Kinder Morgan: How to Buy KMI at a Discount

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Back in August, Kinder Morgan Inc. (KMI) announced that it was going to acquire the limited partner interests in its pipelines. Kinder Morgan expects plenty of benefits from the merger, which would enable it to pay close to $2 per share in annual dividends in 2015. After that, Kinder Morgan expects that dividends will grow by about 10% per year for five years.

As a result of the deal, unitholders of Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB) are going to receive shares in Kinder Morgan Inc., as well as some cash consideration. KMP unitholders will receive 2.1931 KMI shares and $10.77 in cash for each KMP unit. EPB unitholders will receive .9451 KMI shares and $4.65 in cash for each EPB unit. Limited partners are receiving some cash, because the act of exchanging their units for Kinder Morgan Inc. shares is a taxable event, which could trigger some tax liabilities to the IRS.

The holders of Kinder Morgan Management (KMR) will receive 2.4849 KMI shares for each share of KMR, which will be a tax-free event because those holders are exchanging one asset type for another.

The deal has to go through some regulatory hurdles, but I’m confident it will finalize. The timeline for the Kinder Morgan deal to close is somewhere between the end of 2014 and the first half of 2015.

kinder morgan kmi kmr kmp epb
At the closing prices on Monday, investors seem to have an arbitrage opportunity. Investors could buy KMP, EPB or KMR and then have those converted into KMI shares when the deal does close. As a result, those investors will be able to effectively purchase KMI shares at a discount, when all is said and done.

If I were to do set myself for KMI shares at a discount, I would go for KMR for the complete tax-deferral of the arbitrage opportunity. If I went with KMP or EPB, I would have to deal with partnership taxation and K-1 forms, which scare the hell out of most dividend investors.

If I already owned enough Kinder Morgan Inc. stock in a tax-deferred account, I would simply sell it and purchase shares of Kinder Morgan Management. I would not sell KMI for KMR in a taxable account because the capital gains taxes would make this arbitrage play not worth it. However, if you expect to be in the 10% – 15% bracket for Federal tax purposes, your dividends and capital gains might be taxed at zero. Of course, state taxes could still apply.

For example: If I had 1000 shares of Kinder Morgan Inc. in an IRA, I would sell it and put the proceeds into Kinder Morgan Management. When the deal closes, I would end up with approximately 1013 shares of Kinder Morgan Inc.

However, if I wanted to purchase 100 shares of Kinder Morgan Inc. with new money, I would simply buy Kinder Morgan Management and wait for my stake in Kinder Morgan Inc. when the deal closes. The amount of 1.30% might not seem like a lot, but even a small seed can turn into a mighty oak.

The added bonus in this exercise is that investors who purchase KMR rather than KMI, will likely be eligible for a $1.39 quarterly distribution paid in stock somewhere around November 15, 2014, which would be a tax-deferred dividend reinvestment. Then, the investor would have more KMR shares to tender for KMI stock. The tax-deferral of those reinvested KMR distributions is really nice and could widen the spread as well as potential accretion effect for those enterprising dividend investors.

The yield on KMR is higher than KMI, and the KMR yield is entirely tax-deferred (until you sell KMR). The facts that KMR dividends would be automatically reinvested, KMR distributions didn’t cause any tax headaches and KMR always sold at a discount to KMP, made KMR an ideal investment for me. Unfortunately, once the acquisition closes, I will end up with a lot of Kinder Morgan Inc. stock, and KMI dividends would be fully taxable under the preferential tax rates for qualified dividend income. Hence, I do not plan on adding new cash to my Kinder Morgan position for the foreseeable future.

Full Disclosure: Long KMI and KMR.

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