Back when Kinder Morgan (NYSE:KMI) announced it was going to acquire all of its operating subsidiaries and partnerships, lots of investors started to wonder if other companies with similar structures would follow suit. Well, last week, we saw Targa Resources (NYSE:TRGP) announce during its earnings report that it would acquire all remaining shares outstanding in its limited partnership Targa Resource Partners (UNKNOWN:NGLS.DL).
Let's take a quick look at why Targa decided to follow the path of Kinder Morgan to become a full fledged c-corp, and what it means for shareholders in the company.
By the numbers
Targa Resources, the parent company, will acquire all of Targa Resource Partners for a total value of $6.67 billion. It's an all-stock deal where unit holders of Targa Resource Partners will receive 0.62 shares of the parent company.
At the time the deal was announced, it was an 18% premium to current share prices. If there was a time to buy up the remaining shares in the partnership, though, this would be it. Shares of Targa Resource Partners are down more than 42% since the beginning of 2014 and are at their lowest price in the past five years.
At the same time, though, making this transaction in today's market seems to have ruffled a few investors' feathers. A little over a year ago, management rejected a takeover offer that would have valued the combined company at $15 billion, citing that management believed the price was too low. So, for the company to do a deal today that essentially values the combined company at $9 billion isn't making any friends of its partnership's shareholders.
Hoping to be a mini-Kinder Morgan
When you look at management's rationale behind this deal, you might start to think that it might have just ripped it out of the original Kinder Morgan presentation. Targa cites that some of the benefits include greater access to capital in the financial markets as a larger single entity, a lower cost of capital since the partnership will no longer need to pay incentive distribution rights, and the ability to defer taxes by recapturing the depreciation and amortization of its assets over time.
However, there are some more sublte differences that made Kinder Morgan's consolidation effort more appealing. When a company buys out its subsidiary partnership, the public unit holders will be taxed on the capital gain to "step up" its shares to the parent level. When Kinder Morgan did its deal, part of the transaction was an amount of cash per share to pay for the taxed transaction. Based on the current structure of Targa's deal, there will be no cash kicker to pay the taxes.
Another reason Kinder Morgan consolidated is that the company has a project development backlog greater than $20 billion. To finance that many projects, it needed to make this move to give it greater access to the capital markets. While Targa cites a similar reasoning for its own consolidation, its project backlog is considerably smaller. Its total capital expenditures for 2016 are slated to be $600 million, and its $4 billion in potential projects are not slated to come online for quite some time.
What may be a major driver of this deal is the fact that the company is pushing up on its debt covenants. If it has already maxed out its debt leverage, it would be increasingly difficult to finance these new projects. So by consolidating, Targa can hope to get a more favorable credit rating thanks to increased cash flows, which would ease those debt covenants.
What a Fool believes
Based on what we have seen at Kinder Morgan and other midstream companies that have consolidated in recent years, Targa is making the right move long term. However, there is a slight feel of desperation around this one that wasn't as much the case with others. It's going to be a bit of a stinker for owners of the partnership to saddle the tax implications of management's decision, but if Targa's projections about its payouts are to be believed, this move will shore up cash flows for a few years and help it get back on track to deliver on that development portfolio.