Pipeline profits: 3 stocks to buy now

By Jim Jubak

It's the size of the deal that has garnered the headlines. Top executives at Kinder Morgan (KMI, news, msgs) have bid $13.5 billion in cash to buy the public company and take it private. That would make this the largest management-led buyout on record and, if you add the $8 billion in company debt that the buyers proposed to take on, the price comes close to the $30 billion Kohlberg Kravis Roberts paid for RJR Nabisco in the largest and most famous private-equity deal during the leveraged buyout frenzy of the 1980s.

But I think investors ought to pay attention to what the management at Kinder Morgan is buying: energy pipelines. I think the buyout offer at Kinder Morgan is just another sign that energy distribution has by no means finished its run from stodgy backwater to hot stock sector.

Not that the energy distribution business hasn't had a great run. Starting with $40 million in assets purchased from Enron in the late 1990s, Richard Kinder has used acquisitions to build Kinder Morgan into a company with a $13.4 billion market capitalization. From Jan. 1, 1999 to Aug. 29, 2005, Kinder Morgan's shares climbed 355%.

In the pipeline

So the stock market can be excused for thinking that, after a run like that, the stock was done. Certainly, the shares haven't done much except slide gently lower since fall 2005. From Aug. 29 to May 26, they fell 7%.

Why are the managers of Kinder Morgan so eager to buy this company, when the stock had done nothing for almost 10 months? Because they can look past the short-term need for huge amounts of capital spending to build new pipelines to a future when those pipelines are in place and the cash from what is essentially a monopoly transportation business is flowing like, well, oil and gas. In the short term, Kinder Morgan is signed up to build a pipeline from the Rockies to Ohio at a cost of $4 billion. Short-term investors can only see the way that capital spending will cut into cash flow and raise debt.

The managers who have proposed a buyout of Kinder Morgan, on the other hand, know that once the pipeline is built, they won't have any trouble generating enough cash to pay off the capital costs and to assure long-term investors a hefty profit on their investment. Customers have already signed up for the capacity of the Rocky Mountain-to-Ohio pipeline, the first to be built in the U.S. since the Alaska pipeline was completed in 1977.

Kinder Morgan's long-term growth isn't by any means unique in the energy distribution business. Under just about any future-energy-supply scenario you construct, energy producers will be moving more oil and gas and electricity from increasingly far-flung sources of supply to increasingly distant customers.

So, for example, the development of new oil supplies from Alberta's oil sands has led TransCanada Pipelines (TRP, news, msgs) to proposed the 1,800 mile-long Keystone Pipeline to carry approximately 400,000 barrels of oil a day from Canada to the United States. The cost -- a projected $2.1 billion -- and the distant projected completion date – 2008 -- are negatives to short-term investors. But for anyone willing to take a long-term view, that $2.1 billion represents an investment in a monopoly cash-cow business. (Since pipelines are so expensive to build, no company will propose and no investor group will finance a new pipeline in competition with an existing route, unless the existing pipeline is turning away customers.)

Two paths to profit

That mismatch between the short-term view of stock investors -- who see only capital costs -- and the long-term view of pipeline executives -- who see future cash flows -- is the reason that Kinder Morgan's management wants to take the company private. As a private company, Kinder Morgan won't be punished in the public markets from taking a long-term view of capital spending and it can raise capital from private investors with compatible long-term goals. Kinder Morgan Management has signed up Goldman Sachs (GS, news, msgs), American International Group (AIG, news, msgs), the Carlyle Group and Riverstone Holdings as investors.

This dynamic -- and the headline coverage given the Kinder Morgan deal -- assure that other pipeline companies will at least consider going private as they raise capital. That gives public investors in pipeline companies two possible pathways to profit. First, they could get a premium -- Kinder Morgan's executives offered 18% above the market price -- in any buyout. Or, second, they could see their shares of public pipeline companies rise in value as the public equity market is educated, by the buyouts, about the value of the long-term investments these companies are making.

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