At the expense of squaring off with the traditional guild of merger arbitrageurs, I will elaborate in this piece my personal view of how I think a strategic transaction such as El Paso (EP) / Kinder Morgan Inc (KMI) (OTCBB: KMI-WT-WI, KMI/WS-W) should be "played".
As an occasional opinion provider to risk arbitrageurs, I have my deal flow biases with regards to what deals I follow and how I add value, if any. This write-up attempts not to remake the world of risk arbitrage, where the opinions are quite pre-set, but to show very different perspectives of how to make sense of a deal in a very different way than traditional arbitrage would be doing. The El Paso / Kinder Morgan transaction is slated for closing on May 24 and the time to make elections is about up. The deal as undertaken struck me as being compelling enough to delve on some of the strategic aspects that are commonly ignored by risk averse arbitrageurs.
The deal has been long in preparation. While the deal appears to be surrounded by some recent controversy brought about by M&A related shareholder litigation that has at one point or the other lead to an oversized spread, there are some overarching strategic rationales why this company is being patched together and in this respect the transaction should be far less controversial with the passage of time.
Contrarian M&A Investors stay clear of controversy and rather than swimming against the tide, embrace the managerial views of why a deal is undertaken and how and when it would be of benefit to shareholders.
Contrarian M&A Investors rarely get excited about the existence of miniscule spreads to be earned by taking no risk at all or by taking big risks that may or may not work out. Contrarian M&A Investors in other words are agnostic to what an actual spread might be and what an annualized return in a situation might be, no matter how appealing it may sound on a hedged or unhedged basis.
Contrarian M&A Investors are really looking for stochastic upside movements and generally claim to have time on their sides with the few investment dollars they carefully place by undertaking highly selective bets. Not surprisingly, there is no real publishing market for Contrarian M&A Investments because the folks who will typically get excited about the strategic nature of an M&A deal such as the one already undertaken by Kinder Morgan Inc. already own the stock for a long while and do not need to be convinced that Kinder Morgan Inc is a heck of a company to use some superlatives.
Just ask Goldman Sachs if they would be willing to pay a subscription fee for learning what they already know, namely that their 19% KMI investment is a great investment. They sure enough will not want to pay such money.
On the other hand those folks with little concern for what a company does fundamentally speaking and who claim to be short-term oriented spread driven investors, are willing to pay top dollar for the questionable advice that most often boils down to summaries of the legalese and deal terms.
For this and other reasons it is hard to find good contrarian M&A advice that actually goes beyond just the basic deal mechanics and deal terms. Such is really the nature of the beast of M&A advice.
There are though exceptions in this analytical guild. I will give for instance great credit to GFI for a great fundamental writeup on CVI Energy where Carl Icahn took 80% control (not the 100% that he wanted). I am not a subscriber but was mightily impressed with the fundamental details they provided on what was evidently an event driven involvement.
A contrarian investor would now look for reasons compelling enough to invest in the remaining CVR Energy (CVI) stub that is left trading in the market. But that is a wholly different beast and we are not going here into this hairy story with legs.
Contrarian M&A deals with investing on the basis of the not so obvious, and investing on the basis of a long term oriented investment strategy based on finding M&A deals that are executed for the right reasons.
It is quite OK for a Contrarian M&A Investor to enter a long term investment using multiple entry points over time. A Contrarian M&A Investor knows when an investment is right for his long term portfolio and what type of management and shareholder base has to come with it.
Is Richard Kinder the type of CEO that I would entrust my money with strategic asset allocations, if I wanted to get exposure to the natural gas transportation, processing and storage sectors? I am inclined to believe YES.
My first encounter with the name of Kinder Morgan was sometime in the late 1990s or early 2000. I was working at the time at a firm called Horizon Asset Management, where there was a rather smart individual in the capacity of Vice Chairman and he seemed to invest and behave very much like you wanted a long term investor to behave. With calm, and a tendency to write long profusive letters to his clients explaining what was driving this performance of stocks. This individual had the habit of writing letters by hand in the very traditional old school way of doing so. I have not encountered lots of advisors since who actually enjoy to engage their clients in lengthy personal narratives of what is going on in their portfolios. I am not sure if this gentleman, Mr. Meditz, still engages in this practice but it sure enough left me with a lasting impression on one very appropriate way to engage your clients in a dialogue about stocks.
Rather than getting nervous about any tiny bit of volatility in his portfolio, such as Exxon Mobil stock or Kinder Morgan, he continuously was reinvesting the dividends received, aside from using them for his charitable undertakings including a nice Medieval Library at Fairfield University. I honestly do not know what this gentleman thinks today about Kinder Morgan but I bet you that it still is in some fashion or other in his portfolio along with a sizable stake in Exxon. No doubt.
So, with this short and biased backgrounder, I will venture on that Kinder Morgan under the stewardship of Richard Kinder has performed quite well on its own. In ways that I do not need to elaborate here in more detail. Any well written brokerage report on the subject (such as the one authored in March by Morgan Stanley) will give the basics on what this story represents today, after incorporating the sprawling businesses of El Paso into the corporate fold. We do not have to be that innovative here. Others have fortunately covered ample of ground and deserve credit. I am clearly not the one who will despise a well written brokerage report if it helps me save some time.
That Kinder Morgan has done quite well over the years is no doubt the result of careful strategic planning and opportunistic pouncing here and there with the help of the right backers. Even though Goldman Sachs has come into the limelight of controversy recently, who could really blame them for backing a smart dealmaker such as Mr. Kinder or wanting to have a part on follow on advisory deals.
It does not hurt that Mr. Kinder has shown great contrarian skills by getting out of the way at Enron when he saw the place go down the wrong path. Whether Mr. Kinder actually wanted a promotion to CEO at Enron and whether Enron would have turned into a better place under his leadership is left aside. Generally it does not hurt to have luck on your side. Some brilliant career moves are made out of adversity. What matters or should matter to prospective KMI investors is that Mr. Kinder has been keen in creating a self funded MLP organization, and KMI as the owner of GP interests earning ample cash flows should come very close to a self-funded organization. This should make the organization very appealing to long term oriented institutional investors. It deserves to be mentioned that KMI was only recently listed on an exchange after some 4 year hiatus from public markets. The company is today controlled by Mr. Kinder and there is an elaborate voting arrangement in place. The El Paso deal that is partly funded with stock will no doubt enhance the liquidity and institutional appeal. It deserves to be noticed that until recently the amount of shares that were part of the public float of KMI was rather small at approximately 20%. No doubt, as a result of this deal, the liquidity of this company will increase, and this has in part justified the addition of this pipeline behemoth to the S&P 500. This should be an important institutional milestone and the rediscovery of KMI in institutional portfolios is just beginning.
As Contrarian M&A Investors we actually want to take the opportunity of this deal to praise what has been achieved by Mr. Kinder. While really we are no investment banker getting paid for flattering remarks there is something to be said about the positive energy that comes with saying that someone has done something right. Just imagine the antagonism of the M&A class action shareholders suing El Paso and Kinder Morgan execs and bankers in Delaware court and frothing like Pavlovian dogs at the prospects of litigation profits, meanwhile many of these litigation investors or law firms might be missing the boat by not actually participating in the future prospects of Kinder Morgan Inc post merger. Contrarian M&A Investors certainly could not care less about an M&A related bump or sweetened deal consideration in response to antagonistic jaw-breaking. Everything leading up to the deal from the background to the final negotiation should convince these M&A litigants to jump onto the KMI bandwagon before it leaves the railroad for good.
Maybe those KMI $40 strike warrants maturing in February 2017 are actually worth more than the paper they are written on and potentially are even worth accumulating as a leveraged way to participate in the bright future prospects of KMI post merger. Maybe they are not that worthless after all.
In the eyes of contrarian M&A Investors extraordinaire Joel Greenblatt, these warrant merger securities discarded by thrill-seeking arbitrageurs are certainly worth gobbling up, particularly at the currently depressed levels. I often hear from arbitrageurs the excuses that we are too big to engage in such and such strategies. I disagree. Nobody is too big not to engage in a 1 billion market cap warrant tranche. You have to be though really contrarian to see value in those papers and the possibility for them not expiring one day worthless. 5 years is admittedly a long period of time and lots of things can happen in 5 years. These warrants can temporarily drop to 50 cents or they can appreciate in one straight shot over X years to 15 dollars or more. There are many scenarios possible here.
I certainly would not bet here against Mr Kinder on the basis of what I have learnt here and there about Kinder Morgan Inc over the past 10 plus years.
While we seek no investment banking fees, we are really here to praise Kinder Morgan as if we wanted to earn such fees in the future. Becoming part of a management litigation can never be the objective of a Contrarian M&A Investor. This is not to say that we will go into bed with scumbag managers that might run certain companies. Far from it.
Contrarian M&A Investors spend quite some time understanding the managers and strategies pursued over the years to get into the brains of decision making managers and board members. There is nothing more boring than not to discern or understand why a deal is actually being undertaken and how it is being financed and whether this is a compelling deal over short, medium and long term. Short-term arbitrageurs rarely spend the time envisioning the future post-deal capitalization of a company. If they did, all of the outgoing risk arbitrage investors of Anheuser-Busch would now also be also be shareholders of Anheuser-Busch InBev for quadrupling of their capital in contrarian style since that original cash financed deal closed in late 2008. I have yet to meet one arbitrageur who was involved in BUD pre-deal and reallocated his chips into InBev on the logic that this leverage deal could actually make sense. Most arbitrageurs are not here to ask stupid questions but are ready to pounce and rarely ask those inconvenient contrarian questions that could result in stochastic upside movements and outperformance over time.
Judging from the KMI share price post deal announcement, this deal between El Paso and Kinder Morgan appears to follow a quite impeccable logic. Despite a strong arbitrageur inspired short interest in KMI (the cost of borrow is reportedly approaching 50-60%), the stock is up quite sizable along with some pipeline peers (not sure if there is outperformance or lagging in the price of KMI vis-a-vis its peers) but the fact that it is not downtrodden seems to be a good indication that the share price of KMI is here to stick for strategic reasons.
There are deals undertaken without compelling reasons and that defy logic and where the deal terms are not right, neither to the buyer nor the target. This does not appear to be the case here as neither Mr. Foshee or Mr Kinder are inexperienced as negotiators and dealmakers.
As a Contrarian M&A Investor not willing to get into controversy with managers and questioning their rationales, we readily go for what managers have come up with as being the best deal for both shareholder camps. If anything we are willing to spar a good ideological fight with short term investors. Our wooden pitchforks of contrarian investing are good enough for that matter.
The more I look at the terms of the deal, I truly have to say that there is something for everyone involved here. Nobody can claim to be a total loser. There should be winners aplenty, even the anxious EPB holders who may wonder about what the future holds. The future is bright, Hello!!! KMI is getting to use a sizable portion of cash to finance this deal (Thank you Central Bank for printing wads of dollar bills to fuel the M&A economy!). We are not here to make prognostications about how earnings will be met or accreted through this deal. I learnt this at Horizon to not waste my time on modeling and forecasting. The future is unknown or has already been written about by hoardes of capable publishing analysts. Barring any unforeseen developments it makes sense to stick with the existing guidances provided by a very credible management. If Kinder Morgan management claims that 5% of combined EBITDA is possible in merger synergies (or $350 MM) I sure am not in a position to question that. They have provided additional guidances that I can go with without further questioning.
Its not like I understand the pipeline business inside out. But I understand that others have dedicated their credible executive careers to this industry and if I desire to get exposure to that, I might as well go along with that.
I will admit at this point that within the universe of pipeline owners and operators I do not know the who is who of top managers. I am just starting now to follow this Mr. Kinder closer after having tracked him very casually at my former employer Horizon. I was also fortunate at Horizon that the principals there had developed a number of research strategies involving capital structure arbitrages involving the El Paso bonds that existed at various times. Thus, while only casually familiar with Kinder Morgan and Mr. Kinder, I think that I can claim to have a lot more familiarity with the El Paso operations and their historic evolution. Such, that I am quite happy and comfortable with the prospect of owning a piece of both, for the long term. These are just my personal biases and circumstantial casual insights into both companies. I was never a publishing analyst on any of these, but have enjoyed reading the reports and insights developed by others. I am at this point not even trying to outdo whatever has already been written about this subject. The pros on pipeline stocks are out there and aplenty. Where I can spill my beans is by reiterating the contrarian manifesto in the wake of a very interesting deal.
I have to admit that the Horizon principal team was quite prescient on the entire utilities and power generation and pipeline sector, in a way that I did not fully understand and appreciated at the time that I worked with them. Clearly some of these gentlemen with whom I had the pleasure to work such as Murray Stahl or Steven Bregman had been asked to cover utilities at Bankers Trust long before I even entered the field of investment research. Not surprisingly, Horizon did very well over the years on the entire utilities and pipelines related trades by adopting a low turnover, long-term and opportunistic investment approach.
The same might be suggested now with regards to this newly assembled mega pipeline and storage constellation. Rather than trying to outsmart management at their own game by adopting a prescient short term strategy, I may as well throw in the towel and invest first in El Paso pre-merger for the long term and secondarily invest in Kinder Morgan with all the pieces that come with it.
One strategy to Contrarian M&A Investing would simply involve entering the El Paso investment unhedged (not afraid of the future) and making the right stock or cash and stock based elections, accepting the warrant kicker with the greatest joy, and even reinvest the cash proceeds into more KMI shares or warrants post-merger closing. There is little time left to do so. In fact, May 23 is the last day to make elections.
Such would be the simplistic Contrarian M&A Investing playbook. Admittedly, part of this playbook has been borrowed from other investors before me. I mentioned Greenblatt and his adequate treatment of merger securities. (I was lucky to be of advice to Mr. Greenblatt at one point in my publishing career during the spinoff related untangling of Delta Woodside into Duck Head Apparel, Delta Apparel (DLA) and Delta Woodside Industries. This was at an early stage in my career and sitting in the almost empty roadshow presentation with executives from these companies and with Mr. Greenblatt himself felt quite like a Kodak moment. Mr. Greenblatt tripled his money on a junky set of assets that resulted from this otherwise ignored spinoff. I do not know anyone else who was actually willing to give this constellation of assets the proper credit.). So who am I to really ignore parts of the playbook that Mr. Greenblatt has so carefully laid out. Who am I to ignore all the great work done before me in writing by the diligent contrarian authors at Horizon.
This is really a matter of the right positioning. In the short term, there is no way to predict the up or down direction of the Kinder Morgan bundle of assets. I am not a magician. And contrarian investing is certainly not about magic. However, if I am willing to place some investment bets for the long term, this could be as good as any moment to place those bets and just tuck away this investment and come back in 3, 4 years to just see how it performed.
This is admittedly not something that short term oriented investors worried about the future market to market value of assets will do or are even willing to pay for. What sets apart the Contrarian M&A Investor from a short-term oriented arbitrageur is the ability to look well beyond the actual deal that is now on the plate. Would anyone have discerned that InBev would be a Euro 55 stock, four years after hitting rock bottom at Euro 10? Would anyone have predicted that Reinet Investments SCA would climb from Euro 2.50 to Euro 13 4 years after being spun-off out of luxury good maker Richemont? Short term arbitrageurs rarely ask these "what if" type of questions. You have to be really visionary for seeing value at this point in out of the money, 5-year $40 strike warrants.
This deal in that sense to me is just a reminder of a well managed company and that it exists and that it is here to accept a long term subscription of shares. Given my likings of the GP nature of KMI, I like exposure to KMI common stock and warrant bundle by investing in EP stock pre-merger. This corporate M&A deal comes with a default option that includes cash and stock consideration. Thus it is not too late to pick up the whole bundle at a slight discount. Unless you make the express all-cash election (which is not advantageous) you will automatically be swiped into the cash and stock election. This is at least how the corporate action person at Ameritrade laid out the the available elections.
Eventually we will have to come back to this situation with more so called fundamental insights. At this point, this article though only serves as a reminder that Contrarian M&A Investors are out there and do invest in stories as compelling as this and there could be decent upside.
From previous investments in spinoffs, merger securities and contrarian M&A constellations where interesting discounts were offered, I know that the post-merger market can be quite volatile. I have, thus, no simplistic dividend rationales for investing in a company such as this. Dividends may be just one part of the equation. And I sure will reinvest from time to time.
It has helped me hold onto such contrarian deal investments such as McRae Industries (MRINA.PK), or companies such as DVL Inc (DVLN.PK) on the busted REIT front or real M&A titans such as Solvay (SOLB BB)/Solvac (SOLV BB) in Belgium. I also still own A. Schulman (NASDAQ: SHLM) securities after I was quite impressed by their move to buy a long time distressed investee of mine ICO Incorporated where I was invested in the preferred shares. For an analyst such as myself to be excited about an M&A deal from a contrarian perspective, I truly have to discern something that other intelligent investors are not willing to discern. In the case of Solvac which not too long ago purchased French Rhodia in what appeared a plain vanilla M&A deal, I was mightily impressed by the compelling nature of the all cash financed deal and even more impressed by the severe holdco discount at which Solvac was trading relative to the underlying Solvay shares it owned. Rather than getting excited about the underling Rhodia deal, the nature of Contrarian M&A Investing is truly to do what the buyer is doing, and if you cannot outbeat them on strategy and the discount is compelling enough, there is all the more motives to join them.
These examples merely serve as illustration. When a company announces a deal, whether M&A, spinoff or distress related, there are always two ways to play the deal. The plain vanilla M&A arbitrage front is getting way too much attention but the buzz typically quickly wears off.
In the case of El Paso and Kinder Morgan, the pre-merger constellation has everything that intrigues me. I specially like the idea of the S&P 500 addition of KMI post closing and the fact that part of the outgoing El Paso shareholders (of which S&P Index funds are part of it) will be paid in part in cash. This will most likely compel institutional net buying pressure in KMI stock. This, together with the current sizable short position in KMI, should be enough to lift the stock higher. Although I am sure that there are investors who are firm believers in the KMI 5- year warrants, I have so far not met them. Judging by the relentless selling pressure, we have to assume that the warrants are still in a spinoff related seasoning process. Albeit they have traded now for a little bit over 3 months. It is worth considering that there will be almost 500 million warrants issued. The market cap of the warrants as of current reckoning alone approaches almost $1 billion. This is serious money, and given that the warrants exercise at $40, if ever the warrants come to be seriously in the money, the exercise of the warrants alone will bring serious spare change into the corporate coffers of KMI. Overall, this could occur to the tune of $20 billion, if ever the warrants are to be exercised in the future. We have to assume that the vampire squid bankers will get a piece of this fundraising action in the future.
All of this has me excited, the fact that there is so much alignment in this transaction. Lined up investment banking business never hurts and the fact that El Paso just undertook a small deal with EPB is proof enough that investment bankers will have lots to feast on post-merger closing. So far, a total of 356 million of the warrants have traded in over the counter when issued trading and this may involve double counting. The shareholder rotation in the warrants is in all likelihood not quite done yet, but as it subsides, we shall see where the real embedded value of these merger securities lies. It evidently will depend on where the KMI common stock moves but for a Contrarian M&A Investor and spinoff aficionado, this is more than a welcome feast.
I plan to invest some spare cash into the warrants for more leveraged upside in this, and one potential strategy to reduce the cost basis of holding onto a large warrant position may be to write short term calls from time to time.
There is thus a way to earn dividends even by just going long the straight 5-year $40 warrants. Construct your own do-it yourself limited partnership so to speak. It will require though special accounts or margin privileges to write naked $40 calls from time to time, but some brokers might even accept the $40 warrants as credible collateral to offset any call writing exposures.
This is a lengthy piece but hopefully of interest or further amusement. Unlike Anthony Trollope, I am not getting paid by the word in the novel. Since contrarian strategies to common M&A constellations interest me, there will be more of this in the future as interesting situations unfold.
Disclosure: I am long EP.