Kinder Morgan Grows Leery of MLP Structure; Consolidates Holdings
publication date: Aug 11, 2014
author/source: Brian Nelson, CFA
Kinder Morgan is the largest midstream and the fourth-largest energy company (based on combined enterprise value) in North America. The entity owns an interest in or operates ~80,000 miles of pipelines and 180 terminals. The firm’s publicly-traded companies include Kinder Morgan (KMI), Dividend Growth portfolio holding Kinder Morgan Energy Partners (KMP), Kinder Morgan Management (KMR) and El Paso Pipeline (EPB). KMI owns the general partner and limited partner interests in both KMP and EPB. KMP is one of the largest publicly traded pipeline master limited partnerships in America. KMR is a limited liability company and its only significant assets are the partnership units it owns in KMP. EPB is a publicly traded pipeline master limited partnership. -- source
The convoluted structure of the Kinder Morgan umbrella will now change, as KMI announced Monday it will purchase all of its subsidiaries KMP, KMR, and EPB. The combined entity is expected to receive investment-grade marks from the credit agencies, and to please the dividend growth crowd, the “new” KMI expects 10% annual growth in the dividend from 2015-2020. The deal amounts to ~$70 billion in total transaction value and is expected to close by year end. We think the transaction is a smart one and speaks loudly about the limitations and risks of the MLP structure (click here).
At the time of this writing, units of KMP, KMR, and EPB are up ~18.5%, ~26%, and ~23%, respectively. KMI is advancing ~11% on the news. KMP is a holding in the Dividend Growth portfolio, and the news today puts this position well into the black. However, as a result of the lost income stream associated with the buyout, KMP will be removed from the income-oriented Dividend Growth portfolio September 1—or at the time of the release of the September edition of the Dividend Growth Newsletter (KMP, KMR and EPB will cease trading once the deal closes before year-end).
The stated reason for the deal is that it will open up the firm to more growth related to the US shale drilling boom and offer it a lower cost of capital for M&A. To us, however, the reason is not as sanguine. The Kinder Morgan empire and other MLPs have recently been under analytical attack due to their business structures, which rely heavily on management estimates of maintenance capital spending in deriving distribution coverage and the healthy functioning of the capital markets for new debt and equity capital. By rolling up the umbrella, Kinder Morgan has essentially reduced the conglomerate’s capital market dependence (at least in its subsidiaries structured as MLPs) and can now build retained earnings and a greater cash buffer on the balance sheet for new deals--or to strengthen the safety of the payout to investors. MLPs are structured to pay out a significant portion of operating cash flow to unitholders, and therefore are less able to handle adverse shocks—as in the case of Boardwalk Pipeline (BWP).
To some, the deal could be considered a surprise as the trend in recent years has been toward energy firms spinning off their pipelines and oil terminals into MLPs, not re-consolidating them. Moreover, Kinder Morgan has long been the poster child of the MLP structure, and we think the news could start a trend toward the reconsolidation of MLPs (to the general partner), given the market’s very positive reaction to the transaction today. The deal could also mark the beginning of change with respect to the perception of the very real risks related to the MLP structure, which exists more to feed investors’ appetite for lofty cash distribution payouts than for creating economic value (a large ROIC-less-WACC spread). In any case, we’ll be monitoring industry developments closely, as we raise a very important red flag: if investors applaud both the spin-offs and re-consolidation of MLPs, what will they shun? Is this more evidence of a bubble?
Even though we applaud KMI’s toll-road-like (fee-based) assets that are core to North American energy infrastructure (and we like Rich Kinder), we do not intend to use the proceeds of the KMP removal to add KMI (the suitor) to the Dividend Growth portfolio at this time. Our list of dividend growth ideas is long, and while our team will take a diligent look at where we expect to redeploy capital in coming weeks, we’ll likely choose the energy space in order to replace the diversification lost from the KMP removal. Our best dividend growth ideas are always included in the Dividend Growth portfolio.
Deal notes: Upon closing, KMP unitholders will receive 2.1931 KMI shares and $10.77 in cash for each KMP unit, KMR shareholders will receive 2.4849 KMI shares for each share of KMR, EPB unitholders will receive .9451 KMI shares and $4.65 in cash for each EPB unit.
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