Kinder Morgan Merger Is a Growth Catalyst Worth Considering

Kinder Morgan Inc just announced a record quarter, silencing a barrage of recent critics who doubted its growth prospects. This article points out an interesting growth catalyst that many investors might not know exists; a potential merger between Kinder Morgan Energy Partners and Kinder Morgan Inc.

May 17, 2014 at 6:31AM

The recent bad press regarding Kinder Morgan Inc (NYSE:KMI) that culminated with Barron's article, "Kinder Morgan: Trouble in the Pipelines," resulted in a 10% price decline within a few days. Critics of the company argued that the company's best growth days were behind it (due to its massive size). The company's reiteration of 8% dividend growth -- and 5% distribution growth for Kinder Morgan Energy Partners (NYSE:KMP) -- did little to alleviate these concerns. 

Well, the company just posted record quarterly results that proved doubters wrong:

  • Record gas volumes (at Kinder Morgan Energy Partners) of 33 Bcf/d (one third of all gas transported in America).
  • Revenues up 37%.
  • Cash available for dividends up 12%.
  • Dividend increased 11% from last year (beating guidance of 8%).
  • Dividend coverage ratio increased from 112% to 131%.

The company announced that it would be dropping down additional assets to its MLP -- El Paso Pipeline Partners. These drop downs include its 50% stake in the Ruby Pipeline, 50% stake in Gulf LNG and 47.5% stake in Young Gas Storage. These drop downs will help El Paso accelerate distribution growth and raise the IDR (incentive distribution rights) fees paid to the general partner.

In addition, the company reiterated its increased project backlog of $16.4 billion (up 16% this quarter) and 8% dividend guidance for the full year. 

As a dividend growth stock, investors are hard pressed to do much better than Kinder Morgan Inc; its 5% yield and 8+% dividend growth rate could very well result in market-crushing total returns. However, there is one additional growth catalyst that makes Kinder Morgan Inc a special situation that investors should consider.

Merger will supercharge returns
A recent report by investment bank Credit Suisse argues that Kinder Morgan Inc could be merged with Kinder Morgan Energy Partners. The report cites three possible ways the merger might proceed:

MLP units (from both Kinder Morgan Energy Partners and El Paso Pipeline Partners) are used to buy out just the IDRs of Kinder Morgan Inc (the general partner of these two MLPs). This scenario would leave Kinder Morgan Inc a pure holding company for its MLPs, akin to the situation between Linn Co and Linn Energy Partners. Kinder Morgan Inc would receive nearly all its income from distributions from its MLPs (which would grow twice as fast without IDRs to pay) and the yield would track the weighted average of the two MLPs. The benefit to shareholders in this situation would be a lack of tax complications that come with a K-1 form. 

The second method a merger might occur is that Kinder Morgan Energy Partners outright buys Kinder Morgan Payment would be in units (at a sufficient premium to Kinder Morgan Inc's current price). 

A second benefit to existing Kinder Morgan Inc shareholders (in addition to the above mentioned premium) would be the elimination of the traditional MLP discount. Specifically, I am referring to the fact that Kinder Morgan Energy Partners trades at a 45% discount to Enterprise Product Partners (who bought out their general partner several years ago) on a price/DCF basis.

Thus the result of situation two, the most likely form a merger would take, is that existing Kinder Morgan Inc shareholders would see their 5% yielding shares replaced by 7% yielding units whose distribution growth rate would be doubled (due to a lack of IDR fees). Coupled with the likely increase in unit price this scenario would be a most beneficial to current shareholders despite the additional tax complications associated with owning an MLP. 

The final scenario, the Credit Suisse Report mentioned was a dilution of Kinder Morgan Energy Partners units to lower the distribution sufficient to reset the IDRs to a lower level. This scenario is very unit holder-unfriendly (and in no way benefits Kinder Morgan Inc shareholders) and can most likely be rejected out of hand.

When specifically asked about the possibility of such a merger, which would need the blessing of founder and CEO Richard Kinder (who owns 26% of Kinder Morgan Inc shares), the company stated that it would consider such a merger if it felt that distribution growth at Kinder Morgan Energy Partners wasn't sufficient to reward unit holders.

Foolish takeaway
Kinder Morgan is one of the finest natural gas plays in America and one of the best dividend growth stocks, period. Its record quarterly results, guidance-crushing dividend growth, and quick growing project backlog foretells strong, consistent returns for decades to come. Add to this the special situation represented by the potential merger with Kinder Morgan Energy Partners and long-term income investors have every reason to own this company -- especially at the current historically low valuation. 

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Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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