Normally, when a company proposes to buy a competitor for a roughly 22% premium, investors are fairly pleased. But when Oneok (OKE -0.39%) agreed to a 22% premium so it could acquire Magellan Midstream Partners (MMP), one of Megallan's largest unitholders cried foul. The vote on the deal is drawing near, and Magellan's stock is trading at a discount to the takeover price, but most investors should stay far away from this complicated mess -- if they can.
The players and the play
Oneok is a natural gas-focused midstream company. Magellan is an oil and refined products-focused midstream master limited partnership (MLP). And Energy Income Partners is a pooled investment vehicle that is one of the largest shareholders in Magellan. The most important factor here is that Magellan is structured as an MLP. That makes it a passthrough entity, so unitholders are basically treated as if they own the company directly and are responsible for their portion of the MLP's income taxes. That can lead to a lot of complications, most notably the yearly K-1 form investors have to deal with at tax time.
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However, as an "owner" of this energy infrastructure business, a unitholder benefits from things like depreciation. Such passed-through income offsets allow investors to defer the taxes that would otherwise be owed immediately on distributions by reducing the cost basis of their investment. When eventually sold, the unitholder will owe more taxes than the purchase and sale prices would indicate. It can be very complicated, and a tax advisor can be helpful in sorting everything out.
Here's where things get really interesting. Assuming unitholders agree to the merger, Magellan will effectively be selling itself to Oneok. That will trigger a tax event for unitholders. The impact will be different for every unitholder, and a lot will depend on the length of time the units have been owned and, thus, the number and value of the distributions collected. But, on average, Magellan estimates that the tax hit will equate to $13.40 per unit. That's not a small number. Energy Income Partners says the tax hit that the acquisition will cause turns the deal into a loser for unitholders, and it plans to vote against the deal.
Being paid to pay taxes
The merger calls for Magellan unitholders to receive $25.00 in cash and 0.667 shares of Oneok stock for each Magellan unit, equating to $67.50 per unit, or the aforementioned 22% premium to the pre-merger price of Magellan. The cash piece of the deal is meant to help unitholders pay for the individual tax issues the deal will cause. But those taxes, even if there is cash available to pay them, will still reduce the deal's benefit to unitholders.
Magellan has stated that the merger itself will create a relatively small tax liability compared with what already existed for unitholders because of historical distributions that were collected, reducing each individual unitholder's cost basis. Magellan's contention is that unitholders would have owed those taxes, at some point, regardless of the merger. Energy Income Partners suggests that it would prefer to decide when it has to pay those taxes itself, by selling Magellan units, instead of being forced to sell to Oneok.
This is a shorthand version of the story, with a focus on trying to simplify very complex merger and tax issues -- like how Magellan actually arrived at its tax estimates. Even highly experienced investors might be left scratching their heads on this deal. And that's the point. If you don't own Magellan, the difference between the current unit price of around $65 and the $67.50 takeover offer probably isn't worth the headache of trying to figure out whether unitholders will approve the deal. And if they do, you also need to consider the profits you expect versus the tax hit you might end up with. There are much better ways to spend your investment time and energy.
The vote
The bigger problem is for investors who currently own Magellan units. If the deal goes through, there will be a tax issue to face, and it could be material depending on how long you have owned the units. If the deal falls through, nothing changes with Magellan, but the unit price will probably fall back to pre-merger announcement levels. That may seem like the better option to investors who are happy collecting the 6.3% distribution yield and don't want to be troubled with the tax headache this merger will cause.
Meanwhile, Magellan is playing up the potential negatives of remaining a standalone entity -- such as being in a mature industry with limited growth opportunities -- in an effort to spur "yes" votes. It isn't wrong about the industry dynamics the partnership faces, though management did seem more positively disposed about the future before the merger. Once again, there's no easy answer, with the complexity all revolving around the MLP business structure. The worst part is that selling before the merger to extract yourself from this mess will still leave you owing material taxes.
In other words, there's no clear winning move. It's probably best to simply stick out the merger vote and see what happens. If the deal gets approved, you just accept that you'll have to deal with the tax implications. If the deal falls through, meanwhile, you might want to reconsider your commitment to Magellan. It wouldn't be shocking to see management look for another deal at some point down the line if this one fails, reigniting the complicated mess that you're suffering through now.
