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August 15, 2014

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The Big Rich

In the media, there is the concept of a pre-written obituary.  News outlets (TV and print) prepare segments and obituaries in advance of a celebrity’s death, so they have facts straight and are ready to publish when the famous person dies.  The New York Times apparently has a database of more than 1,200 pre-written obituaries, with the oldest one written in 1982 (according to this article on the subject).
When Robin Williams died earlier this week, the NY Times may have had a pre-written obituary ready to go, but most news outlets probably didn’t.  If it were my policy to have pre-written obituaries on MLPs that could potentially be consolidated and go away entirely, KMP would not have been at the top of the list.
It wasn’t a surprise to see KMP announce a transaction that fixes the IDR burden on a permanent basis.  The first post I wrote on this blog asked the question, can KMP sustain distribution growth of 5%+ per year given its huge GP take?  It’s a question that’s been around a long time.  But Kinder endured with the El Paso acquisition, which allowed KMP to continue its growth for a few more years, while sucking EPB’s coverage dry.
Eventually, KMP needed to fix itself, and certainly the expectation was that it would someone make it happen.  But the market (and KMP investors in particular) was surprised at the structure of the transaction that would leave no publicly-traded partnerships bearing the Kinder name.  We’ve always seen IDR buyouts where the MLP buys out the parent and continues on as a public company (e.g. EPD, MMP, BPL), even when the GP was held in a corporate structure (e.g. MWE’s buyout of Markwest Hydrocarbon, Inc.).
What follows is my post mortem on the deal announced this past Sunday, after lengthy discussion and reflection on the transaction.
Transaction Review: A Simpler Kinder Complex
Kinder Morgan, Inc. (KMI) is acquiring all of the outstanding units of KMP and EPB, and all of the outstanding shares of KMR, in a cash and stock transaction valued at $71.0bn (press release).

  • KMI will have a stepped up tax basis on the acquired companies, and will use higher depreciation from that basis (and from accelerated depreciation) to reduce the effective tax rate at KMI and grow distributions at 10% per year for the next 5 years.
  • KMI announced that the combined entity will have target leverage of 5.0-5.5x EBITDA, and that it would be investment grade.
  • KMI announced that its lower cost of capital and size would enable it to be an acquirer of other midstream companies.

What will Kinder Look Like in the Future?
KMI may be advantaged relative to MLPs when it comes to buying assets outside the U.S.  KMI will be able to buy non-qualifying assets abroad more easily than MLPs.  Does this mean they will buy Canadian pipelines, LNG regasification terminals in Asia or Europe, or terminals in Latin America?  I don’t know, but it seems like this transaction sets them up to be able to do that.
Kinder will have another MLP someday, whether it’s a spin out of existing assets in 2016 or 2017, or it’s an MLP acquired as part of buying an existing MLPs G.P., I don’t know.  But the flow through tax advantages are still there.
Other Open Questions Asked this Week

  • Who are the acquisition candidates for KMI?
  • Is a 5.0x-5.5x levered company really investment grade?
  • How will the new MLP compete on a cost of capital basis against other MLPs when the depreciation and coverage at KMI burns off?
  • Doesn’t KMP have an advantage not paying taxes vs KMI over the long term?
  • Maintenance capex looked at differently going forward?
    • Kinder said this somewhat circular comment on conference call: “Maintenance capex is less relevant with all the extra cash we have, we think it becomes a lot less important given our size”

Impact on the Sector
MLP Structure: Neutral Impact
I don’t think this will lead to other MLPs leaving the MLP structure. EPD is much larger than KMP, with a market capitalization of roughly $70bn.  EPD is under no pressure whatsoever to convert its MLP to a corporate structure.  EPD solved its cost of capital issues long ago by eliminating the IDRs, as others have done.

  • The traditional MLP structure continues to work as is, and if an MLP’s cost of capital becomes a drag because it becomes too big, there are a number of solutions to that, a KMI-type deal being just one of them.
    • Shell’s MLP IPO, Dominion’s MLP IPO, Hess’s MLP IPO, and the large shadow backlog of unannounced MLP IPOs should still move forward
  • There are MLPs that have high IDR burdens, but none of them is as large as KMP was.  The top 5 MLPs that have the highest percentage of cash flow being paid to the GP/IDR interest (excluding KMP and not counting IDR givebacks/waivers): ETP (38.1%), PAA (34.9%), WPZ (32.2%), OKS (31.2%), and ARLP (31.2%).  KMP is paying 46.0% to its GP (gross, not counting waivers), and EPB is paying 28.1%.

Capital Flows: Positive Impact

  • The retail investor base of KMP includes big pool of investors that have been long-term holders and never wanted to sell for tax purposes, and were probably planning to die and get a step-up in basis on their KMP units.  Now those investors are forced to sell and will have to pay out massive taxes.  The end result is that that big pool of retail investor money is now free to diversify into other MLPs.
    • Combined between EPB and KMP, retail ownership is approximately $21bn.  Some portion of the after-tax proceeds of that has a good chance of finding a home with other MLPs, which is good for MLPs.
  • With this transaction, KMP will essentially graduate from the Alerian MLP Index up to the S&P 500.  KMP and EPB represent more than 12.5% combined in the Alerian MLP Infrastructure Index, which is tracked by the ETF AMLP (and its $9bn).
    • The weights of the other large cap MLPs should go up (ETP, PAA, MMP, WPZ, etc.) in this index and others, which has positive implications for their stock prices.

Consolidation / M&A Premiums: Positive Impact
Other MLPs are likely to carry consolidation M&A takeout premiums for a while, given how vocal KMP has been about consolidating the sector.  KMP buying other natural gas pipeline MLPs is a challenge given HSR anti-trust issues, but gathering & processing MLPs and liquids-focused MLPs would be logical targets.  Also, this transaction may increase pressure on other large MLPs to grow even larger, and could lead to consolidation outside of KMI.
Tax Impact: Turn in Your Deferrals
KMI is basically forcing a huge step up in basis on its largely retail investor base and then will be using that new step up to have higher depreciation and save on taxes at KMI, which is the key driver of KMI’s ability to grow at 10% a year for the next 5 years.
KMI put out an estimated tax cost for the average KMP unitholder of approximately $12.39/unit.  But that is going to vary wildly.  Newer unitholders will do better on an after tax basis than older ones.  I personally know someone who has owned KMP since 1993.  His CPA has estimated that he will owe around $27/unit in taxes. In the hypothetical, illustrative example below, I show you what that will mean (using a round number of 10,000 units) to the income he is used to receiving.  He will need to sell shares of KMI to pay taxes and the net result is 44.5% less take home cash on an annual basis. This is an extreme example, but you see why long-time KMP investors, who rely on KMP for income, might be a little upset that this transaction messes up tax planning and also actual cash flow.
Income Loss_KMP
KMP’s Legacy
KMP first went public 22 years ago as Enron Liquids with a market capitalization of approximately $150mm and a 9.5% yield.  At the time, there were only 9 MLPs.  By the time Rich Kinder took over in 1997, 4.5 years later, Enron Liquids hadn’t grown very much. KMP was only a 3.5% weight in the Alerian MLP Index (Amerigas was the largest at 12.5%).  But less than 3 years later, at the end of 1999, KMP had grown its market cap by 10x to $2.4bn, making it the largest MLP of all at the time, a title it carried for several years more before EPD overtook it.  At the end of 1999, KMP represented a 22.4% weight in the MLP Index.  That was KMP’s peak relative size.  As the number of MLPs grew, and the index eventually reached its 50 stock maximum, KMP’s weight in the Index slid down to 8.5% at the end of July.

KMP Snapshots

Before Rich Kinder took over Enron Liquids, MLPs were all about yield.  Investors bought them in the early 90s as an alternative to bonds and utilities because of their high yield and stable cash flows, not their growth prospects.  Today, annual distribution growth has become as prominent as yield when reviewing the MLP sector.  The CAGR-ization of the MLP space began with KMP.
15 years ago, in July 1999, there were 21 MLPs in the Alerian MLP Index (it wasn’t until 1Q 2006 that the AMZ reached its maximum number of 50 names).

  • 12 were midstream, 9 were other (including 7 propane MLPs)
  • Of those 22, 12 are still trading today, 9 of which are midstream MLPs
  • Of those 9 midstream MLPs, KMP has grown distributions at a faster rate than all of them at a 9.6% annual rate
  • The fastest growth for KMP came in its most active dealmaking period, when it grew distributions 15.1% annually from 1999-2004

KMP CAGR Rankings
Landmark Kinder Deals
So, how did KMP grow so big so fast early on and maintain its growth over the years?  Well, it wasn’t a single transaction that did it; it was the growth machine that KMP management built, first through acquisitions and later through organic growth. In all, in 17 years, KMP executed 88 acquisitions for a total of $26.5bn.  It was a combination of large acquisitions and small bolt-on acquisitions, see below (click to enlarge).
KMP Timeline
Below are two press releases from two of the larger deals KMP did early on.  Reviewing those press releases takes you back to a time when competition for assets wasn’t as great and capital wasn’t as easily obtained, such that KMP could buy another publicly-traded MLP and its GP and still have it be 12.5% accretive to distributions per unit, or could buy a $750mm pipeline asset at 7.5x EBITDA.

  • Santa Fe Pacific Pipeline Partners acquisition (press release)
    • Announced 8 months after Kinder took over, this transaction more than double the size of KMP
  • Tejas Gas acquisition (press release)
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