Kinder Morgan: The Warrants Are Clearly Not 'Trashy'

| About: Kinder Morgan, (KMI)


A recent Seeking Alpha article on Kinder Morgan’s warrants has sparked a debate as to their true value.

The article argued that the warrants were essentially worthless, as Kinder Morgan was unlikely to reach the $40 strike price.

However, the article still went on to claim that the warrants are massively dilutive if exercised.

In addition, the article initially failed to mention Kinder Morgan efforts to buy back its warrants, an error which has since been corrected.

Kinder Morgan [(NYSE:KMI), (NYSE:KMP), (NYSE:KMR)] has been in the news quite a bit recently. Last week, the company committed a faux pas when it cited the possible economic "benefits" of oil spills in its Trans Mountain pipeline expansion proposal. As you can imagine, this event was the cause of major embarrassment, with the company soon backtracking from the language. Even so, as I noted in a recent article, investors in Kinder Morgan should focus on its operations and not get sidetracked.

However, another article here on Seeking Alpha really caught my attention as it covered a seldom discussed topic-- Kinder Morgan's warrants.

What are Kinder Morgan's warrants and why they were created

Before I discuss the potential value of Kinder Morgan's warrants, a bit of background is needed. Back in 2012, KMI decided to merge with El Paso. In doing so, Kinder Morgan took over 100% of El Paso Pipeline's (NYSE:EPB) general partner as well as a 40% limited partner stake.

As part of the transaction Kinder Morgan offered El Paso shareholders 0.640 of a warrant to purchase one share of KMI as part of the consideration per share. Each warrant allows an investor to purchase one KMI P share at $40 and expires on May 25, 2017.

To use a simplified example: An owner of 100 El Paso shares would have received 64 warrants along with either: cash, ($25.91 per share), or a mixture of cash and KMI class P stock valued at $25.91.

In effect, these warrants were offered by Kinder Morgan to El Paso shareholders to allow them to have some long-term upside in exchange for their shares. For KMI, the warrants were a costless method to sweeten the pot for El Paso at a moment when closing the deal seemed dicey at best.

What are Kinder Morgan's warrants really worth?

At the time of the closing of the merger, the KMI warrants were basically a long-dated call option, with little intrinsic value, especially as KMI was trading in the mid $20s. However, as the stock approached $40, they have gained some value. Over the past year or so, the KMI warrants have traded for as high as $6.00 and as low as $1.60.

While costless at the time of the merger, Kinder Morgan has not rested on its laurels. Indeed, the company has been buying back the warrants at a breakneck pace in recent quarters. During Q1 2014, the company repurchased 31 million warrants for $55 million, which implies an average price of $1.77 per warrant. At the moment, KMI has around 317 million warrants outstanding, down 37% from over 500 million originally.

With roughly three years remaining, it is hard to put a value on the KMI warrants. Save for a few short days, the stock has never really traded above $40 per share. Indeed, the closer to $40 the stock approaches, the more "dilutive" the warrants become. In essence, the warrants serve as a strong resistance for the stock price. However, this should dissipate as Kinder Morgan's earnings continue to grow,

Why the recent article got it all wrong

Finally, let me touch on a topic which generated a large amount of interest recently, namely the KMI warrants article. In the piece, the contributor noted that these warrants were "extremely dilutive" and were set up by Goldman Sachs (NYSE:GS) to its own advantage.

While that article was well-researched, it did have a few flaws. First, the article failed to mention that a large chunk of warrants were bought back by Kinder Morgan. However, this error has now been corrected. Second, the article argued that KMI is likely to get dragged now from the incoming "dilution". This is just plain wrong.

When KMI bought El Paso, it offered the warrants in lieu of offering more cash or additional stock. In essence, KMI saw a short-term accretive effect from the warrants, getting to buy the assets at a lower price point than it should have.

At current prices ($1.77 per warrant), Kinder Morgan could in theory buy back the rest of the warrants for around $560 million, or under 2% of its market cap. Yet the article makes it seem as if KMI has a potential 25% to 33% dilution hanging over its head, a hyperbolic claim at best. At the current pace of repurchases (30 million per quarter), Kinder Morgan will have bought back all of its warrants before they expire in 2017.

That being said, the warrants could offer some value if Kinder Morgan's share prices recovers. Not that long ago they were trading hands at over $5.00. At below $2.00 they seem like a bargain. Remember, they have a constant buyer who is aggressively retiring them. As the supply dwindles, the value should increase. However, they are an extremely volatile instrument, with daily 5 to 10% moves not uncommon.


For those looking to buy into Kinder Morgan Inc, I suggest just buying shares of KMI directly. The stock offers a solid yield at 5.20% and above average dividend-growth at 8%.

The warrants are currently a trading instrument and not suited for risk-averse investors. However, if you have an extremely long-term horizon and can tolerate a potential 100% loss, they do offer a compelling risk-reward dynamic. The time value is slowly declining, however, a sudden spike higher in KMI could net a double or a triple.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Disclosure: I am long KMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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