Kinder Morgan Warrants: Trash Courtesy Of Goldman Sachs

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 |  About: Kinder Morgan, Inc. (KMI), Includes: EPB, GS
by: Alpha Hunter

Summary

Kinder Morgan offered long-dated warrants as merger consideration for its purchase of El Paso.

Goldman Sachs, which has now settled a lawsuit, structured the deal to its own advantage.

This has resulted in extremely dilutive warrants that are unlikely to be exercised.

While I'm not one who would agree with all the excessive outrage at most banks today, this one is hard to ignore. For those who aren't familiar, Goldman Sachs was sued for its role in playing an advisor to both Kinder Morgan (NYSE:KMI) and El Paso (NYSE:EPB) in KMI's acquisition of El Paso. And oh yeah, it also owned $2 billion of Kinder Morgan while it advised both sides, which it sold immediately after the deal. While I can't say anything for sure, it's hard to not to admit that doesn't look too great.

An SA article sought to point out that there is value within the warrants that Kinder Morgan offered as merger consideration, which can be seen here. While the author's beliefs about the fundamentals of the business are great, I believe he was missing a large piece of information when discussing these warrants. While he did take into account a "break-even" price, however, he skipped the large drag on upside that results from the large quantity of warrants.

First off, Goldman, to its credit, structured this deal beautifully in its own interest. If you know you're going to sell immediately after a deal, the best thing to do would to be to offer as many out-of-the-money warrants as possible, since then the deal is very accretive before that point is reached. So, when advising both sides to accept 505 million warrants, that's exactly what it did. Now these warrants trade for around $2, which appears not to be too bad for how long-dated they are.

However, Kinder Morgan only has 1.03bn shares outstanding, so the warrants represent a massive 54% dilution. Indeed, the exercise of the warrant does put $40 in the company, but at the cost of dilution. For example, for simplicity, if there were two shares outstanding, with $60 in value each, then the total value of the firm is $120. Then an exercise of this warrant would result in a $160 value, and divided by three instead of two, this results in a value of $53.33 dollars per share, instead of the previous $60. However, on the way up to $40, you have a great acquisition in which you paid using a bunch of warrants that don't kick in until a later stock price.

Thus, we can essentially see that after the stock breaks $40, the firm has around a 33% drag on return on instrinsic value, in that every $10 in instrinsic value per share KMI gains, only $6.66 will be reflected in share price gains after warrants are exercised.

As a result of this massive dilution, I caution many investors against investing these warrants. This will not only be a large overhang that will weigh on the value of the warrants, but a large overhang that will weigh on the stock price until 2017 approaches, as investors will be hesitant to own a stock with such incoming dilution, perhaps waiting until after the expiration of these warrants. My suggestion is a covered call strategy in which an investor buys the stock and sells the warrants short, as the upside to $40 looks to be reasonable, and an extra $2 for selling off what seems to be far upside appears to be a reasonable trade-off.

CORRECTION: Some warrants have been retired, bringing the count to 300mm from 550mm. Thus, the math is a bit different, resulting in a ~25% dilution above $40 rather than ~33%. The cost of retiring these options should be noted. Moreover, the math here is not meant to be a precise exercise, but rather a mental exercise to emphasize the point.

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.