Goodbye to a Great MLP: What Now for Kinder Morgan?

This leading energy company’s recent offer to wind up its various MLPs into a single entity has MoneyShow's Jim Jubak thinking that reinvestment may be the next step to take, so he’s selling his shares as of today, August 13.

The pop on the deal is just about enough to pay the taxes for investors in the Kinder Morgan Energy Partners (KMP) master limited partnership (MLP) for most investors.

The deal, of course, is the offer to wind up all the different pieces of the Kinder Morgan empire—the master limited partnerships Kinder Morgan Energy Partners, Kinder Morgan Management (KMR), El Paso Pipeline Partners (EPB), and managing partner Kinder Morgan, Inc. (KMI)—into a single entity. The non-MLP Kinder Morgan, Inc. will buy out the MLPs for $44 billion, mostly in shares.

On the news—and the news managed to reach as far as Italy, where I’m engaged in a grueling fact finding expedition to see if the euro debt crisis has caused a decline in the quality of Italian food (so far, the answer is no, but I’m not done eating until they drag me onto the plane in Milan on August 18)—units of Kinder Morgan Energy Partners, the MLP that is a member of my dividend income portfolio, closed up 17.96% on Monday to $94.77.

The new structure will abandon the tax breaks and complex cash flows of the existing MLP and holding company structure in favor of a simple straight corporate structure that will—Kinder Morgan CEO Richard Kinder told Wall Street on Monday—reduce the company’s cost of capital. The simpler structure—Standard & Poor’s has apparently told Kinder—will raise the credit rating on the company’s debt because there will be fewer potentially competing claims on cash flow. The deal will also, Kinder said, allow the company to make straight equity acquisitions in the midstream pipeline space. Ending the tax-free MLP structure for KMP, KMR, and EPB will reduce tax liabilities at Kinder Morgan, Inc. KMI by about $20 billion over the next 14 years, according to a company presentation.

Investors in two of the various MLPs won’t be so lucky. The company has confirmed that the deal will constitute a taxable exchange for owners of Kinder Morgan Energy Partners KMP and El Paso EPB. (Owners of KMR look like they’ll see a tax-free transaction.) Taxes on payouts from MLPs are deferred until the units are sold or—and this is the key here—exchanged. The company estimates that the average owner of units of KMP and EPB will owe taxes ranging from $12.39 to $18.16 a unit. You are obviously not average so ask your accountant about your own tax exposure.

So what should you do?

There’s no point in waiting for a higher offer. All the various boards have agreed on the terms and Richard Kinder has effective control of the deal through his ownership in Kinder Morgan, Inc. KMI.

At a minimum, I’d suggest selling enough units to cover your future tax liability so that no matter what happens in the stock market you’ve got your debt to the IRS cover.

What else you do depends on your analysis of the deal’s benefits to Kinder Morgan, Inc. KMI, the surviving entity.

Because the deal will simplify the calls on the cash flows of the combined company and increase the ability of Kinder Morgan to pay stock for acquisitions, it will provide a big boost to potential growth and increase the rate at which the combined company will be able to grow distributions. Kinder has said the company will be able to raise Kinder Morgan, Inc. KMI dividend by 16% in 2015 and by 10% a year for the rest of the decade. That growth rate is well above the 5%-7% rate of increase projected by Wall Street analysts for Kinder Morgan Energy Partners KMP.

Of course, the current payout at Kinder Morgan, Inc. KMI is lower than that at KMP, the increase in the growth of the payout comes off a lower base. With the projected increase and the unit/share exchange ratio in the deal, holders of KMP who elect to keep their new shares in KMI will receive about $4.39 per old KMP unit after the conversion to KMI shares. The KMP master limited partnership looked like to would pay out $5.75 in 2015. So KMP master limited partnership owners are looking at a significant drop in cash flow in the next few years.  (That will be true even if KMP holders decide to reinvest the $10.77 cash payment from the deal.) Assuming that a KMP holder doesn’t reinvest the cash payment, the deal results in positive cash flow from distributions (a higher growth rate but lower initial payout) in 2019. Reinvestment moves that break-even point into 2017.

Since we don’t have any way to move that breakeven point closer, our unhappiness with reduced cash flow now is moot. The question becomes whether we want to own shares of Kinder Morgan, Inc. KMI versus some alternative. And the answer to that hinges on our assessment of what Richard Kinder is saying with this deal.
Part of what he’s saying is specific to Kinder Morgan. Thanks to the way that cash flowed through that network of master limited partnerships and managing partners, Kinder Morgan looked to have a capital cost/growth problem. The company, as a whole, was so big and the obligations on its cash flow so diffused that the market had become skeptical that Kinder would be able to find enough good investments to keep payouts growing at the targeted 5%-6% rate. Wall Street’s enthusiasm for Monday’s deal is largely a result of its opinion that the new structure will fix that growth problem.

But is Richard Kinder also saying something about the energy infrastructure/MLP sector as a whole? In recent months, we’ve seen consolidation in the sector in a rash of deals. The structure that Richard Kinder has put in place—which would create a new stock-based currency for doing deals—would indicate that he sees more consolidation ahead. And that the big need in this next stage for the sector is to create more currency than the MLP framework provides.

I think Richard Kinder’s sense that consolidation will continue is correct. The question for investors, though, is do you want to own the acquiring entities or those being acquired. That will largely depend on the price that acquirers pay. And we don’t have a sense of the Kinder Morgan in-house deal of what the acquisition premiums are likely to be.

I’d bet that CEOs less savvy than Richard Kinder will have trouble holding the price line and that owning potential acquisition candidates such as Targa Resources Partners (NGLS) is the way to go. But we’ll know more as the tide of deals keeps rising.

As of August 13, I’m selling Kinder Morgan Energy Partners out of my dividend income portfolio with a gain of 1.82% (plus dividends) since I added it to the portfolio on February 24, 2012.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. In preparation for closing the fund at the end of May, as of the end of March I had moved the fund’s holdings almost totally to cash. My personal portfolio is now totally in cash. When I start to put that money to work again, I’ll disclose it here.