It's a theme we've been harping on for the last year here: investors in master limited partnerships are frequently at risk from conflicts of interest.
For captains of the industry, MLP investors -- also known as limited partners -- are less true partners than a convenient source of capital. Once the convenience wears off...well, it's a jungle out there, and the last place you want to be is between the apex predator and his next meal.
Because if you do end up there, the partnership agreement won't save you and neither will a board of directors that's really there to do the bidding of the MLP sponsor.
The only solution is to own, if possible, the securities in which the decision-makers are invested most heavily. Because there hasn't yet been an MLP deal unfair to insiders.
At MLP Profits, we've applied this reasoning most enthusiastically to Kinder Morgan (NYSE: KMI), naming it a Best Buy in July for the rich incentives KMI reaped from its MLP affiliate Kinder Morgan Energy Partners (NYSE: KMP). Importantly, KMI is where founder and CEO Rich Kinder has invested the bulk of his billions.
Then, late Sunday, came the news that KMI would buy out KMP, as well as KMP proxy Kinder Morgan Management (NYSE: KMR) and another affiliated MLP, El Paso Pipeline Partners (NYSE: EPB), at a premium.
True, the Kinder offer was mostly KMI stock sweetened with a modest dollop of cash. Still, the gains for all the Kinder investors Monday were undeniable, as was the fact that the limited partners in KMP, KMR and KMI saw more of them than KMI shareholders.
Perhaps Rich Kinder has gone soft and forgot where his own bread was buttered. I kid, of course. In fact, while Kinder limited partners have had a good week, Rich Kinder has positioned himself (and, unavoidably, other KMI shareholders) for a much better decade. A lot of long-term value has been shifted to KMI from the partnerships it's buying out.
Impetus for the deal came from the fact that KMP was already turning over nearly half its cash flow to KMI, which had two undesirable consequences. First, it required KMP to earn a return of at least 14% on an investment just to cover KMI's take and its own nearly 7% yield. Also, as a result of heavy equity issuance to finance new investments, per-unit distribution growth at KMP had slowed, turning off enough investors to push up the yield and thereby make its equity financing that much costlier.
The merger announced last week attacks this problem from two directions. First (at least this is the part that Kinder was keen to stress) it takes advantage of the assets on the books of the affiliated MLPs and the stepped up basis made possible by the buyout to claim for the new KMI $20 billion in tax savings from depreciation over the next 14 years.
Under the current setup, most of this basis would have been available to KMP and EPB limited partners to defer taxes on their distributions. Now the benefits will accrue to KMI, serving to dramatically lower its income tax bill.
Using a 6% discount rate (well above what it will cost the merged company to borrow money in the near term) the net present value of these tax savings is somewhere north of $13 billion. A bit more than $7 billion of that is staying with the limited partners of KMP, KMR and EPB, since they will own 55% of the merged company and will benefit from its ability to pay lower income taxes. But the other $6 billion is going to benefit the KMI shareholders prior to the merger. And though some of that will be courtesy of the stepped up basis created in the merger, a lot will come from the MLPs and their limited partners.
Let's just estimate the present value of the tax savings transferred from the MLP limited partners to current KMI shareholders at more than $4 billion. As it happens, $4 billion is what KMI has offered for its MLPs in cash. It's also paying $40 billion in stock and assuming debt of another $27 billion, but the point is that the cash cost likely doesn't even cover the present value of the transferred tax savings.
And it most certainly doesn't cover the other major benefit of this deal to KMI, which is the serious reduction in the aggregate equity income paid by the Kinder Morgan corporate family as a result of replacing MLP LP units yielding nearly 7% with KMI shares yielding 4.3% currently.
The savings are impressive. KMP, KMR and EPB declared aggregate distributions of $795 million in the most recent quarter. If those units were immediately replaced with KMI shares at the exchange ratios stipulated by the merger, their owners would have been paid $548 million based on the current KMI dividend. That's a savings of $247 million a quarter, or roughly $1 billion a year.
After the 15% dividend increase KMI has promised for next year it would still end up paying the former limited partners $637 million per quarter, or $158 million less than it will send them this month. In fact, the savings are so large that if KMI merely opted to pay its expanded shareholder base next year as much as the entire MLP family will pay shareholders and limited partners this year, it would need to raise its 2015 dividend by 25% rather than the promised 15%.
Now let's look at the long-term cumulative effect of the reduced payouts for KMP and KMR unitholders only. To do that, I've assumed that KMP could have continued increasing its distributions by 5% annually, as it's doing this year, and compared those to the KMI dividends KMP limited partners stand to collect under the stipulated unit exchange ratio and the merged KMI's projected dividend growth rate (15% in 2015 and 10% annually thereafter.) The last column simply multiplies the per-unit shortfall by the 461.7 million KMP and KMR shares currently outstanding and keeps a running total of the cumulative savings likely to be realized by KMI over these years.
Now, Kinder Morgan has a similar table in its merger presentation, only it adjusts the hypothetical KMP payout to factor in the $10.77 per KMP unit it has offered in cash.
But we've already established that the cash portion doesn't fully compensate for the tax benefits transferred in the merger, much less the yield shortfall. Nor will the cash payout be enough to cover the tax bill KMP limited partners will face as a result of the combination. Kinder Morgan estimates the average tax bill of its LPs at $12.39 per unit at the Aug. 8 KMI share price of $36.12 and at $16.41 should the share price rice to $44.44 by the deal close expected late this year.
These are tax bills the limited partners could have continued to defer without the buyout, and would have dodged entirely had they passed on the units to their heirs. And while these tax benefits weren't listed on KMP's balance sheet, they are certainly central to the value proposition of any MLP. Now they're gone. Rich Kinder doesn't care about your tax bill. He's hungry.
The insight driving this deal is that investors have been valuing rapid and predictable dividend growth much more highly than a high absolute yield. So instead of an aggregate yield of maybe 6% growing at 6% a year for its affiliates now, the new Kinder Morgan will offer 4.5% growing at 10% annually. And this in turn means the company will save $2.8 billion on reduced payouts over the next seven years, for a net present value of $2.4 billion. Add in similar savings on EPB distributions and net present value tops $3 billion.
Note that these savings are exclusively at the expense of the KMP, KMR and EPB limited partners at the time of the merger. The corresponding benefit will accrue to current KMI shareholders, who not only won't see their payout cut but will in fact receive higher and more secure KMI dividends as a result of the reduction in the payouts to their merger partners.
The updated merger value exchange scoreboard looks like this:
The thing about 2022 is, it's a long way off and any benefits that don't start to accrue until then are highly uncertain. But the big tax bill and payout reductions will be felt as soon as the deal closes.
In contrast, current KMI shareholders appear to be paying $4 billion cash for tangible benefits with a net present value of at least $7 billion, and probably meaningfully more than that. Have I mentioned yet that Rich Kinder owns 23% of KMI but only 0.14% of KMP and KMR?
So, to sum up, Kinder Morgan's proposed buyout of its affiliated master limited partnerships provides a number of cheaply purchased advantages for current shareholders. It will lead to faster, more secure dividend growth based on tax offsets and distribution savings secured at the expense of the limited partners in those MLP affiliates.
The added financial flexibility will allow the company to promote a faster dividend growth rate to investors and give it the means to continue investing in costly but potentially lucrative new projects.
This article originally appeared in the MLP Investing Insider column. Never miss an issue. Sign up to receive MLP Investing Insider by email.
0 comments:
Post a Comment