My thoughts on the KMI merger

I may be completely wrong about Kinder’s reasons for merger KMI with KMP/KMR/EPB.  Here’s my guess.

Things have gotten to the point where the GP/LP structure is becoming unwieldy.  Any investments that the LPs make must be accretive to the LP unitholders.  Because of this, the hurdle for new investments is extremely high (?somewhere around 18% EBITDA yield?).  Because KMP and EPB are so large, there is a limited universe of investments that make sense for the unitholders after paying the onerous Incentive Distribution Rights (IDRs) to the GP.  (In the past, this problem has been avoided by the GP waiving its incentive fees.)  By getting rid of the GP/LP structure, the resulting company has more flexibility to pursue opportunities with lower returns that are still attractive.

I believe the other problem with the GP/LP structure is that the LP has to distribute its cash flow to unitholders.  If it did not do this, it could reinvest the proceeds into the business at attractive rates of return.  Instead, the LP has to sell shares to grow.  (*With the exception of KMR, which always reinvests its distributions in more units.)  If KMP shares happen to trade at a low valuation then KMP may not necessarily invest in projects with attractive rates of return.

After the merger, the strategy will change.  Kinder Morgan will invest more heavily into midstream assets than before.  To finance its growth:

  1. It will pay out less dividends.
  2. Hopefully, its share price will be higher due to the simplified story and higher growth prospects.  The stock may become slightly easier to analyze without the GP/LP structure.  The company will hope that it will be able to issue shares at high prices.  I believe this is what the company means by lowering its cost of capital.  It seems to me that Kinder Morgan’s presentation slides on the merger project a much higher KMI share price ($44) after the merger.  The $44 price assumes a ~4.5% dividend yield on a $2.00/year dividend in 2015.  $44 is much higher than Friday’s closing price of $36.12.

Taxes

Unfortunately, the merger will give up the tax advantages of the MLP structure.  I also believe that the merger may be disadvantageous to some KMP unitholders as they will have to give up their tax deferrals on their holdings.  (Forbes has a good article that explains taxes on MLPs.)

I believe that the combined company can only reduce its corporate taxes by rapidly expanding.  The new investment will allow Kinder Morgan to apply depreciation expenses against its taxable income.  For tax purposes, I believe that Kinder Morgan can claim higher depreciation charges that far exceed the economic reality of the asset.

Will KMP/KMR/EPB share/unitholders see this deal as fair?

I have no idea.  Some parts of the deal have poor optics.

Firstly, the KMP/KMR/EPB share/unitholders will see their dividend yields drop, even if they reinvest the cash they receive from the merger.  In the long run, their dividends will grow much faster than without the merger.  I think that the two factors likely balance each other out.  However, KMP shareholders may lack long-term thinking.

Secondly, there are some negative tax consequences for some share/unitholders.

On the positive side, the KMP/KMR/EPB share/unitholders are getting a takeover premium on their shares.

Is this deal good for KMI shareholders?

I don’t know.

Fuelfix.com has a very good article on the merger with some comments from Richard Kinder:

“I think the real test of whether this makes sense or not is that I should be the canary in the coal mine [….] So if I didn’t think this was going to be a really good deal for the KMI shareholders, I certainly would never have voted to do this transaction.”

(EDIT 8/11/2014) Why the cost of capital might fall dramatically post-merger

Pre-merger, KMI has a dividend yield of about 4.5%.  In the merger presentation slides, management states that dividend growth would be 7% from 2015-2020.

Post-merger, the dividend growth rate will increase from 7% to 10% plus an additional $2b in dividend coverage.  Because of the higher dividend growth rate, Kinder is implying that KMI should trade at the same dividend yield or a lower dividend yield.  If KMI trades at the same yield and the dividend is $2.00/year in 2015 as projected, then the stock should trade at $44+.

*Disclosure: I am long KMI warrants and call options.

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7 thoughts on “My thoughts on the KMI merger

  1. Fair synopsis. One point I’d probe a bit further is:

    “I believe the other problem with the GP/LP structure is that the LP has to distribute its cash flow to unitholders. If it did not do this, it could reinvest the proceeds into the business at attractive rates of return. Instead, the LP has to sell shares to grow. ”

    –> here’s the core of it. pre reorganization KMP was paying about 50% of its distributions up to KMI solely due to KMI’s GP stake (2% + IDRs). Distributions were approx = Funds Flow – sustaining capex, aka Distributable Cash Flow (DCF).

    At any given point in time if KMP had expansion projects it could retain some portion (p) of DCF, distribute the rest [DCF*(1-p)] and then deal with the funding gap by raising money in the capital markets.

    The problem is that for any p > 0, the GP is worse off.

    If you are the GP, would you rather

    (a) collect 50% of the current asset portfolio’s distributable cash flow * (1-p), and then get 50% of DCF generated by growth projects?

    or

    (b) just get 50% of DCF generated by those same growth projects?

    What happens is the GP always chooses (a) and always sets p to = ~0%.

    (There are a few other nits here like the 2% GP claim and related match to external equity raises, and some flexibility on the equity : debt mix at KMP, KMR’s role, etc. but materially speaking these are all just distractions.)

  2. It is NOT a good deal for KMP holders. The cash won’t pay for the entire tax hit come tax time. Especially for short-term holders, like me, who will have to pay a short-term capital gains tax bill. If you are unfortunate enough to have had income this year that pushes you into the highest tax bracket, also like me, the cost will be so much that this merger will leave you sick to your stomach with your head spinning desperately for a way out. Plus, we are losing the MLP we had planned to hold onto for our beneficiaries to receive without tax consequences. If I had known this was coming, I NEVER would have bought KMP. Shame on Kinder Morgan for not giving enough cash to KMP investors to at LEAST pay for the tax bill! Not all of us fall into the category of what they consider to be an “average” investor. Obviously, they could care less about the rest of us; yet perhaps we are in the category that are their largest investors! I am literally sick over this.

    • This does not seem to be the right way to think about this at all. If you get short-term cap gains treatment on all of KMP units at the time the deal closes, that means you purchased the units during Q4 2013 at the absolute latest—more likely the purchase occurred more recently. Ignoring about $5 of distributions, this means that you have a basic pretax rate of return in the range of 11% – 20% all for holding onto something for less than a year. Adding in the distributions bumps this up to the 15% – 25% pre-tax rate of return for holding a less than 1 year investment, in a world where most smart market participants (Buffett, Dalio, Ilmanen, et. al) are saying you should be expecting mid single digit nominal rates of return, and the S&P has returned high single digits or less over this time period. Rates of return are about in line with the Alerian MLP Index as well. Sure, there can be a big tax bite, but fundamentally you’re talking about returns that are far higher than those consistent with nominal interest rates and stock market pricing in general.

      If you’ve held the units for less than a year, you really don’t have to worry about very much deprecation recapture and can buy units in a different MLP and use those units for estate planning purposes. (Setting aside valuation which is way beyond the scope, EPD and / or MMP would be extremely obvious choices here as they are big and eliminated their IDRs years ago).

      Very simply, if you are worried about having enough cash to pay for the associated taxes, either (a) sell now or (b) sell the KMI shares when you receive them. Either way you will be able to generate more cash than is needed to cover any associated tax bill. Mathematically this has to be true as at the limit, taxes are some rate less than 100%, multiplied your gain, which at the limit, if you have zero basis, is equal to the market value at the time the gain ‘crystalizes’. The amount of cash received in the acquisition is basically a red herring.

      The reality is that the only people who “should” be complaining are those who have held KMP for an extremely long time (say more than a decade) and have an extremely low basis in it and have a high likelihood of using the units for favorable estate reasons in the very near future. But if we look at the IRR that Rich Kinder has generated for such people over the last ~1 – 2 decades, then it becomes rather ridiculous for someone who has had annual returns of ~15% to 25% over a decade or two to complain about the evolution of the business brought on by its extreme success.

      On top of all of that, if you use the current market price of KMI and the implied values for KMP, KMR, and EPB, assuming the deal closes, you can work through and see that this deal values the GP (2% + IDR) stake in the underlying MLPs as 42% of their equity value, with the other 58% going to the LP unitholders. This is quite generous as the GP stakes were supposed to receive ~41 – 42% of the distributions from the MLPs in 2014. Yet GP stakes are inherently more valuable than the underlying comparable LP stakes in a MLP stakes for reasons unrelated to control; this is especially obvious when MLPs are very high in their distribution splits. Very simply, which is more valuable a 1% claim on a LP’s cash flow, or a 1% claim on the equivalent paid via a GP stake? The GP stake is always more valuable because LPs and GPs both get their pro rata amounts of Distributable Cash Flow, but LPs have to pay in full for growth via organic capex programs or acquisitions. GPs get a free ride on this. (Technically its allocated 98% vs 2%, but this is a rounding detail of little consequence in the case of KMI.) If you are ‘equal’ partners with someone, splitting dividends 50:50 but you always have to pay for every expansion in the business while your ‘equal partner’ does not, it becomes pretty clear who’s partnership claim is worth more. The ‘junior’ partner in that situation has a claim worth less than ( 0.5 / 0.5 ) x the senior partner’s claim. In the case of KMI, the LP holders have a claim worth less than (0.58 / 0.42) x the GP’s claim, yet that is what they are being paid in this deal if it closes.

      • D, but what if I’m in the highest tax bracket? I will owe 39.6%, won’t I? All the scenarios for the “average” investor seem to be overlooking that those of us taxed at higher rates.

  3. Actually– I was a touch worried you were in the highest of highest tax brackets, which is the income tax rate + obama care surcharge on investments + california state income tax. It works out to ~50% as I recall — not appealing at all.

    While the details of taxes for MLPs give me a very bad headache, high level if your whole gain is short-term you’ll probably owe 40% or so on the to gain relative to your adjusted basis (i.e. amount your bought for plus pro rata net income – distributions received). Thinking about depreciation recaptures is giving me a headache again, so I’ll stop there.

    All that being said you are still getting a good gain after tax here, given the market and interest rate environment we are in.

    Being a pragmatist, part of me wonders about two different things though:

    1) Can unitholders lobby Rich Kinder to do the deal, but have it close in Jan 2015, instead of Q4 2014?

    2) It might be worth while asking a tax adviser as to what would happen if you sold your KMP units and immediately bought some sort of replicating option package (for instance buy a KMP call and sell a put at a strike near say $95) . This goes so far beyond my knowledge of taxes with publicly traded partnerships that I can only highlight this is an innovative, unfounded, and likely wrong speculation on my part about potentially deferring some of the gains using derivatives.

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