Kinder Morgan Merger Is A Win For All

Aug.11.14 | About: Kinder Morgan, (KMI)


KMI announced it would be acquiring KMP, KMR, and EPB in a landmark deal.

While KMP holders are diluted up-front, elimination of the IDRs make this deal a winner over time.

KMI holders get more stable cash flows and a 10% dividend growth rate, making it a solid deal for them too.

This deal is a win for all parties, and KMI is a buy, especially below $40.

On Sunday, Richard Kinder stunned the world by announcing that Kinder Morgan Inc. (NYSE:KMI) would acquire Kinder Morgan Energy Partners (NYSE:KMP), Kinder Morgan Management (NYSE:KMR), and El Paso Pipeline Partners (NYSE:EPB), consolidating his companies into one ticker symbol with a $140 billion enterprise value (press release available here). This structure of this deal surprised me, as typically the MLP acquires its general partner, as in the case of Enterprise Products (NYSE:EPD). In this case, the opposite happened, with KMI acquiring its MLPs. As a consequence, investors don't have to deal with K-1s, but also lose this pass-through tax status of MLPs. On the whole, this deal addresses the core problems associated with KMI and KMP, and makes the stock a more attractive investment.

First, let's address the core financial parameters of the deal. KMP holders will receive 2.1931 shares of KMI and $10.77 in cash, which translates to an 11.4% premium. KMR holders will receive 2.4849 shares of KMI for a premium of 16%. As a reminder, KMR is merely an LLC that holds KMP units and reinvests distributions. EPB holders will receive .9451 shares of KMI and $4.65 in cash for a 15% premium. Thanks to this deal, KMI expects to increase its 2015 payout to $2.00 from $1.72. It also aims to grow its dividend by 10% annually through 2020.

Now while KMP is being sold at a premium, it should be noted that investors will see less cash flow up-front. In 2015, KMP was on track to pay out at least $5.75. With the $2 anticipated dividends, KMP holders will now receive about $4.39 per KMP unit from their new KMI holding. Even if they were to automatically reinvest their $10.77 cash payment, their dividends will be about 14% lower. Functionally, with the new tax status, the payout will be a bit lower. At first glance, this might upset some KMP holders, especially those in retirement who rely on the distributions. That's an understandable but short-sighted reaction.

In past articles, I have explained how incentive distribution rights hurt KMP. Under the previous set-up, KMP had to pay 50% of incremental cash flow to KMI, even though KMI did not put up any of the capital to fund projects. This made it extremely difficult to find accretive growth projects. In a sense, a project with a rate of return of 16% would only return 8% to KMP holders, barely enough to cover the cost of capital. In its presentation explaining the deal, KMI addresses the phenomenon (presentation available here). A $1 billion project will now lead to incremental cash flow of $65 million, versus only $18 million.

KMP investors can now feel far more optimistic about the firm's $15 billion backlog. Under the MLP structure, it would be difficult for this backlog to add much value, whereas accretion is much easily achieved now. As a side note, this comparison shows how much value the IDRs sucked out of KMP, which was the reason I turned negative on the stock. Investors who own other MLPS with external general partners like Energy Transfer Partners (NYSE:ETP) should keep note of this. There is a very strong argument that general partners get too much of the incremental cash flow, and these mergers help to address the problem.

Because KMP holders are freed from the IDRs, the future dividend growth rate will be much faster. Over time, the annual dividends under the structure will exceed those under the old regime. In all likelihood, the time when this deal becomes accretive for KMP from a cash flow perspective will be 2019. If we assume reinvestment of the cash payment, accretion should occur by the end of 2017. So for longer-term investors, this transaction is a major win for KMP. The thrust of the bear case on KMP, the IDRs, is gone, and within three years, investors will be getting more cash. Certainly, some will nitpick and argue the share exchange should have been higher to make accretion occur sooner, but the IDRs paid KMI at the expense of KMP, meaning KMP needed a deal more. The accretion schedule is certainly fair.

For KMI, the biggest risk, the structural subordination of its cash flows, is eliminated. It only receives IDRS after KMP pays the interest on its debt. As a consequence, KMI's cash flows are subordinated to other claims on KMP's cash flow. When times are good, the system works well for KMI, but the firm is especially vulnerable to a downturn, especially given the $9 billion in debt it carried (all financial and operating data available here). Now that all operations are fully housed under one roof, the issue of the structural subordination is eliminated, meaning that KMI investors are getting more stable cash flows. With safer cash flows and a 10% dividend growth rate, this is a winner for KMI.

On EPB, I would also classify this deal as a winner, if only because I believe it has a weak asset base and would have struggled to grow its distribution for at least two years (my past article on EPB here). Investors in this MLP should be glad to get bought out at any premium, and now have a piece of the superior pipelines in KMP's portfolio.

Finally, it should be noted that these cash payments will amount to roughly $4 billion, bringing consolidated debt past $40 billion. KMI will be funding this with debt, which will move its leverage to about 5.6x 2015 EBITDA. This is an elevated leverage ratio, but KMI says it expects to have an investment-grade rating. This is crucial because KMP relies on long-term contracts, and many producers are hesitant to sign such contracts with non-investment grade companies, as the contracts could be altered or cancelled in bankruptcy court. It seems the ratings agencies will give KMI at least a year of breathing room to bring leverage back towards 5x. So long as this deal does not push the combined entity into junk, it is a clear positive for investors in all the stocks.

The only major question remaining is what type of dividend policy KMI will pursue. KMP typically paid out virtually all of its distributable cash flow, forcing it to raise debt and equity to fund the entire growth budget. Now as a corporation, KMI can choose to retain more cash to limit future equity and debt, or it may target a very high payout ratio. I expect more color on this issue on the conference call Monday morning.

At the end of the day, this deal is clear win-win for KMI and KMP. It also makes me look like an idiot for selling KMP several weeks ago because I did not believe a merger was imminent. This deal successfully addresses the key problems at each entity, while offering everyone a fair price. I expect KMI shares to shoot past $40 and would recommend buying at $40 or lower, where investors will get a solid 5% yield.

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