This article was originally published on TheStreet.com on August 18th, 2014 at 2:12pm EST
Some of the biggest M&A news last week came from within the Master Limited Partnership (MLP) space. Pipeline mogul Richard Kinder, Founder and Chairman of the Kinder Morgan family of companies — Kinder Morgan Management (KMR), Kinder Morgan Inc (KMI), Kinder Morgan Energy Partners (KMP), and KMI’s recently purchased El Paso Pipeline Partners (EPB) — decided to roll up all the companies into parent KMI. The deal is being valued at $71 billion and the stocks of all four companies rallied hard on Monday and closed out the week even higher.
When it comes to the deal itself there is plenty of both discussion and confusion — investors are curious why Kinder appears to be abandoning the MLP structure he championed, why he’s doing it now, and what they should do with the four names above.
The most sensible speculation appears to be that Kinder has been suffering from Berkshire Hathaway Syndrome. As Berkshire has grown into the $320 billion behemoth it now is, it has become more and more challenging to find acquisition targets that will meaningfully affect its bottom line. Were Berkshire to buy a company worth $1B and have it double or triple, for instance, the impact would pale in comparison to their $14B of annual free cash flow.
It’s Going Down, I’m Yelling Kinder!
By far the largest midstream energy company in the US, Kinder Morgan has been having the same trouble of late. Their most recent purchase of El Paso Pipeline Partners was enormous, but there were doubts whether Kinder would be able to keep moving the needle. That doubt had been priced in to all of the Kinder companies over the last year in particular — units of KMP had dramatically lagged the broader Alerian MLP Index (AMZ) through Friday, August 8th:
But caught up quickly last week:
Last week it became clear that Kinder has not, in fact, become complacent. On the contrary, he is almost certainly looking to put himself in position to do other sizable deals. To do so using KMP’s balance sheet would be expensive — because MLPs operate with little to no free cash flow, KMP’s cost of funds is substantially greater than KMI’s. Rolling up all four companies’ balance sheets into that of their C-Corp parent will increase the size of KMI’s “credit limit” while keeping the cost of funds down.
We’ve heard the term ‘MLP’ a good amount the past few years as the overall size of the MLP asset class has grown from about 30 names ten years ago, and $30B in market capitalization, to nearly 100 names with a market cap of over $350B today. But what exactly are these things?
Mutton, Lettuce, & Tomato Sandwich?
An MLP is a publicly traded partnership that enjoys a unique tax structure; today the only types of companies that qualify to operate as MLPs are owners of pipelines that transport natural resources and some related facilities used to store them. The MLP tax structure was created in the early 1980s by our government, in an effort to reduce our reliance on foreign oil — the favorable tax treatment provided incentive for investment in our country’s energy infrastructure. And it worked.
A vast network of pipelines exists in this country — hundreds of thousands of miles long, stretched out from places where oil, gasoline, natural gas, propane, and other petroleum products are refined to the places where they are consumed: Everywhere. MLPs are our nation’s toll-road for anything that powers a car, a truck, factories, airplanes, tankers, and even your grill.
Like a real estate investment, Master Limited Partnerships offer investors the benefits of depreciation and depletion — the assets owned by each partnership deteriorate over time and are constantly being kept up and replaced. Barriers to entry are enormous, as it is extremely difficult and expensive to commence construction on an underground pipeline that spans thousands of miles. This lack of competition provides a built-in business cushion to the best-positioned companies already in operation. It’s the same logic that explains Warren Buffett’s love of railroads.
Today the benefits are enjoyed by those investors who understand this tax treatment and how these vehicles tend to trade. And most don’t — including Barrons’ Andrew Bary, who wrote yet another bearish article on Kinder Morgan this weekend.
An MLP does not itself pay corporate taxes — this responsibility is passed on to its unitholders (this is what MLP shareholders are called). As such, the majority of an MLP’s cash flow is also passed along to its unitholders, giving them some similarities with other pass-through entities like REITs. But this is where many stop digging….
MLPs pay quarterly distributions. Their distributions are not traditional dividends, hence the ‘distribution’ moniker. These distributions are largely coded as ‘return of capital’ from a tax standpoint, which means — in non-technical terms — they are giving you back your own money. This portion of the distribution is not taxable today. It does, however, reduce the investors’ cost basis (which increases the future tax liability). Unless, of course, the units are passed to the next generation as cost basis steps up to market value at the untiholders’ death. For these reasons we treat MLPs as both a municipal bond surrogate as well as an estate planning vehicle in client portfolios. Bary and others seem to think MLPs, because they trade like equities, ought to be valued using traditional equity valuation metrics.
Dissecting the deal
Owners of KMP are scheduled to get 2.1931 shares of KMI plus $10.77 when the deal officially closes (expected close is December). When the deal was announced last Sunday, KMI had most recently closed at $36.12, putting the immediate implied value of KMP units at $89.98 on Monday’s open. But the stock opened at $96 and closed out the week around $99. In order to value KMP units, investors should only be paying attention to what KMI is doing. Unless you think the deal is going to fall through, this is the only metric that matters now.
Reading through the terms of the deal a bit, you can find that with the added cash flows the deal brings to KMI, the C-Corp plans to boost its $1.68 annual dividend up to $2.00 for 2015. Kinder added that he expects the now giant KMI to be able to grow its dividend 10% annually from 2015 to 2020. Historically, Rich Kinder has under-promised and over-delivered. So what is KMI worth?
KMI’s yield has been around 4% for some time — and while that would be nothing special for an MLP, it’s quite healthy for a C-Corp with serious growth prospects. Using the projected $2.00 dividend for 2015, KMI shares could trade to $50 before its yield gets back down to 4.00%. If KMI is worth $50, KMP units are worth over $120.
If you have already owned KMP for at least a year, consider selling now to lock in recent profits (and your long term capital gain rate). You may wish to roll your proceeds into KMI, which is not yet fully pricing in the benefits of this deal. If you don’t own KMP but are thinking about buying now, consider KMI instead. The two are trading in lock-step now and only one will exist at the end of the year…
If you have questions or feel we might be able to help you, please don’t hesitate to call.
Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main
Adam Scott’s profile on TheStreet.com can be found here.