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Summary

  • The transaction will result in a substantial tax bill for KMP unitholders, depending on the purchase date of units.
  • The tax bill might even result in a loss for some KMP unitholders instead of a premium offered by KMI.
  • Some KMP unitholders might try to sell their positions now and add KMI shares to their portfolios as tax event is inevitable.

Kinder Morgan (NYSE:KMI) caused a major activity in the sector when it announced the intent to consolidate all of its entities - the company is going to buyout its master limited partnerships and the management company. This is a major decision and it is going to have an impact on a number of investors - the impact of this decision will be different for the investors of all the three companies. I will try to explain the implications for the Kinder Morgan Energy Partner (NYSE:KMP) in this article. First of all, let's look at the details of the transaction.

The transaction will cost a total of about $71 billion to KMI -- $40 billion will be in the form of KMI equity and $4 billion will be in the shape of cash, while the remaining $27 billion will be for the debt the company will be assuming. This deal will certainly bring a variety of advantages to KMI in the medium-long term. However, what will be the impact on the shareholders of the companies being bought? Let's see what the KMP shareholders will get from this deal.

(click to enlarge)

Source: KMI presentation

KMP unit holders will receive 2.1931 shares of KMI equity in return for one unit of KMP - this represents a premium of 12% on August 08 closing price and a premium of 11.4% on July 16 closing price. At the moment, KMP unit price is around $99. Furthermore, the KMP unitholders will also receive $10.77 in cash per unit. The deal certainly looks attractive for the KMP unitholders. However, tax implications might be the biggest issue for these unitholders.

The basic advantage of a master limited partnership [MLP] is the tax benefit as these partnerships do not pay any corporate tax distribute about 90% of the cash generated to their unitholders - the unitholders pay tax on the distributions received from the partnership - this structure allows the companies to avoid double tax and distribute more cash to its unitholders. Furthermore, most of the MLP investors want to hold for the long-term to avoid paying capital gains taxes and enjoy cash distributions.

This transaction will force KMP unitholders into paying taxes, and the tax bill can be substantial depending on the time of the purchase of units. KMI's offer to exchange KMP units for KMI shares will be considered a sale of KMP units, which will result in a taxable event for KMP unitholders. Although, the $10.77 will lessen the impact of the tax bill and make up for some losses, some investors might actually end up with a discount rather than a premium offered by the company.

At the moment, it looks like some portion of the capital gains will be taxed at the ordinary income tax levels, which tops at 39.6% and the remaining capital gains will be taxed at the capital gains tax level, which tops at 23.8%. So, KMP unitholders will have to pay a hefty tax bill. The sale of units before the transaction will also result in the same event and KMP unitholders will have to go through this inevitable event. Some unitholders might look to sell the units now to take a position in KMI thinking that the stock might have a discount at current levels and it might go up. This strategy makes sense to some extent - if the stocks of Kinder Morgan group continue to move higher, then switching to KMI might result in better returns.

If KMP units continue to gain then the tax bill for the unitholders will continue to rise, and a larger gain might result in a higher bracket of tax - As a result, some investors might want to buy the security they intend to hold for the long-term, in this case, KMI. If an investor does not intend to sell KMI shares in the near future, then he/she will not be exposed to capital gains tax on KMI shares and the total return might come out to be higher than KMP unitholders. According to Wells Fargo (NYSE:WFC), some KMP unitholders might end up with an effective loss of about 4% instead of a gain. Furthermore, the deal will be completed in the fourth quarter of the year, which means investors will also not be able to transfer their tax liability into the next year.

Although KMP continued to grow at an impressive rate, there were always fears about the general partner interest. Unitholders were showing concerns about the future cash distributions as the general partners' interest was taking a substantial chunk out of the cash flows. The deal certainly makes sense for KMI as it will not have to pay taxes on the cash that it was receiving as general partner's interest. One advantage to KMP unitholders will be that they will not have to submit form K-1, which is a comparatively complex form and certainly increases the tax reporting responsibility - tax reporting will be easier for the owners of the new entity.

Bottom Line

The bottom line here is that KMP unitholders might suffer a little from this transaction - a number of investors will have to pay taxes and they would have ideally wanted to avoid this event. However, this short-term pain should not push these investors away as the growth prospects of the business remain strong, which we have explained in our previous articles. In fact, the change in structure will result in enhanced cash flows for KMI, which will allow the company to grow dividends at a higher rate. Furthermore, there will be a number of other benefits to KMI [I will explain these benefits in a separate comprehensive piece], which will ensure solid total return to the KMI shareholders in the long-term.

Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investing in stock markets involves a number of risks and readers/investors are encouraged to do their own due diligence and familiarize themselves with the risks involved.

Source: What Will Be The Impact Of Consolidation On KMP Unitholders?