How To Arbitrage The Upcoming Kinder Morgan Consolidation

Aug.13.14 | About: Kinder Morgan, (KMI)


The market continues to mis-price KMP, KMR, and EPB in relation to KMI, given the consolidation news created an excellent arbitrage opportunity.

KMI post-consolidation will be posed to deliver excellent shareholder value for the long term, and is positioning itself to be a major oil/gas player in years to come.

KMI consolidation will make the firm the third-largest oil company on the planet, coupled with one of the most attractive dividend policies.

Merger Monday took a new spin this week, when chairman and CEO of Kinder Morgan, Richard Kinder announced that his plans to consolidate all his entire Kinder Morgan empire into one giant publicly traded company, Kinder Morgan (NYSE:KMI). The deal is valued at around $44 billion ($70 billion including debt). The combined entity will be the third-largest energy company in the world, directly behind Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM). This is the largest consolidation/merger in this space since Exxon bought Mobil back in the late 90s.

The purpose of the deal, according to CEO Kinder, is that the combined entity will allow for increased simplification when it comes to deal making, as well as decreasing the overall complexity that was associated with the incentive distributions rights that were previously set up between the four separate entities. Additionally, Kinder said that the MLP structure had gotten so big that it actually had become a limitation in its efforts to continue to grow.

The deal is structured as follows:

  • Kinder Morgan Partners, LP (NYSE:KMP) shareholders will receive 2.1931 KMI shares and $10.77 in cash for each KMP share held.
  • Kinder Morgan Management, LLC (NYSE:KMR) shareholders will receive 2.4849 shares of KMI for each KMR share held.
  • El Paso Pipeline Partners, LP (NYSE:EPB) shareholders will receive 0.9451 shares of KMI and $4.65 cash for each EPB share held.

The deal, of course, is subject to regulatory and shareholder approval, but given the huge benefit that this consolidation will bring shareholders, I highly doubt there will be any fight from them. As for the regulatory aspect of the story, the fact that this is merely a consolidation story of four separate entities that were already all owned and run by the same group, I also doubt this will pose any risk to the deal not going through.

This deal is expected to close by the end of the year. Given that time frame, some interesting arbitrage opportunities should be explored by investors leading up to the consolidation. When the market opened up on Monday after this announcement was made, the market was not doing a good job of pricing in the complete terms of the deal for each stock. This type of mis-pricing to me spelled opportunity.

An example of this pricing can be seen here. At the time of this writing, KMI was trading for around $39.65 per share. According to the terms of the deal, that price should dictate a per share price on KMP of $97.72, yet the market had priced KMP shares at only $95.01, a $2.71 opportunity. Similar situations were also true on both EPB and KMR shares as well.

The real opportunity exists in determining at what price KMP, KMR, or EPB should be purchased at, given the new direct correlation to KMI. For purposes of this article, let's assume that worst-case scenario, KMI were to lose all of its post-consolidation premium and revert to its average trading price from last week, $36 per share (on average). I realize that this is not super-technical, but when trying to determine an entry point, I always like to assume the worst-case scenario and use a price that reflects where the market thought fair value was prior to all of the news and hype.

Using $36 per share as our base, the below table displays the bottom-end of the pricing for each of the other three stocks.

KMI Price of $36/Share

Current Price

Floor Price

Current Conversion Price













Click to enlarge

The current price reflects what the current closing price of each stock was at the time of this writing. The floor price is, in my opinion, the bottom-end of the range and ideally the purchase price that would create the greatest potential for arbitrage opportunity, based on the above assumptions. The current conversion price is the price that would be received if the deal were to close based on the terms outlined above. Keep in mind that when I say conversion price, it is factoring in the value of the actual KMI shares.

Currently, opportunity exists in the spread between what KMP, KMR, and EPB are trading for in comparison to their parent company, KMI. Additionally, since all four stocks still trade independently until the upcoming consolidation, opportunity exists in purchasing any of the three stocks above at what I have called the "floor price", since KMI is likely to be above $36 at the time of the consolidation.

There are several reasons why I think KMI will be higher in price leading up to the consolidation. After the consolidation, KMI will roughly be worth around $92 billion in market capitalization, with an enterprise value of $140 billion. This compares to KMI's current $41-billion market capitalization. The consolidation will also make it far easier for the firm to engage in other mergers and acquisitions, while making it more nimble to penetrate the ever-growing domestic oil market. Lastly, CEO Kinder mentioned that he anticipates future dividend distributions to continue to increase at a rate of 10% from 2015-2020, starting with a $2 distribution (5.04%) in 2015. That distribution rate would put the dividend at $3.22 at the end of 2020. Compared to any of the other major oil firms, that dividend rate and anticipated distribution rate is unheard of. In an environment where the 10-year is yield around 2.40%, this should generate a great deal of buzz.

Lastly, I am really impartial to which of the three stocks are owned going into the end of the year. I currently am playing KMP, but I feel that both KMR and EPB would do just as well. Additionally, I highlighted in this article the potential of an arbitrage trade, but I do believe that the newly formed KMI will be an excellent stock to own for the long term, and I think Sunday's announcement by Richard Kinder further emphasizes his desire to create and return shareholder value for the long term.

Disclosure: The author is long CVX, KMP. 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.