Kinder Morgan Shareholders Are The Winners Of This Transaction

Aug.21.14 | About: Kinder Morgan, (KMI)

Summary

KMI will become even more attractive investment after the transaction as this will result in increased cash flows and better dividend coverage.

The growth prospects of the business remain unchanged and the transaction should put KMI in better position for future acquisitions.

The elimination of IDRs will result in lower cost of capital and the C-Corp structure will also allow the company to have access to a wider pool of funds.

The decision to consolidate the business from Kinder Morgan (NYSE:KMI) has caused a lot of excitement among the shareholders of the company. The excitement is understandable as they will be the beneficiaries of this transaction and KMI will become an even better investment - we have recommended KMI in the past due to the strong growth prospects of the business. However, after this transaction, I believe KMI will grow at even higher rate and the prospect of dividend growth will also be enhanced. The market realized the potential of the transaction and the stock has been on an upward trend since the announcement of the transaction.

I have looked at the impact on Kinder Morgan Energy Partners (NYSE:KMP) unitholders in a separate article - in this article, I will look at the impact on the KMI shareholders and how this transaction will make KMI an even better investment. First, let's look at the transaction.

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Source: KMI Investor Presentation

KMI is going to pay about $71 billion in total to buy these three entities - KMP is the biggest entity here with the largest set of assets - KMI is paying around 12% premium to KMP unitholders and an additional $10.77 per share in cash. The second MLP, El Paso Pipeline Partners (NYSE:EPB), will also receive considerable premium and cash distribution of $4.65 per unit. The third entity is the management company, Kinder Morgan Management (NYSE:KMR) - KMR shareholders will receive premium of around 16%. The transaction will cost KMI around $4 billion in cash and $40 billion worth of new equity will be issued to the unitholders of KMP and EPB and shareholders of KMR. Generally, when a company decides to issue new shares; it results in dilution and existing shareholders are usually not impressed. However, issuance of new shares for the purpose of acquisition is usually a good thing, especially, if the shareholders of the company being acquired are willing to accept shares in exchange of their holdings.

The first advantage that I will talk about is related to the cash flows of the company. It is important to remember that this transaction will result in a change of structure only - it will not have an impact on the business prospects of the company. Kinder Morgan Energy Partners and El Paso Pipelines were the two main assets of KMI - all the cash flows for KMI were coming from these two partnerships as KMI was acting merely as a holding company. As we are aware that MLPs do not pay corporate taxes, the cash flows coming from KMP and EPB were being taxed at the corporate level at KMI. Additionally, shareholders of the company were also paying taxes at individual levels according to their own income tax brackets.

The new structure will impact the cash flows in two ways: First, the cash flows will not be divided between the two sets of unitholders and will result in a higher cash flow levels available for dividends to KMI shareholders. Secondly, this is a capital intensive business and depreciation and amortization charges are substantial - new structure will allow KMP to include depreciation and amortization, which are non-cash expenses, in its income statement and this will result in lower taxable income - since these charges are non-cash, total cash flows will not be impacted and the company will pay lower taxes. This is a key reason why KMI management is positive about dividend growth of close to 10% for the next five years. The growth potential of the partnerships is massive as we have explained the future growth drivers of KMP in two separate articles here and here. Increased cash flows will also allow the company to have strong dividend coverage over the next five years - dividend coverage will also be enhanced through growth projects coming online, which we have explained in the articles linked above, along with the positive impact from the consolidation.

Typically, MLPs have an advantage when it comes to cost of capital - the tax exempt status allows MLPs to have higher cash flows and the partnerships can have more internally generated funds if there is a need. As a result, the cost of capital is usually low for MLPs. In addition, these MLPs have attracted a number of investors due to the income potential which has resulted in sharp rise in the unit prices. As a result, secondary offerings have become attractive and MLPs can generate funds from the capital markets as well. On the other hand, C-Crop status allows the companies to have access to a wider pool of funds, which makes the funding process easier. However, this transaction will not only result in giving the business access to a wider pool of funds, but also in lower cost of capital - the main reason behind the lower cost of capital is the elimination of incentive distribution rights [IDRs]. IDRs result in lower cash flows for the common unitholders of a partnership as the general partners are given preference when it comes to cash distributions. The elimination of IDRs will allow the company to have higher cash flows which will result in lower cost of capital - KMI's ability to fund future acquisitions internally will be a key element for the future growth.

KMI and KMR shareholders are the main beneficiaries of this transaction while KMP unitholders will suffer in the short-term. As I explained in my previous article about KMP, almost all of the unitholders will have to pay substantial taxes due to this transaction - majority of these unitholders would have liked to avoid paying these taxes as most of them are the long-term investors and the biggest charm of investing in KMP was cash distributions. On the other hand, KMI shareholders do not have to pay any tax bill as they do not have to sell their shares. Furthermore, KMI is getting an extremely attractive set of assets and all the future cash flows will come to the company. This is the main reason that despite a considerable cash out flow [$4 billion] and $40 billion in new equity; KMI stock is still rising - the market recognizes the potential of the stock as the new entity will be even more attractive. At the moment, 82% of the cash flows of both these partnerships are fee-based, which will provide cash flow stability to KMI and the fluctuations in commodity prices will not impact its business.

Bottom Line

KMI shareholders should be very pleased with this transaction as it will result in a simpler structure and a stronger company. Furthermore, the structure will also allow the company to have access to a wider pool of funds and future acquisitions will be easier. However, KMP shareholders will suffer in the short-term, but it should not cause these investors to leave the company as I believe the growth prospects of the business are extremely attractive. KMI remains a solid long-term investment, in my opinion, and this transaction should result in an even stronger entity in the energy infrastructure segment.

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.