Kinder Morgan: What Now?

Aug.19.14 | About: Kinder Morgan, (KMI)

Summary

Market has so far taken the Kinder Morgan merger news very well.

Benefits of changing to corporation more than compensate for lost tax advantage.

Kinder Morgan will be the first major pipeline business to be fully corporate.

Last week Kinder Morgan announced a mega merger that would put all of its businesses -- Kinder Morgan Partners (NYSE:KMP), Kinder Morgan Management (NYSE:KMR) and El Paso Pipeline Partners (NYSE:EPB) -- under one corporation: Kinder Morgan Inc. (NYSE:KMI). Basically, Kinder Morgan Inc. is acquiring the three other businesses.

This is a pretty good deal for shareholders of the other three: Based on the closing price on August 8th, KMP is going for a premium of 12%, KMR is going for a premium of 16%, and EPB is going for a premium of 15.4%. This includes the substantial cash payout to unitholders of all three businesses.

The market loved this deal: Since the announcement on August 8th, KMP is up by over 21%. Perhaps even more telling of the market's thoughts on this acquisition is how the acquiring party reacted. KMI has since spiked by 15.5%. While the market seems very happy with this acquisition, and there are good reasons to be so, investors should also know that Kinder Morgan is sailing into uncharted territory: Kinder Morgan is the first pipeline that will be entirely a corporation and not an MLP.

Fixing a big problem

During the last couple years, Kinder Morgan was plagued by a relatively high cost of capital, which made acquisitions difficult to compete for despite a target-rich environment. To understand just how tough it was getting, take a look a following table provided by investor relations.

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For every project that provided a 12% return (as above), Kinder Morgan Partners significantly underperformed what the new Kinder Morgan Inc. will be able to do. While Kinder Morgan does not have to pay cash flow on the taxes, the difference in the cost of new equity alone more than cancels out the benefit from taxes paid. Why? Because Kinder Morgan Partners was just so darn cheap. Investors will remember that just a few weeks ago, KMP was yielding nearly 7% while other partnerships were paying out yields of only 4% or 5% at most. Those higher payout obligations get expensive. Debt was more expensive too, as you can see.

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But it didn't end there. Kinder Morgan Partners had to pay KMI, the general partner, about half of that remaining (albeit hypothetical) cash flow. Kinder Morgan Partners wasn't making much incremental cash flow on acquisitions. Furthermore, a good bit of its cash flow got taxed anyway, because some had to go to Kinder Morgan Inc., a corporation, in the form of incentive distributions.

While there wasn't anything wrong with Kinder Morgan's structure per se, the market assigned it a low value, which made it tough to operate in an environment where capital is needed for rich growth projects. So, this acquisition fixes the cost of capital problem and allows Kinder Morgan to more easily acquire and build organically. The result will be higher growth and more capital spending.

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Previously, KMP could only grow distributable cash flow, or DCF, by 5% per year, and KMI could only grow by between 7%-8%. But, all together, dividend growth will be bumped up to 10% thanks to the "additional firepower" provided by lower capital cost.

The side effects

All investors in Kinder Morgan will have to get used to a lower yield. Based on last Friday's pricing, at a dividend of $2 per share, Kinder Morgan Inc. now yields only 4.8%. Unitholders of Kinder Morgan Partners have even more to get accustomed to. Those who own KMP will receive a little over two KMI units for each unit of KMP, which means distributions will go from $5.56 per year to a little over $4.00 per year. Over time, KMI's new growth rate of 10%, much higher than KMP's growth rate of just 5%, will more than make up for the lower yield today. For some, however, that's not much of a consolation.

Lingering questions

Richard Kinder has lately spoken much of the new Kinder Morgan Inc. versus the companies of the S&P 500. Specifically, Kinder talked about how much Kinder Morgan will both yield and grow its dividend faster than any other S&P 500 company.

Yet unknown, however, is how the market will take a major corporation paying dividends well above its GAAP earnings. For example, Kinder Morgan Inc. paid $3.6 billion in dividends over the last twelve months, yet has earned only $1.195 billion in net income. Pipelines are very capital-intensive businesses, and therefore depreciation allowances tend to be very high. Kinder Morgan Inc. is no exception. The company's net income would be well over twice as much if depreciation were not subtracted from net income. Of course, distributable cash flow is the most relevant metric, but how will the market react to a very capital-intensive pipeline company whose most important profitability metric is not earnings but distributable cash flow?

Optimistic as I am, I'm still not sure. After this transaction closes, Kinder Morgan will be the only major pipeline business that is entirely a corporation. This is, in a way, uncharted territory. On the plus side, management said that Kinder Morgan Inc. would, going forward, have "coverage" of $2 billion for its dividend. I would assume that coverage refers to distributable cash flow.

Conclusion

Basically, here's what the new Kinder Morgan comes down to: This is a very capital-intensive industry and therefore, in the case of Kinder Morgan Inc., depreciation is multiple times net income. As a corporation, where eyes will naturally gravitate towards net income vis a vis the dividend, this may cause worry for some. Then, as now, investors have to trust that Richard Kinder will bring value to the table and will do the right thing.

Kinder Morgan is no longer undervalued. Kinder Morgan Partners used to trade at under 15 times DCF while other names, such as Enterprise (NYSE:EPD) and Plains All American (NYSE:PAA), traded consistently above 20 times DCF. That gap has closed significantly. On the other hand, 10% dividend growth, year after year, is hard to find from a big company, and Kinder Morgan has precisely that. I believe that shareholders who stay along for the ride will be generously rewarded.

Personally, I am not selling, and I will not consider selling until Kinder Morgan has climbed to the point where its dividend yield is even with or lower than that of the leader in this space, Enterprise Products Partners. That still looks to be a long way off as Kinder Morgan Inc. yields around 4.8%, while Enterprise yields only 3.75%.

Disclosure: The author is long KMI, 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.