Pipelines and midstream operations typically are pretty boring subjects, as far as Wall Street is concerned.
But the past few years at pipeline kingpin Kinder Morgan Inc. (KMI) and its master limited partnership subsidiaries Kinder Morgan Energy Partners, LP (KMP) and El Paso Pipeline Partners, LP (EPB) have been anything but.
Today is more of the abnormal same for the Kinder Morgan family.
Kinder Morgan is making a massive deal in which it will purchase all the units of KMP and EPB, as well as KMP limited partner Kinder Morgan Management, LLC (KMR), for $44 billion in cash and stock and assume around $26 billion in debt, coming to a grand $71 billion. Investors will get between a 12% and 16% premium when the deal closes.
The combined market value of the new KMI — which will trade as a regular corporation — will be more than $90 billion, making KMI the fourth largest energy firm in the U.S. and more of a powerhouse in the midstream sector.
The approach is a radical one — taking out the lucrative MLPs in the name of boosting shareholder value — but it does show that Kinder Morgan still has plenty of gas left in the tank.
Why Goodbye for MLPs?
One of the cool things about Kinder Morgan is its size. It’s basically one of the largest pipeline and midstream firms in the nation, with more than 82,000 miles worth of pipelines and over 180 different terminals and storage facilities crisscrossing the country.
Problem is, Kinder might just be too big.
Growth is there, but it has slowed. Thus, the appeal of KMI/KMP was the ability to collect steadily increasing distributions tied to Kinder’s pipelines and other midstream infrastructure. It became a nice “utility” play for investors.
Richard Kinder apparently didn’t want to be “just” another utility, though, which brings us to the deal.
The combination of Kinders will mean an abandonment of the lucrative tax structure that Kinder Morgan helped popularize back in the 1990s — ironically enough, at a time when everyone else is jumping on the MLP bandwagon.
The reason? Kinder wants to be able to aggressively grow into the future.
A while back, Kinder Morgan was subject of several negative articles published in Barron’s. Analysts at Hedgeye Risk Management questioned KMP’s ability to continue producing quality cash flows as well maintenance CAPEX at several of its pipeline due to the amount of capital and incentive distribution rights (IDRs) paid back into its parent KMI. That caused shares of the entire Kinder Morgan complex — KMI, EPD, KMP and KMR — to drop.
Ratings agency and mutual adviser Morningstar estimated that to increase its distribution by 5% to 6% a year, Kinder would have to put nearly $3 billion to $4 billion to work every year on new projects.
That’s an insane amount of spending, and perhaps an impossible task given Kinder’s sheer size.
Already, KMI has been forced to add some not-as-lucrative or instantly accreditive assets — like oil tankers — to its mix due to its higher cost of capital. It simply can’t “afford” to go out and buy larger pipeline and midstream rivals that make more sense.
Since that time, Kinder has been able to regain ground and raise its dividend distributions just fine, but it seems that rising earnings and dividend distributions weren’t enough for founder and CEO Richard Kinder.
By essentially getting rid of the MLPs, KMI will be able to cut its cost of capital and use its shares in an acquisitions. It’ll be easier for the new combined C-corporation to add new energy infrastructure projects in a way that will mean growth — namely, growth of the company’s earnings, and ultimately, growth to Kinder’s dividends.
So What Should Kinder Investors Do?
The question you’re looking for an answer to is, “Is the deal really good for shareholders?”
If you own KMI, it’s a resounding yes. In the end, the buy only strengthens the firm’s appeal as a major midstream player. Over the longer haul, Kinder Morgan will be able to buy more assets, increase earnings and cash flows and pay out higher dividends. That’s exactly why you want to own a midstream/pipeline firm in the first place.
Already, that’s coming true. Along with announcing the deal, KMI upped its dividend to $2 per share, giving it a 5% yield. Management also expects the newly combined entity will be able to increase its payout by 10% annually through 2020 — a substantial jump from KMI’s current dividend growth rates.
As for the MLPs — KMP and EPB — the answer isn’t so easy.
People buy MLPs for a host of reasons, but the two biggest are deferring taxes and high income. And current KMP and EPB shareholders might not get either with the deal.
First, the tax bite of exchange could sting. Remember: MLPs defer taxes because the bulk of their distributions count as return of capital (ROC). ROCs basically reduce your cost basis in the units you own, which means you could end up owing a bigger capital gains tax on the exchange than you might think.
Secondly, initial distributions for the new KMI will be lower than what you’ve been getting in KMP and EPB. EPB is yielding nearly 7.5% currently, KMP pays 6.9%. While the combo of cash and shares may net out to be positive for unitholders in the long term, losing around 2.5% in annual yield does sting.
KMR shareholders — who receive dividends in the form of KMP shares — are basically in the same boat.
However, if you bought the MLPs as a truly longer-term play on America’s need for more energy infrastructure, then the offer still is a great deal.
At the end of the day, the newly combined Kinder Morgan will prove to be a successful dividend machine. For investors, KMI remains a solid midstream buy.
Disclosure: Author is long KMI and KMR. However, the author intends to close-out his position in KMR within 72 hours.