By Jason Stevens
The merger of Kinder Morgan Inc. (KMI) and El Paso (EP) will work out very well for their shareholders as well as those holding Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management (KMR), in our view. Prospects are somewhat less rosy for unitholders of El Paso Pipeline Partners (EPB), as the partnership will no longer be the sole recipient of asset drop-downs from El Paso.
Investing in EP, KMI, and KMR are the best ways to play the deal, in our opinion. Our merger-case valuation for KMI implies a $30 per share value for EP, or 19% upside to current prices. KMI is trading 15% below our merger case currently. We think this deal may help KMR close its discount to KMP, suggesting 7% upside.
The Midstream Two-Step
We've seen this playbook demonstrated twice, with Energy Transfer Equity's (ETE) bid for Southern Union (SUG) and now with Kinder's purchase of El Paso. Step 1: A general partner buys a C corporation with lots of pipeline assets. Step 2: The general partner sells the assets to its controlled master limited partnerships, realizing three distinct benefits.First, the drop-downs move the pipelines to a more tax-efficient structure at the MLPs, in effect securing a higher multiple on future cash flows for the assets. Drop-downs are priced at a level that guarantees cash flow accretion for the MLPs, enabling the MLPs to raise distributions at a faster rate. The general partner benefits directly from increased distributions on the limited partner units it owns and from increased incentive distributions.
Second, to finance the drop-down, the MLPs come to market and raise fresh debt and equity, typically in roughly equal measure. For a $1.0 billion drop-down, the MLP typically raises $500 million in new equity. The increase in units outstanding at the MLP elevates the general partner's incentive distributions, which are calculated based on the total dollar value of distributions paid to limited partners.
Third, the general partner takes the proceeds from the asset sale and pays down its acquisition debt, with a goal of holding zero parent-level debt upon completion of asset drop-downs. The math works as long as a general partner doesn't pay more for assets than it can charge its MLP and still have the drop-down be cash flow accretive.
Kinder Morgan's Bid and Valuation
The accounting for the deal is complex, as there are five publicly traded entities involved, and our final valuations are based on path-dependent assumptions. The size, pace, and pricing of asset drop-downs, and the share of assets sold down to KMP versus EPB, can greatly affect the valuations of not only KMP and EPB, but also KMI. The reason these assumptions are critical has to do with KMI's ownership of limited and general partner interests in each MLP, which affords KMI significant cash distributions. As assets are dropped down to either KMP or EPB, the MLP will finance the deal with both debt and equity (we assume a 50/50 split). Drop-downs have two effects on the MLPs. First, drop-downs increase distributable cash flow (based on our assumed transaction prices, which keep drop-downs accretive to distributions for both KMP and EPB), which allows the MLPs to raise distributions at a faster rate than otherwise possible, increasing KMI's cash inflows from distributions. Second, the new equity issuance required to finance transactions also increases KMI's cash inflows, thanks to incentive distributions that are based on the total cash payout of each MLP. As the size of the payout (limited partner units times declared distribution) increases, so does the size of incentive distributions.
The merger math for this deal is premised on drop-downs. We think KMI is worth $34 per share in our base merger case, versus our $28 predeal fair value estimate. However, if we were to assume that KMI does not drop down El Paso's assets to the MLPs and instead keeps them at the KMI level indefinitely, our valuation would decline to $26, unless we factor in aggressive cost savings. Similarly, drop-downs account for $8 of the $9 per unit fair value increase for KMP (and KMR), to $75. Were KMI to drop 100% of El Paso's pipes down to KMP, our fair value estimates would increase to $80 for KMP and KMR.
Our $34 per share base merger case valuation of KMI implies a $30 value for El Paso, higher than the $27 valuation based on the predeal stock price of KMI. We think the upside potential in owning KMI shares argues strongly in favor of the stock consideration option for El Paso's shareholders. Under the terms of the deal, for each El Paso share, shareholders can opt to receive either (a) $25.91 in cash, (b) 0.9635 share of KMI, or (c) $14.65 in cash and 0.4187 KMI share (regardless of election, all EP shareholders will also receive 0.64 warrant for each EP share owned, worth $0.96 per EP share). Based on our fair value estimate for KMI, we think options (b) and (c) are superior to cash, worth $34 and $30 per share, respectively. However, investors' election will be prorated, and based on the numbers provided by Kinder Morgan, it looks as if the company anticipates roughly 40% of EP shares being redeemed for cash, 30% for KMI stock, and 30% for cash and stock.
We assign an 80% chance the merger will go through, though we see little reason to believe it won't. Taking our merger odds into account, our fair value estimates are $33 per share for KMI, $73 per unit for KMP, $73 per share for KMR, $28 per share for EP, and $34 per unit for EPB. Should the merger not go through, our stand-alone fair value estimate for El Paso would drop to $21. Our El Paso valuation includes an estimated $8.1 billion enterprise value for the company's E&P operations; if the sale proceeds of El Paso's E&P assets are materially different, it would affect our fair value estimates for each stock. We figure that a $1 billion higher or lower sale price would add or subtract roughly $0.80 per share from our KMI fair value. Our valuation ignores potential pipeline asset sales for regulatory or antitrust compliance. In the event of a forced divestiture, KMP and/or EPB would see lower drop-downs, which would reduce, at the margin, KMI's cash flows from distributions. By our estimates, a $1.0 billion asset sale would reduce our fair value estimates for KMP by $1 per unit, EPB by $0.50 per unit, KMI by $2 per share, and EP by $1 per share.
Widening a Moat
The combined Kinder Morgan-El Paso entity will be a very attractive, wide-moat pipeline franchise. While we already had rated KMI and KMP as having wide economic moats, we have expressed concerns that the companies' exposure to commodity prices through their carbon dioxide segments detracted from an otherwise highly predictable cash flow profile. After all, Kinder Morgan is among the top five oil producers in Texas, a fact many midstream investors overlook. While the carbon dioxide segment currently accounts for roughly 28% of earnings before interest, taxes, depreciation, and amortization, the merger with El Paso will downshift this to 17%, and only 12% directly tied to oil production. El Paso's pipelines have a very high percentage of reservation fee revenue and long-term contracts, and the addition of this cash flow will shift Kinder's overall cash flow profile to 85% fee-based, by our estimates.
The pipelines are also regulated, interstate lines. Competing pipes will not be approved unless there's a demonstrated need, and odds are good that Kinder would add compression or loop existing lines long before another pipeline could get approval. The addition of El Paso's assets also extends Kinder's footprint across the continent, reaching every major market and producing region. We suspect that if anyone knows how to take advantage of such a pipeline network, it is CEO Rich Kinder.
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