On Seeking Alpha, a fellow contributor wrote an article entitled, Kinder Morgan Warrants: Trash Courtesy of Goldman Sachs. This article goes on to explain why the Kinder Morgan (NYSE:KMI) warrants will severely dilute shareholders and suggests that the deal to buy El Paso Pipeline Partners (NYSE:EPB) was structured to enrich Goldman Sachs (NYSE:GS), which owned $2 billion in KMI stock. GS sold this stake when the deal closed, enjoying gains from an accretive merger while not having to worry about the future dilution from the 505 million issued warrants, which would increase the share count over 50%.
Across the board, the facts in this article are right, but I think the analysis is too negative. If all of the warrants are exercised, there will be an increase in the share count, and Goldman sold its shares before this could happen. However, I think the negative impact of this issuance is overstated. Furthermore, I cannot speak to Goldman's motives in advising this structure, but it does not appear to be nefarious. In essence, this structure gave El Paso shareholders a guaranteed payout plus a warrant in case the merger proved to be exceedingly accretive. This gave El Paso holders the chance to participate in the upside, if there was any, and was critical to getting the deal done. However, if the upside doesn't materialize, these warrants would end up worthless.
For those unaware, these warrants expire May 25, 2017 with a strike price of $40 (warrant details are available here). Kinder Morgan shares are currently trading at around $32.50-$33, meaning shares will need to rally by 22% in the next three years for these warrants to hit the strike price. This gain is not very unreasonable, but it is also not guaranteed, which is why these warrants trade for around $2. Now, KMI has been aggressively repurchasing warrants to limit the potential dilution if shares do perform well. During the first quarter alone, KMI repurchased 31 million warrants for $55 million (all financial and operating data available here). KMI has another $45 million remaining on its warrant authorization.
With the share price low, KMI is buying back warrants cheaply, thereby minimizing potential dilution. There are now around 315 million warrants outstanding, which means they would increase the share count by around 31% if all were exercised. However in reality, the dilution is far smaller. The warrant gives holders the right to buy KMI at $40 irrespective of where it is trading. Let's say you held 100 warrants and exercised them when KMI was trading at $50. You would receive KMI worth $5,000 and would pay KMI only $4,000 (giving you a paper profit of $1,000). With that $4,000, KMI can go on the open market and repurchase stock. It could buy back 80 shares, resulting in the net issuance of only 20 shares.
Under $40, the warrants will not be exercised because it is just cheaper to buy KMI on the open market. At $40, there would be not net issuance as KMI could repurchase the same number of shares as it issues. With the current warrant count, the net dilution at $45 is 3.4%; at $50, 6.1%; at $60, 10.19%. For the dilution from these warrants to exceed 5%, shares need to rally about 50%. Moreover, investors do well if the stock price rises 50% and dilution is only 5%, as there is still a net gain of around 45%.
There warrants are at worst mildly dilutive, and there is a good chance they won't be dilutive at all. Anyway, the dilution isn't all bad news, as it means shares have rallied substantially! I am unconvinced that KMI will pass $40 in 2017 as Kinder Morgan Energy Partners (NYSE:KMP) is growing more slowly, while El Paso is not growing. KMI shares currently yield a solid 5.2%, but its dividend growth has been slowing. These factors make a significant rally unlikely. 8% annual price appreciation over the next three years is a pretty optimistic view, as it would lead to a total annual return of 13% when you factor in the dividend. That only pushes shares to $41.25, for about 1% dilution.
In reality, this was a structure for KMI to employ. In essence, it included warrants to get an acquisition done, and these warrants will end up being worth very little. This is in part because El Paso has not performed that well, minimizing the upside of the transaction; EPB is unlikely to grow its distribution in the next 18 months. These warrants were meant to compensate El Paso sellers if the merger went far better than expected. Instead, the merger has been a more modest success, which is why shares have not soared. These warrants will end up costing KMI very little, if anything, and dilution is unlikely to be more than 5%. Investors can buy KMI without worrying about the warrants creating an overhang on shares. The warrants have limited value, and I would not buy warrants, preferring instead to simply buy KMI shares.
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.