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As a result of the El Paso purchase by Kinder Morgan Inc (NYSE:KMI), holders of El Paso shares were given a warrant on KMI common stock as a part of the transaction. The warrants are now widely traded and liquid under a variety of symbols (KMI-WT on Yahoo Finance). Roughly 505 million warrants were initially issued.

As a result of the El Paso acquisition, KMI became the general partner for El Paso's MLP El Paso Pipeline Partners (NYSE:EPB) with a 42% ownership stake in the partnership. Kinder Morgan Inc is already the general partner for two other MLPs: Kinder Morgan Energy Partners (NYSE:KMP) and Kinder Morgan Management (NYSE:KMR). KMI owns roughly 10% of KMP and KMR. KMP also recently bought Copano Energy in an all-stock deal. The Kinder Morgan management stated that the deal would be immediately accretive to KMI's cash available to return to shareholders.

The warrants have a strike price of $40.00 per share and an expiration date of May 25, 2017. Here's an introduction to warrants if you are not familiar with them. This strike price is roughly 10% above the current stock price, so the entire value of the warrant is time value with no intrinsic value. These warrants will see relatively wide swings in price as a result. The 52 week range of the warrants is $2.93 to $6.48 (a 54% drop to the low from the high), a large swing compared to the KMI stock which has a 52 week range of $31.93 to $41.49 (a 23% drop to the low from the high). As a result, this instrument is for investors who want a leveraged way to gain (speculative) exposure to KMI stock price increases over the next few years. The warrants began trading in early 2012 for just under $2 per share. They have rallied over 200% since then. Over that same time, the KMI share price is only up roughly 15%.

The table below lays out specifics of the Kinder Morgan warrant relative to the stock price.

KMI Stock

KMI Warrants

Current Price

$37.22

$5.20

Expiration

--

May 25, 2017

Strike Price

--

$40.00

Time Till Expiration (years)

--

3.76

Warrant Break-even Price ($)

--

$45.20

Total Stock Price Increase Required for Warrant Break Even ($)

--

$7.98

Total Stock Price Increase Required for Warrant Break Even (%)

--

21.4%

Stock Compound Annual Growth Rate Required for Break-even:

--

5.3%

For the warrants to break even at expiration, KMI's stock must increase 21% or roughly 5.3% per year. This level of stock appreciation is not out-of-the-question for the stock though it is not a 'sure-thing' either. Since its IPO in February 2011, the stock has a 13% compound annual total return - or roughly a 9% per year stock price appreciation given a dividend yield of 4%. If that rate of stock price continues until expiration, the warrants would be worth roughly $11 at expiration - over a 100% return from current levels. That is a good return but if there is even one year where the stock price appreciation is negative or meaningfully below 9%, the returns the other year need to be much larger to make up for it.

These warrants do provide a small amount of dividend protection. As the quarterly dividend rises above the levels noted below, the warrant strike price is adjusted down - making the warrants more valuable. The dividend threshold is raised each year.

Threshold for Warrant Adjustments:

Calendar Year

Quarterly Dividend Threshold

2013

$0.60

2014

$0.70

2015

$0.80

2016

$0.90

2017

$1.00

Given the current quarterly dividend of $0.40 and the company's guidance that the dividend will grow at 9% to 10% per year, it is unlikely that the warrant strike price will be adjusted downward during the life of the warrants. As a result, the warrants only provide exposure to the share price of KMI with no dividend exposure. In a rising rate environment where high dividend stocks get sold off, this is not the best way to be exposed to shares. So if investors believe interest rates will continue to rise, these warrants should be avoided. If the stock price appreciates to the point where the warrants break even, the total return of the stock itself would be upwards of 9% per year including dividends.

In May 2012, KMI announced a buyback program specifically for the warrants. The program allowed repurchase of up to $250 million in warrants. In Q2 2013, the company completed this repurchase in its entirety. After this buyback, there are 414 million warrants still outstanding. This buyback reduced the number of warrants outstanding by 18%. The average repurchase price for the warrants thus far in 2013 was $5.77 each.

When the company announced their most recent quarter, board approved a buyback of up to $350 million of common stock or warrants. The company did not provide guidance on the number of warrants and stock they plan to buy back with this new buyback. Buying back warrants instead of stock does still increase shareholder value because once the outstanding warrants are exercised there will be a dilutive effect on shares. The company's effort to buy back these warrants aims to reduce that future dilutive effect. By buying back the warrants instead of common stock, the company is in essence betting the warrants will be valued higher at expiration than they are now and thus the share price will be above the current break-even price of the warrants at expiration. If this was not true, the company money would be better spent buying back common stock.

In researching KMI's fundamentals, the most impressive thing I noticed is the significant insider ownership. Insiders own roughly 35% of the shares outstanding. There have been no recent insider sales but two directors purchased a combined $15 million of shares in early August and Richard Kinder purchased nearly $18 million in shares in late June. That significant ownership and buying trend illustrates the faith the management has in the company. Also, it suggests that management is focused on increasing shareholder value.

To help reduce the break-even point of the warrants, investors could sell upside calls on the warrants. For instance, the January 2014 $40 call could be sold for $0.75 per share. This would reduce the cost of the warrants by nearly 15%.

The Kinder Morgan warrants that are currently trading require KMI shares to appreciate meaningfully between now and mid-2017. The required CAGR of 5.3% for the warrants to break even by expiration is not infeasible given KMI's past stock performance. Investors could sell upside calls to reduce their cost basis as well. The company believes that this share performance is probable because they recently spent $250 million to buy back the warrants instead of the common stock. Given the significant insider ownership of the stock, I believe the company has shareholders' interests at heart in this repurchase. So while it seems odd to buy a 4% yielding stock in a way that avoids the dividend, there appears to be value in the warrants for medium risk investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: A Pure Play On Kinder Morgan Growth