What The Kinder Morgan Consolidation Means For The Warrants

| About: Kinder Morgan, (KMI)


Kinder Morgan has been, and will remain, a solid pick as an investment in the energy industry.

The structure of the Kinder Morgan/El Paso family prior to the consolidation has been both ambiguous and confusing to potential investors. With the consolidation, investors won’t have to choose.

The warrants issued for the El Paso merger still remain fairly unheard of, but will become massively more valuable with the merger.

Kinder Morgan (KMI, KMR, KMP, EPB) has created a great entry point for both dividend and value investors after falling considerably in price as a result of malicious press. The company's performance could only be described as stellar with a 24.4% annualized EPS growth rate and a newly projected 10% dividend growth rate for the next 5 years. KMI has been a favorite for many investors, myself included, as it is a growth choice in a value marketplace. The warrants are an excellent choice in capitalizing on Kinder Morgan's current success while speculating for the long run.

Note: This article primarily talks about the KMI warrants and is not meant to be an analysis of KMI itself.

If you are new to the Kinder Morgan warrants, they are a result of a merger deal with El Paso Pipeline Partners. In order to sweeten the deal for EPB shareholders prior to the merger, KMI issued warrants for itself, trading under quotes to the effect of KMI/WS or KMI.WS, depending on the quote provider. These warrants are expiring in May 2017 with a strike price of $40, with 1 warrant entitling the holder to 1 share of KMI. With KMI currently trading at about $36 and change, the warrants are still fairly inexpensive at about $2.80. As with other warrants, these can be treated as a European option and technical analysis can be calculated using the Black-Scholes model. The results and assumptions are below:

As you can see, on a purely theoretical basis, the warrant is undervalued by about 60 cents. However, the secondary market has been suppressing the value, and the value seems like it will remain uncorrected for the short term. If you have already reviewed the press release regarding the consolidation (if not, it is available here), you would have read that KMI is projecting an increase in dividend to about 5.55% with 10% YoY growth. This, of course, affects our values. The Greeks remain roughly the same, while the theoretical value drops to about $3.17. This could have two possible effects on the market price of the warrants. First, the warrants could drop accordingly to the dividend yield adjustment and continue to trade undervalued. The second possibility is that this is the correction the warrants need and they will remain along their current trend. In either case, a drop in the price of the warrants could follow, but it should not be reason for alarm. The strong dividend yield and growth verifies the strength of the company, and by extension, the warrants

The unchanged, fundamental justification for warrants

KMI has a vested interest with the warrants, as the management recognizes that a ~$3.50 price increase spread over 3 years is very likely. As a result, KMI has previously bought back $250M of these warrants and has led investors to believe that a future buyback program is possible. With the consolidation, a new buyback program is simply imminent. Several effects arise from this situation. First, share dilution is being prevented with a buyback program, so if the price were to come around $40 in the near term, it would not likely be pinned to that amount as a result of the buybacks. This also means that there will be a consistent demand for the warrants, so unlike an option, the price of the warrants will be pushed up as the number of them outstanding becomes scarcer. This should, at least for a while, counteract any significant time decay. Where options are a wasting asset and lose demand over time, consequently losing value, these warrants will only gain value.

Investment bull thesis

The investment objective would be more conservative and would have less reward. However, it is still a worthy objective and should not be dismissed. In this case, the investor would buy the warrants at time value (since KMI is sub-$40) and hold them until expiration. Upon expiration, he would execute the warrants and ideally have the shares above breakeven. Given current prices, this would be about $43. Provided that the consolidation goes smoothly, KMI should be well above this level in 2017.

Speculative bull thesis

The alternative to buy-and-hold is a speculative strategy that uses the warrants as leverage of KMI. With a delta of approximately .40 (roughly in the middle of the current dividend yield and the future yield), the warrant is essentially at the money. The delta also indicates leverage, and that the warrant price should move about two times as much on a percentage basis compared to the underlying. The goal here would be to sell the warrant back before any significant time decay is occurring. This is typically 30 days before expiration. The upside would be determined by intrinsic value and remaining time value subtracted by current price (or time value). The downside would simply be any time value lost. With a theta of less than .01, it will take some time for the warrant to lose value.

Regardless of which thesis one would use to approach, both contain risks. At the end of the day, both theses are just on different spectrums of speculation and they both carry a very real risk of total loss of investment. While KMI looks very promising in the short to medium term, 3 years out is far away and many events (including macroeconomic) can drastically alter the price around expiration. One of the major weaknesses I noted was that KMI has a hefty backlog of projects, primarily due to civil and environmental permitting issues. Should these issues persist, or stricter environmental standards in any of the North American countries be implemented, the forecasted growth of the company will take a deep turn.

I personally prefer the speculative strategy because I am very confident in the long term outlook of KMI and I like the idea of having growth leveraged over a long period of time. I also feel that investment objective has a much higher cost of carry with a similar level of risk. I would ideally like to exit the warrants when they reach $4.30, but that number is fairly arbitrary, as is the case with most price targets, so I will remain flexible. Although both scenarios give up the possibility of gaining the healthy dividend, I made my decision based off the fact that I already am long KMI. If your situation is different, you should obviously calculate your maximum benefit differently and potentially consider a long position in KMI before tangling with the warrants.

Disclosure: The author is long KMI. 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.

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