Offer Strong Leveraged Upside on Bullish KMI Growth Prospects

Kinder Morgan warrants (NYSE: KMI-WT) offer a highly-attractive, low cost leveraged alternative to Kinder Morgan shares (NYSE: KMI), with significantly more upside for the same level of investment and holding period, with comparable levels of risk. Warrants carry substantial anti-dilution provisions that protect shareholders from a loss in warrant value. Moreover, Kinder Morgan’s aggressive warrant buyback program has also boosted warrant value (so far, Kinder Morgan has bought back about 40% of previously issued warrants, with more buybacks expected to follow).

Kinder Morgan warrants were issued in May 2012 to shareholders of El Paso Corporation as part consideration for Kinder’s acquisition of El Paso Corporation. Each warrant gives its holder the right to purchase one KMI Class P common share for $40 (the strike price) anytime through 5 p.m. EST on May 25, 2017 (the warrant’s expiry date).


Warrants will not receive dividends and do not carry voting or other shareholder rights, and can be exchanged for shares through Computershare Inc., the warrant agent.

As of August 29, 2014, warrants had a market price of $3.91 per warrant, with a recent jump in price attributable to Kinder Morgan’s August 10, 2014, announcement to consolidate all subsidiaries and MLPs under one unified entity.


With KMI shares at $40.26 (8/29/2014), warrants are currently in-the-money, with intrinsic value of $0.26 ($40.26 – $40 exercise price) and time value of $3.65, and KMI shares will have to rise to $43.91 for warrants to breakeven. Here is a spreadsheet from 1-week ago:


Planned KMI Consolidation Will Boost KMI Share Price, Warrant Value

KMI’s strong business fundamentals and its recent consolidation announcement – to acquire all outstanding shares/units of Kinder Morgan Energy Partners (KMP), El Paso Pipeline Partners (EPB) and Kinder Morgan Management (KMR) – further strengthen its leadership in the midstream energy sector and boost its ability to capitalize on tremendous growth opportunities in the North American energy sector. So, investors should see a steady increase in KMI’s revenue, cash flow and enterprise value in the coming years, which will carry KMI shares higher and boost warrant value.

The consolidation announcement also received strong support from Wall Street, with many analysts raising their 12-month KMI share price target to well above $45 per share, implying that shares could easily ride higher by May 2017 when warrants are set to expire.

Strong Leveraged ROI for Warrants

The table below strikingly shows the strong leveraged upside potential of warrants relative to shares. For example, should shares rise to $48 by May 2017 (up from about $40.81 as of August 22, 2014), KMI warrants would deliver a 95% return (assuming they are purchased at $4.10), well above the 18% return delivered by KMI shares over the same investment holding period.


However, for these excess returns, warrant investors need to be comfortable with a small but finite probability that they could lose some or all of the money they invest in warrants if KMI shares fail to exceed the breakeven threshold of $44.10. Further, warrant holders should be okay with not receiving dividends (KMI shares currently pay $1.72 in annualized dividends for a current yield of 4.7%).

Anti-Dilution Provisions Substantially Protect Warrant Holders against Value Decline

The warrants carry anti-dilution provisions that would lower the strike price (and increase the number of shares each warrant could buy) should Kinder Morgan undertake dilutive stock splits and reverse splits, pay common stock cash dividends that exceed established annual thresholds, distribute other warrants, securities or rights, or engage in certain share buyback transactions. Warrants will also be protected against dilutive business combinations such as mergers.

The table below lists quarterly dividend payout levels that must be exceeded for a lowering of the warrant’s strike price. Any reduction in strike price will be accompanied by an increase in the number of shares exchangeable per warrant.


However, Kinder Morgan’s dividend payment schedule, announced in early August 2014, suggests that dividend thresholds likely will not be exceeded before warrant expiry. For example, KMI announced plans to raise its 2015 quarterly dividend to $0.50 per share which is well below 2015’s $0.80 threshold for strike-price adjustments. Kinder Morgan plans to raise dividends by 10% each year from 2016 through 2020, so dividend payments will still not exceed thresholds listed above unless KMI announces strong upward revisions to its current dividend policy.

Aggressive Buybacks Reduce Warrant Supply, Boost Warrant Value

Through August 2014, KMI had bought back about 206.5 million, or 40% of the 504.6 million warrants initially issued. This aggressive level of warrant buybacks underscores management’s belief that warrants are significantly undervalued relative to KMI’s growth potential.


In addition, KMI expects to have about $2 billion in excess cash through 2020, after the payment of planned dividends, and will likely use some of this excess cash to buyback additional warrants. This reduction in warrant float will also boost warrant value.

Summary

KMI warrants offer compelling value at current levels and stand to benefit from KMI’s aggressive buyback of warrants and the company’s consolidation into a single entity under the KMI umbrella. After the acquisition of all outstanding subsidiaries, the new KMI will become North America’s third largest midstream provider, uniquely positioned to capitalize on significant natural gas and oil growth opportunities. Wall Street believes the consolidation will significantly boost future revenue, earnings and cash flow, and send shares higher. Investors can reasonably expect shares to rise above $44 before warrants expire in May 2017, and could see handsome returns on their warrant investments. That said, warrant investors must also be comfortable with the small but finite risk of capital loss should KMI shares stay at current levels.

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