Kinder Morgan Energy Partners (NYSE:KMP) is down over 5% so far in 2014 as investors worry about slowing distribution growth and the structure of the partnership. Hedgeye's Kevin Kaiser, Barron's, and others have become increasingly critical of the partnership agreement in 2014. General partner Kinder Morgan Inc. (NYSE:KMI) operates the partnership and is paid handsomely for doing so. This has raised suggestion that KMP should buy out KMI, and last week Credit Suisse argued that such a merger could be possible (details available here). In this article, I will explore whether or not a deal is financial feasible.
In an MLP, the general partner receives "incentive distribution rights" ("IDR") or a proportion of distributable cash flow. As KMP generates more cash, KMI gets paid more. These IDRs also accrue at a marginally increasing rate. At this point, KMI is in the top IDR bracket and receives 50% of all additional cash flows. During all of 2013, KMP generated distributable cash flow ("DCF") for its limited partners of $2.244 billion (all KMP financial details available here). At the same time in 2013, KMI's general partner interest generated $1.756 billion for it (KMI's financials are available here). In other words, KMI received about 44% of KMP's pre-GP distributable cash flow.
The easiest way for KMP to repurchase the general partner rights from KMI would be a stock swap where it issues KMP units to KMI in exchange for the IDRs. After all, KMP retains no cash and carries over $19 billion in debt already. KMI could either hold these units or distribute them to shareholders on a tax-free basis. Using 2013 results as a guidepost, KMP could give KMI a 44% stake in the partnership while still maintaining its distribution. In others words, this deal would not dilute KMP holders, which should be required of any potential transaction. Given KMP's current market capitalization of $33.9 billion, this deal would be worth about $26.6 billion.
Now, Kinder Morgan Inc. has a market capitalization of $34 billion, which is about $7.4 billion more than the 44% stake in KMP. However, it does have other holdings. In particular, it holds about $3.4 billion in KMP and Kinder Morgan Management (NYSE:KMR). KMR is an LLC that solely owns KMP units and automatically reinvests distributions. It also owns about $3 billion worth of El Paso Pipeline Partners (NYSE:EPB) as well as the IDRs in the partnership. If we factor in these holdings, the shortfall is made up, but KMI does have about $10 billion in debt outstanding as well.
Now, KMI will be getting 50% of future cash flows compared to 44% of existing ones, so it is reasonable to suggest giving KMI more than a 44% stake. However, the stake does have to be less than 50% as it will never receive more than 50% of cash flows under the current partnership agreement. At most, KMP could offer a 46-47% stake, which would add $700 million to $1 billion in value. Under this structure, KMI would be left with a 47% stake in KMP from the IDRs, hold the additional 10% it currently owns, and also be the general partner for EPB. When you factor these together, this would be worth about $35-$36 billion.
This is slightly more than KMI's market capitalization, but it is less than its enterprise value. To make this deal attractive for KMI, KMP would have to offer an over 50% stake, which would be a bad deal for KMP holders. In other words, it is not financially possible for KMP to take over all the IDRs from KMI. At best, KMP could buy a portion of the IDR interest from KMI, perhaps half of the IDR for a 23% stake. This would relieve some of the GP burden on KMP while leaving KMI with some IDR ownership to work down that debt load. Then in a few years if KMP units are higher, a deal for the remaining IDR stake could be workable. While it is interesting to speculate on a possible KMP-KMI deal, a deal is not financially tenable at current levels. I expect the current KMI-KMP structure to remain in place for the foreseeable future.
Disclosure: I am long KMP. 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.