In Bold Move, Kinder Morgan Inc. Plans to Consolidate All Kinder Morgan Assets under One Public Company, Increase Dividends and Become Largest Energy Infrastructure Player
On August 10, 2014, Kinder Morgan Inc. (NYSE: KMI) announced plans to consolidate all of its assets under the parent entity. Accordingly, Kinder Morgan Inc. will acquire all of the outstanding common units/shares of El Paso Pipeline Partners LP (EPB), Kinder Morgan Management LLC (NYSE: KMR) and Kinder Morgan Energy Partners LP (NYSE: KMP) in a cash and equity swap worth $71 billion. This acquisition will dismantle all MLP structures, eliminate Incentive Distribution Rights (IDRs) and allow parent KMI to increase annual dividends to $2 per share and deliver 10% annual dividend growth over the 2015-2020 five year period with cash flow significantly above dividend payouts (for a high dividend coverage ratio).
If this transaction goes through, KMI will have a combined enterprise value of about $140 billion and become the third-largest energy company in the world and the largest energy infrastructure provider in North America. Management plans to leverage its new size to capitalize on North America’s growing oil and natural gas production, and has already identified 120 possible acquisitions (worth $875 billion) to propel its growth, which was more challenging under the earlier MLP structure.
Shareholders should also benefit from favorable tax deductions on depreciation of acquired assets and future capital expenditures.
The $71 billion acquisition will be financed by $40 billion in KMI equity (KMI shares issued in lieu of EPB, KMR and KMP, $4 billion in cash for which KMI already has bank commitments for the full amount and $27 billion of assumed debt.
Acquisition terms include a share swap (for all three) and a cash component for KMP and EPB, and deliver a significant premium over market price before the announcement. KMP and EPB unitholders will have a choice between cash and KMI stock, cash only or KMI stock only, subject to available cash and KMI shares on a pro rated basis.
Wall Street applauded the consolidation announcement and boosted shares of all four entities significantly – KMI shares were up over 10%, EPB shares rallied about 20%, KMR was up about 25% while KMP gained about 15%.
KMI does not expect any management changes through this transition and may increase its Board strength to up to six additional directors with up to three each from EPB and KMP. The transaction is expected to close in the fourth quarter of 2014 subject to shareholder and regulatory approvals.
After the acquisition, all share/unit holders will only hold KMI shares and should benefit from this consolidation.
After the consolidation, KMI shareholders should see sizable increases in dividend. KMI plans to deliver cumulative 2015 dividends of $2 per share, a 16% jump over the $1.72 per share planned for 2014. Thereafter, management plans to grow dividends at 10% annually through 2020, with $2 billion in excess cash after the payment of planned dividends for 1.1x dividend coverage.
Here’s How the Math Works
The consolidated growth rate will benefit from lower cost of capital, less equity issuance to fund expansion projects, favorable tax depreciation that will now be retained by the company (no longer be passed on to unitholders) and a small but significant dip in expenses from limited operating synergies (because costs are substantially under control in the existing MLP structure) – just these four benefits would enable an increase in 2015 dividend and 8% annual dividend growth through 2020. In addition, tax-deductible depreciation expenses from asset step-ups will enable an additional 2% annual dividend growth through 2020 and generate $2 billion in cash coverage over and above dividends paid.
Same Level of Growth Generates Double the Dividend Growth
Accordingly, new capital investments will deliver higher dividend growth from. In a hypothetical $1 billion capex comparison: lower taxes, lower cost of capital (on new equity and new debt) and zero cash payments to General Partners would increase KMI incremental cash flow (by $47 million in sample comparison shown in table below) or $0.03 per share on a higher base of outstanding shares. When applied to the $2 planned annual dividend, capex under the consolidated structure delivers a 1.5% growth rate, double the 0.7% distribution growth at the MLP.
MLP Unitholders May Have to Pay Deferred Taxes
Once the consolidation goes through, public MLP unitholders could owe taxes that previously qualified as “deferred”, with distribution income treated as ordinary income for tax purposes, at rates above long-term capital gains. MLP unitholders can no longer continue to defer taxes by moving their units to a trust.
Moreover, generous depreciation and amortization expenses have reduced the cost basis of MLP units and could trigger ordinary income taxes on higher capital gains. However, KMI’s consolidation move appears timely as the IRS more closely examines liberal tax rules for MLPs and unitholders that continue to hold KMI shares will benefit from future tax benefits – primarily from depreciation and amortization on assets acquired by KMI.
Significant Value Uplift for MLP Unitholders
And the table below shows significant value uplift for KMP unitholders under the new structure. For example, implied price rises from $105.05 per unit by 2020 to $167.75 under the new structure, assuming planned exchange rates and projected 10% dividend growth at KMI through 2020.
Using a similar model, KMR unitholders should see 77% value uplift and EPB unitholders should see 89% value uplift.
Dividend Growth above Peers
With about $100 billion in market capitalization, consolidated pro forma KMI metrics compare favorably with its midstream energy peers and S&P 500 high dividend companies, with its projected 10% dividend growth above average and its market cap now greater than Williams Companies (WMB) and Enterprise Products Partners (EPD).
Under the consolidated structure, there will be no IDRs and this will significantly lower cost of capital to fund future acquisitions, which would enhance future dividend growth. KMI sees significant consolidation potential in the MLP space and has identified 120 energy MLP targets with combined enterprise value of $875 billion. In addition, growth in the North American energy sector such as drilling in new fields has created significant infrastructure gaps – such as the lack of transportation and storage assets connecting these new fields – and will require investments of about $640 billion through 2035. The new structure, as a C-corp., will lower cash taxes, enhance profits and cash flow and deliver income tax savings of about $20 billion over the next 14 years with a broader pool of available capital.
After the consolidation, KMI will have 5.6x 2015 Debt/EBITDA leverage and plans to whittle this down to a target leverage ratio of 5.0x – 5.5x, eliminate structural subordination of debt and provide greater transparency, simplicity and operational and financial flexibility. Consequently, KMI expects to have an investment grade credit rating.
The consolidation boosts enterprise value immediately with significant uplift. Although near term cash outlays make the deal dilutive in the short term, synergies, lower cost of capital and acquisition growth opportunities will be accretive to earnings per share in the medium and long-term. With the exchange of KMI shares, all stakeholders will share in future growth.
Through the consolidation, KMI will become the largest energy infrastructure company in North America with over 82% stable fee based cash flows of which 94% will be locked in or hedged in 2014.
Considerably Simplifies Organization Structure
The acquisition will simplify KMI’s organizational structure into one publicly traded company versus four earlier with one equity holder base (KMI shares), one dividend policy, one debt rating, no structural subordination and no incentive distribution rights. The new entity will get 54% of its earnings from natural gas pipelines, 12% from product pipelines, 12% from terminals and 14% from CO2 oil production, with 94% of fee-based or hedged earnings streams.
KMI Shares – One Easy Way to Invest in North America’s Largest Energy Infrastructure Company
The consolidated company will have an enterprise value of about $140 billion and will give shareholders access to North America’s diversified energy infrastructure sector under one roof. KMI has identified $17 billion in organic growth projects and will actively look at acquisition opportunities. The new entity will have the largest natural gas network in North America with ownership or interests in 68,000 miles of natural gas pipelines connected to every major resource play, capacity to transport 2.3 million barrels per day of petroleum products (making it the largest independent transporter of petroleum products in North America) and 1.3 billion cubic feet per day of CO2 (making it the largest transporter of CO2 in North America). KMI will own or operate about 180 liquids or dry bulk terminals with 125 million barrels of domestic liquids capacity and the ability to handle 103 million tons of dry bulk products, making it the largest independent terminal operator in North America. KMI will also have the only oil sands pipeline serving the West Coast with ability to transport over 300,000 barrels per day to Vancouver and Washington State with proposed capacity expansion to 890,000 barrels per day.
Business Strategy to Stay the Course – Fee Based Long-Term Contracts with Minimal Risk
KMI’s business strategy will continue to focus on stable fee-based assets as the market leader in each of its business segments, extensive operational and G&A cost controls, consistent dividend growth and expansion by leveraging its asset footprint through attractive capital investments in organic growth and acquisitions with a lower cost of capital. KMI will continue to maintain a strong balance sheet with investment grade rating and target Debt/EBITDA ratio of 5.0x – 5.5x with transparency for investors and credit rating agencies as a unified publicly traded company.
KMI has a toll-road like, fee based model with volume-based take-or-pay contracts with minimum volume guarantees in many cases, long-term visibility into contracts for pipelines, terminals and CO2, price protection through locked-in or inflation-adjusted pricing, regulatory protections that raise barriers to entry and limited commodity price exposure in each of its business lines.
Promises Kept – Dividends Consistently Exceeded Target across All KM Entities
KMI shares are also attractive because management has deep industry expertise and a stellar track record of delivering shareholder value. For example, total GP + LP distributions have consistently grown at Kinder Morgan Energy Partners (KMP) over the past 18 years (1996 – 2014) with a compounded annual growth rate of 36% and annual LP distributions have gone up 13% per unit CAGR with consistent year-over-year increases while maintaining leverage within a tight range of 3.2x to 3.9x. Dividends have consistently exceeded targets and there is every reason to believe that management will be able to leverage its size and leadership to deliver solid future returns.
$17 Billion in Identified Organic Projects – 5-y Growth Backlog
KMI has identified $17 billion in organic growth projects it plans to undertake over the next five years with key projects in Canada, natural gas pipelines, CO2 storage, transportation and enhanced oil recovery (EOR), terminals and product pipelines. The table below shows planned capex outlays. 88% of this backlog is for fee-based facilities which provide stability and long-term revenue visibility.
The $17 billion presented in the table above does not include a Marcellus / Utica liquids pipeline solution, further LNG export opportunities, a large Tennessee Gas Pipeline (TGP) Northeast expansion, further Mexico natural gas expansion projects, coal and other natural resource investments and potential acquisitions.
KMI has a proven history of identifying and executing capital investment projects. For example, its Kinder Morgan Energy Partners MLP has invested $46.5 billion of growth capital since 1998 (with $22 billion on organic expansion and $24.5 billion on acquisitions) and delivered solid double-digit returns on investment each year.
Tremendous U.S. Natural Gas Opportunity
U.S. natural gas supply is expected to increase from 73.7 billion cubic feet per day (Bcf/d) in 2014 to 100.4 Bcf/d by 2024 with demand also expected to match higher supply and create significant opportunities for KMI in the natural gas sector. Demand will be driven by an increase of 10.1 Bcf/d in LNG exports, 7.2 Bcf/d in power generation, 3.8 Bcf/d in industrial petrochemicals and 2.5 Bcf/d in exports to Mexico. KMI’s extensive infrastructure footprint (pipelines, storage and services) across the U.S. is well positioned to take advantage of this tremendous growth over the next 10 years.
Growth in the natural gas sector will require about $641 billion in infrastructure investments over the next 20 years with about $30 billion in annual capex relative to about $18 billion in annual capex investment over the five-year span from 2009-2014. Natural gas delivers a sizable portion of KMI’s annual cash flow, from assets that capitalize on strategic industry initiatives such stepped up shale oil and gas production, new export permits and energy demand from a resurgent U.S. economy.
KMI has $4.6 billion committed to natural gas infrastructure investments that will generate predictable cash flow through locked-in contracts and attractive margins that should deliver mid-single-digit EBTIDA returns. KMI has also identified $18 billion of prospective natural gas development projects that will partly drive future returns.
$1 Billion in Products Pipelines Growth Capex Through 2016
In addition, KMI’s Products Pipelines segment has identified $1 billion in capital investment projects through 2016 that include condensate processing at Eagle Ford, and pipeline flow reversals, interconnects and conversions in response to changes such as natural gas export laws that have led to the development of Gulf Coast hubs and terminals that need to be connected with newer production fields. Over the years ahead, growth will be driven by production in shale fields, related midstream processing and pipeline transportation and related activities. To date, the products pipelines segment has delivered solid above-average operational performance and 99.8% environmental, health and safety (EHS) compliance.
$2.2 Billion in Terminals Growth Capex Through 2019
The company’s Terminals segment has identified $2.2 billion in capital investments through 2019, with projects related to its liquids and bulk terminals such as the development of chemical terminals, crude transport by rail from production fields in Alberta, the building of new tankers, expanding the network connected to its Houston terminals’, coal terminals and infrastructure improvements at ports for dry bulk products such as steel and copper. In the coming years, growth will be driven by the export of liquids from the Gulf Coast, crude oil transport by tanks and rail, new terminals for coal export and investment in natural resource reserves.
$1.8 Billion in CO2 Growth Capex Through 2019
The company’s CO2 segment has identified $1.8 billion in growth investments through 2019 in storage and transportation (S&T) and enhanced oil recovery (EOR), driven by growing CO2 demand and large reserves of in situ oil waiting to be extracted.
$5.4 Billion in Kinder Morgan Canada Expansion
The company’s Kinder Morgan Canada segment has identified $5.4 billion for further development of the Trans-Mountain-Pipeline (TMP) in Western Canada, driven by increasing oil sands production and strong shipping demand with attractive commercial terms, with completion and in-service expected by late 2017. The company also plans to develop additional dock capacity to over 600,000 barrels per day for global export.
While regulatory oversight raises competitive barriers-to-entry for new or less established market participants, regulation also keeps a lid on what the company can charge and presents some risk related to regulatory noncompliance penalties or punitive damages. The company’s infrastructure and revenues are significantly driven by supply and demand so, for example, a drop in crude oil production volumes could impact revenues. In the energy industry, supply and demand result in significant commodity price volatility and small crude price changes have a ripple-through effect on CO2 or natural gas production and future contracts. KMI’s business is also sensitive to economic cycles (such as a drop in demand for steel which will decrease revenue at dry bulk terminals), operational failures such as a burst pipeline, environmental factors such as expensive litigation for a spill, and terrorism-related incidents. Given the company’s dependence on debt, albeit within acceptable levels, a rise in interest rates in the years ahead will impact interest expense; for example, a 100 basis point increase in floating rates will increase interest expense at KMP by $55 million.
KMI is at some anti-trust risk as disgruntled shareholders accuse the company’s founder and his private equity backers of colluding to fix prices by agreeing to not compete in Kinder Morgan’s 2006 take-private transaction, for which Blackstone, Goldman Sachs, KKR and TPG paid a total of $392 million to settle charges without admitting wrongdoing. KMP unitholders are also up in arms and have initiated litigation that the takeover of KMP violated the Board’s fiduciary responsibility to unitholders by not seeking a higher price.
Kinder Morgan’s consolidation of its MLPs into one publicly traded company (KMI), and the third-largest energy infrastructure play, will handsomely benefit unitholders that elect to receive and hold onto KMI shares because of future benefits from lower cost of capital, depreciation-related tax benefits and significant growth opportunities tied to a boom in the North American energy sector. The company’s new capital structure will increase returns on investment (ROI) and deliver higher dividend growth than before. The deal does, however, face a few risks related to lawsuits by disgruntled MLP unitholders who have complained of collusion and a low bid, but the deal is expected to go through with substantially all of its current provisions and, if anything, could be adjusted upwards to mollify MLP unitholders. Unitholders and existing KMI shareholders will do well if they hold onto shares for the long run because of the sizable growth upside and tax benefits under the newer structure.