After the Mega-Merger Announcement, Is Now the Time to Buy Kinder Morgan?

On August 11, Kinder Morgan Inc (NYSE: KMI  ) announced the second largest energy merger in history -- a $71 billion buyout of its three MLPs, Kinder Morgan Energy Partners (NYSE: KMP  ) , Kinder Morgan Management (NYSE: KMR  ) , and El Paso Pipeline Partners (NYSE: EPB  ) . I wrote an article explaining why the deal was terrific for investors and made Kinder Morgan one of the best dividend growth stocks in America. The market seems to have agreed, as share and unit prices surged on the news, with prices of all involved parties rising between 9% and 24% the day following the announcement.  

KMI Chart
KMI data by YCharts

Three of most popular questions I received related to this article were: "Is it too late to buy Kinder Morgan?"; "Which company/MLP should I buy?"; and "What are the tax consequences of this merger if I own any of the MLPs?"

This article is designed to answer these questions and help long-term income investors profit from the $890 billion energy megatrend

Tax consequences mean one MLP's investors lose in the short term
One of the great benefits to owning a master limited partnership (MLP) is that much of one's distributions are considered "return of capital," and rather than pay taxes on them, they are treated as tax-deferred and lower one's cost basis. When investors sell the units they then pay taxes on the adjusted cost basis, which can eventually hit zero (after which distributions are taxed as regular income). 

Due to this tax treatment, long-term MLP investors can permanently defer taxes equal to their initial investment, as long as they hold units forever and pass them onto their heirs. However, according to The Wall Street Journal's Laura Saunders, Alison Sider, and Russell Gold, the Kinder Morgan merger will trigger a taxable event that means this won't be possible.

According to Robert Willens, an independent tax advisor in New York, "In this deal, one group of stakeholders will owe tax so that the company as a whole can benefit." Most of the previously deferred income will now be taxed as regular income, says Robert Gordon, a tax strategist from New York based Twenty-First Securities Corporation.

While the deal is certainly in the best interest of Kinder Morgan as a whole, and long-term investors are sure to benefit from Kinder Morgan's expected 16% dividend increase in 2015 and 10% growth through 2020, Wells Fargo Securities has released an analysis of the post-tax benefits to investors of each of the bought-out MLPs.

  • Kinder Morgan Resources: non-taxable event, investors net benefit 21%
  • El Paso Pipeline Partners: 7% net benefit
  • Kinder Morgan Energy Partners: 4% net loss
While it may shock investors in Kinder Morgan Energy Partners to learn they will end up losing money (in the short term) on the deal, Wells Fargo goes on to explain why the deal is still in their best interest. "Kinder Morgan was unique in that 45% of its cash flow was accruing to the general partner. With a 45% "GP tax" on KMP, it became difficult for the partnership to grow."
 
The merger will substantially lower the cost of capital for investors in Kinder Morgan Energy Partners, and higher dividend growth is likely to improve total long-term returns.
 
What does this mean for you?
There are two key takeaways from this taxable event. First, the tax consequences that lower the premium for investors in Kinder Morgan Energy Partners and El Paso Pipeline Partners are due to long-term deferred distributions. This tax event will occur either when the deal closes or if you were to sell your units in Kinder Morgan Energy Partners, El Paso Pipeline Partners, or Kinder Morgan Management. 
 
However, currently all three MLPs are trading at premiums to their buyout prices: KMP by 4%, KMR by 5.5%, and EPB by 4.1%. Those price increases mean that current investors in these MLPs, if they sold their units, would lock in these premiums and help offset the tax consequences mentioned previously (KMP investors would break even on the merger by selling now).
 
However, as I'll explain below, I feel that selling units of any of the MLPs would be short-sighted. Better to hold onto your units and wind up holding shares of Kinder Morgan Inc, which, as I'll explain below, is set to be a top performing dividend growth stock over the next few years. 
 
What about new investors? Well the answer is simple: Buy Kinder Morgan Inc.
 
Why you should buy Kinder Morgan today
There are two key reasons why investors should still consider buying Kinder Morgan Inc, even after the pop following the merger announcement: its strong future dividend growth, and the superb total returns they are likely to fuel. 
 
Kinder Morgan's announced dividend plan means a $2/share dividend in 2015 growing to $3.22/share in 2020. Not only does that represent an 8% yield on today's price, but that kind of dividend growth is likely to means strong capital gains. 

KMI Dividend Yield (TTM) Chart
KMI Dividend Yield (TTM) data by YCharts

Over the last four years Kinder Morgan Inc's yield has averaged 4.08%. If we apply this historical yield to Kinder Morgan's 2020 dividend, and factor in the dividends over the next five years while applying the long-term tax rates of 15% and 20% (for highest tax bracket), we can determine a realistic long-term total return and find a present day fair value.

Year Dividend Post Tax Dividend 15% Post Tax Dividend 20%
2015 $2.0 $1.7 $1.6
2016 $2.2 $1.9 $1.8
2017 $2.42 $2.06 $1.94
2018 $2.66 $2.26 $2.13
2019 $2.93 $2.49 $2.34
2020 $3.22 $2.74 $2.58
Total $15.4 $13.1 $12.3
2020 KMI Price (based on historical yield) $78.92    
2020 KMI Total Value (post tax)   $92.04 $91.26
Annualized Total Returns   17.98% 17.78%
Stock Market 1873-2013 Annual Total Return 9.20%    
Market historically predicted return through 2020: (discount factor) 55%    
Present Market Fair Value of KMI $59.38    
Discount to fair value (margin of safety) 32.30%    

Sources: Author's calculations, Kinder Morgan press release, Moneychimp.com

As shown in the above table, if Kinder Morgan can meet its dividend growth targets, it is likely to double the stock market's historical total returns through 2020, and that's not including dividend reinvestment (which brings annual total return to 18.6% post-tax). Given that Kinder Morgan and its MLPs have beat or met dividend/distribution guidance in 18 of the last 19 years, this is highly likely and means that Kinder Morgan is deeply undervalued and that long-term investors will likely be richly rewarded indeed.

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Read/Post Comments (6) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 04, 2014, at 2:29 PM, RudyinTucson wrote:

    Adam,

    As I understand it, the merger means for El Paso Pipeline holders to receive a cash disbursement in addition to shares of Kinder Morgan, though I haven't seen how much cash would be paid. EPB now pays 6.4% interest. How is giving up this for 4.15% from KMI, and waiting two or three years to catch up, a good idea? Wouldn't selling EPB now and investing in another MLP such as Linn Energy be a better move?

    Rudy

  • Report this Comment On September 05, 2014, at 8:49 AM, AdamGalas wrote:

    It depends. By holding onto EPB you end up with cash and shares of KMI. As I showed in the article, KMI is likely to do very well,

    In fact since Linn Energy's IPO its total returns (including distribution reinvestment) have been 11.1% per year, nearly double the S&P 500's.

    KMI is likely to do at least 68% better than Linn Energy due to two factors.

    One, Linn Energy's market crushing performance has largely been due to its torrid growth rate, which allowed it to grow distributions by an average of 8.7% annually.

    Linn's growth will continue, but its larger size will mean distribution growth (and thus overall performance) is likely to slow as well. Thus its unlikely to do as well in the next 10 years as it did in the last 11.

    Second, my 18.7% post tax total return projections for Kinder Morgan are based purely on management's forecasted dividend growth.

    As I explained in the article Kinder Morgan has an excellent track record of beating dividend guidance and if they can grow the dividend at 11%-12% over the next six years than KMI's returns could easily be 20% through 2020.

    As great as Linn Energy is, (I do recommend owning them as part of a high income portfolio because of the safe 10% yield) I highly doubt they'll be able to achieve that level of growth.

  • Report this Comment On October 03, 2014, at 2:16 PM, HarlowsHeights wrote:

    I have shares in KMR in a taxable account which receives tax free (at time of distribution) shares instead of cash dividends. So it seems I'll lose the long term capital gain benefit when they switch to KMI.

    Should I sell my KMR to gain the long term tax benefit and buy back after the conversion??

  • Report this Comment On November 14, 2014, at 12:55 AM, Heidikitty wrote:

    I called my broker and told him I wanted the 1st option when the merger went thru and he took it but said i might not get it and i was frustrated to say the least when he said in all the many pages it was said we may get bottom line something else. What is the deal?

  • Report this Comment On November 14, 2014, at 1:00 AM, Heidikitty wrote:

    Please if you can do we really have a choice when all is said and done or based on whatever can KMI give us whatever they decide with this merger?

  • Report this Comment On November 14, 2014, at 2:37 PM, slofisher wrote:

    I'm thinking it might be better to sell all my KMP shares now at $96 before merger and buy KMI after the merger or maybe even before there merger. Any reason why this idea is not sound?

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