Kinder Morgan’s New Path

Kinder Morgan is a pioneer in the rapidly growing niche of energy master limited partnerships (MLPs). But the company reversed course this week, and announced that it will put all of its MLP assets into its traditional C corporation, Kinder Morgan Inc. (NYSE: KMI).

Kinder Morgan’s various companies operate a huge network of “midstream” assets: pipelines and terminals that move and store oil and natural gas. The company is a direct, lower-risk beneficiary of the new energy boom in the U.S.

In a $44 billion deal, general partner Kinder Morgan Inc. (KMI) will acquire the outstanding shares of Kinder Morgan Energy Partners LP (NYSE: KMP), Kinder Morgan Management LLC (NYSE: KMR) and El Paso Pipeline Partners LP (NYSE: EPB).

The new Kinder Morgan Inc. (KMI) will have an estimated enterprise value of about $140 billion—$100 billion of market value and $40 billion of debt—making it the third-largest energy company in the U.S., after ExxonMobil and Chevron.

As of the announcement, the deal valued KMP and KMR at $90 per unit, and EPB at $39. All are significant premiums over their prices before the announcement. However, KMP, KMR and EPB now are trading well above those levels, as is KMI.

Richard Kinder, co-founder and chief executive of Kinder Morgan, basically set in motion the increasingly popular MLP structure in the 1990s. MLPs pay no corporate taxes and distribute their profits to unit holders.

MLPs over time have delivered high, growing payouts, which have fueled price appreciation too. The number of MLPs has grown from just 38 a decade ago to 120 now, with a combined market value of some $600 billion.

But KMP, the biggest MLP of all ($45 billion market value), in particular has had two problems. MLPs need to constantly buy or build new assets in order to keep increasing their high distributions to investors. But KMP had grown so large that it was ! hard to find suitable targets.

Second, KMP has been paying such large distributions that it has been increasingly difficult to finance big transactions or new projects. And almost half of those cash payouts are going to KMP’s general partner, KMI, as incentive distribution rights (IDRs). That also has limited distribution growth for other investors.

The slower distribution growth rate compared with other MLPs has hurt KMP’s performance. Before the announcement, KMP had delivered a total return of 38% over three years, compared with 76% for the Alerian MLP Index.

Kinder Morgan says this move solves its growth problem. First, it eliminates the costly IDRs. Second, the simplified structure will lower borrowing costs and enable KMI to make more acquisitions and capital expenditures, using its stock as a currency.

Kinder says its potential acquisitions include more than 120 energy operations that have a combined enterprise value of $875 billion. The rapid growth of energy production in the US continues to boost the need for more energy infrastructure.

Third, the new KMI will be able to generate more rapid dividend growth. CEO Kinder said he expects the new KMI to pay an annual dividend of $2 per share in 2015, a 16% increase over 2014. That translates to a 4.5% yield on the current KMI price. He also projects that KMI will increase its dividend by about 10% a year through 2020.

Yet another benefit: As a C corporation, the enlarged KMI will pay tax at a higher rate than before.  But it also will gain significant tax benefits, including (1) the ability to depreciate its newly acquired assets and (2) the tax breaks of any MLP assets it buys, both now and in the future. Kinder Morgan currently expects tax savings of $20 billion over the next 14 years.

Kinder Morgan will also save billions in distributions by buying out high-yielding MLP units with its own lower-yielding shares, even as the dividend growth rate accelerates.

While Kinder Morgan w! ill achie! ve significant tax benefits from this restructuring, its MLP investors will take a tax hit. Not only are they losing their tax-advantaged income streams. Most taxes on those distributions don’t come due until the MLP units are sold. Some investors plan to keep their units until death. In that case, taxes on the distributions would never come due.

However, the transaction generally will be tax-free for owners of Kinder Morgan Management (KMR), which is primarily held in tax-deferred retirement plans.

Kinder Morgan is using mostly stock to pay for the purchases. This enables investors in the three target businesses to continue their ownership. But now the MLP investors must sell their units to Kinder Morgan, and then pay tax on both the price appreciation and the deferred tax on their distributions.

So the limited partners are losing higher-yield distributions and the related tax breaks while facing a tax hit. On the plus side, though, the premium they’re getting on their investments should more than cover the tax bill. And probable future growth of KMI profits and dividends is expected to occur at a much faster rate than at the MLPs, with greater capital-appreciation potential.

The merger is expected to be completed by the end of this year, subject to shareholder and regulatory approval.