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:
- It will pay out less dividends.
- 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.
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.
“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.