 and 2006 operating income estimates even though 3Q05 segment volumes and margins exceeded our estimates. Operating income in 3Q05 exceeded our estimate by $5 mm due to higher volumes and operating margins. Our model assumes minimal volumetric growth in 4Q05 versus 3Q05, with 6% growth in 2006.
CO2.
SACROC production once again fell short of KMP's recently lowered guidance. Although KMP indicated it expects to maintain current product of 33,000 bbl/d (up from a 3Q05 average of 30,800 bbl/d) for the balance of 2005, we are becoming concerned that the field will be unable to meet future production expectations. Despite SACROC's shortfall, segment operating income exceeded our estimate by $3 million due to higher volumes at Yates, higher realized NGL prices, higher third party CO2 sales, and reduced power costs realized following construction of a nearby power plant, completed during the quarter. We are maintaining our 4Q05 segment operating margin forecast - a 2,500 bbl/d reduction in our SACROC production forecast is again offset by power cost savings as well as increased third party CO2 sales. We are modestly raising our 2006 segment operating income forecast due to power cost savings as well as increased third party CO2 sales. Our SACROC and Yates field production forecast is unchanged, and assumes a 14% increase at SACROC to 37,000 bbl/d and a 4% decline at Yates to 22,900 bbl/d.
TERMINALS.
We are increasing our 2006 segment operating income estimate by approximately 1-2% based on the added contributions from various acquisitions. 3Q05 operating income exceeded our estimate by 4% despite hurricane-related downtime.
WHAT TO WATCH FOR: PROGRESS ON LONG-TERM 'TRANSFORMING' CAPITAL PROJECTS, OIL PRODUCTION TRENDS, ALJ RULING.
-- PROGRESS ON LONG-TERM 'TRANSFORMING' CAPITAL PROJECTS.
KMP recently announced plans to undertake two 'transforming' capital projects. 1) The Rockies Express Pipeline, a $3 billion joint venture between KMP (66% owned) and Sempra (34% owned) announced in August 2005, will connect production in the Rockies to the Midwest and Eastern U.S. A recently received MOU from EnCana Corp. brings conditional commitments to 50% of pipeline capacity. The pipeline is scheduled to come into service in phases, beginning in late 2007 with completion in 2008-2009. 2) The Louisiana Pipeline, expected to cost ~$500 million, connects the Cheniere Sabine Pass LNG plant to various Louisiana pipelines as well as KMI's Natural Gas Pipeline Company of America (NGPL) and is expected to be in service in the first quarter of 2009.
-- OIL PRODUCTION TRENDS.
Oil production unpredictability from the SACROC and Yates fields adds a level of volatility that could meaningfully impact earnings and cash flows. SACROC oil production fell short of original budget levels throughout 2005 due to water production/reinjection issues. While a 2-3,000 bbl/d improvement in production is expected in 4Q05, the year-end exit rate will be meaningfully below recent guidance. The shortfall has been offset by stronger production in the Yates field, higher third party CO2 sales, and lower operating costs. However, a decline in Yates oil production to levels more in line with original expectations or failure in Sacroc to increase production would impact our estimates.
-- FERC ALJ RULING ON KMP'S SFPP RATE ISSUE.
There were no developments on this issue during 3Q05. During 2Q05, the FERC issued a decision indicating that MLPs (or other pass through entities) would be permitted to include an income tax expense component in its rate calculation if it could show that its unitholders were likely to incur a tax liability. KMP filed a brief late 2Q05 indicating that this was indeed the case as applied to SFPP, potentially lowering any required refund or rate reduction, and is waiting on a FERC ruling. We believe a decision in the near term on the income tax issue and other remaining rate issues is unlikely.
KEY RISK: HIGHER INTEREST RATES. -- HIGHER INTEREST RATES.
Higher interest rates impact valuation for the MLP sector. We estimate that each 50 bps variance in yield impacts unit prices by about 7.5%. In addition to valuation, higher interest rates impact KMP's earnings as 50% of its debt cost is tied to floating rates.
I, David Chiaro, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
