Second Warning For Kinder Morgan Preferred Stock Investors

| About: Kinder Morgan, (KMI)

Summary

Kinder Morgan preferreds are still trading at elevated levels.

Current common stock price suggests a 19% loss of principal at conversion.

I believe that investors blindly reinvesting dividends into this "high yielder" will suffer.

If you are bullish on Kinder Morgan, you can buy the common stock.

If you are not bullish on Kinder Morgan, why bother buying anything?

Sometimes I just don't understand the market. Last year I wrote about an investment disaster that is waiting to unfold: Kinder Morgan's mandatory convertible preferreds (NYSE:KMI) (KMI.PRA). The time bomb is getting closer to detonation, yet investors are none the wiser. If you have no idea what I'm talking, you can get some background on the situation in this article (check out some of the insightful comments as well).

The premise of the preferred stock was fairly simple. The idea was that investors would get good income while participating the upside thanks to its ability to convert to common stock. The caveat is that the conversion to common is mandatory at preset ratios (i.e. no guarantee of principal), this means that investors should not examine this stock from a simple yield perspective. Nevertheless, it would appear that the only thing that the market cares about is the yield, as the stock has not traded much further away from a 10% yield. I believe that it is extremely important for current preferred investors to understand the magnitude of the problem, unless they are okay with waking up on the day of the conversion and finding out that the preferreds lost 19% of its value in a single day (assuming the current common stock price of $20.98 and the current preferred stock price of $47.25).

Loss of Principal, Negative Total Return

As I talked about in the previous article, the number of common shares eligible to be received per one preferred share at conversion will range from 1.8142 and 1.5440, depending on the average stock price of the 20 trading days preceding the conversion date (October 26, 2018). The higher conversion ratio will apply if the common stock dips below or is equal to $27.56 and the lower conversion ratio will apply if the price goes higher than or is equal to $32.38. The ratio is determined using a sliding scale for prices between the two thresholds. At the current common stock price of $20.98, preferred investors are set to receive just $38.06 at conversion, representing a loss of 19% using the current preferred stock price of $47.25.

Now what about total return? Since the ex-dividend date of the April distribution has passed, new investors have just six more payments to collect. On a dollar basis, this equates to $7.31 per share ($1.21875/quarter). Adding this to the expected conversion proceeds of $38.06, we get a total amount of $45.37, representing a total return of -4% assuming that the dividends are not reinvested back into the preferreds. If an investor chooses to reinvest (and I have a hunch many people are), the total return would be -6%, as the dividends would be taking a hit from the conversion as they've become a part of the principal (see table below).

Now

26-Jul-17

26-Oct-17

26-Jan-18

26-Apr-18

26-Jul-18

26-Oct-18

After Conversion

Value of Investment

$47.25

$48.47

$49.72

$51.00

$52.32

$53.67

$55.05

$44.35

Source: author's calculation

Makes No Sense Whatsoever

I find it baffling that the stock remains buoyant despite its massive flaw. The current price of $47.25 only makes sense if the market is super bullish the common stock. Assuming reinvestment, the stock achieves break-even (i.e. zero nominal return) only if the common stock rises to $22.35. Not saying that's impossible given the year and half time horizon, but betting on a stock to rise 6.5% just to break even (i.e. it's as if the preferred dividends were never there) is not rational in my view. Furthermore, if an investor is bullish, why not invest in the common stock instead? Not only will he or she capture the upside between the current common stock price of $20.98 and the break-even price of $22.35, the common stock dividend can also be collected as well (2.39% yield), making this option even more attractive.

Now what if you are bearish? If you are looking for protection you won't be getting any if you reinvest the dividends. However, you could protect the downside by keeping the dividends. For example, if the commons went to zero you could still theoretically keep $7.31. But this line of thinking begs the question: why bother buying at all?

Given the above, it's clear to me that these mandatory convertible preferreds have less upside than the common stock and minimal downside protection, which has little practical use. I believe that these preferreds should trade substantially below the current level to justify an ok investment. Even though the current price is below the liquidation preference of $50, the preferred stock is no bargain.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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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