Kinder Morgan Streamlines Corporate Structure in $70B Deal

HOUSTON (The Deal) -- Kinder Morgan (KMI) said Sunday it's bringing all of its publicly traded master limited partnerships back under one roof in a cash and stock deal valued at $70 billion, creating North America's largest energy infrastructure company.

Houston-based Kinder Morgan is buying Kinder Morgan Energy Partners (KMP), Kinder Morgan Management (KMR) and a third affiliate El Paso Pipeline Partners (EPB) it said in its Sunday announcement.

KMP unitholders will get 2.1931 KMI shares and $10.77 in cash for each KMP unit they own, or $89.98 per unit, a 12% premium based on the Aug. 8 closing price and 11.4% based on the July 16 closing price reference date the parties used during negotiations.

KMR shareholders will get 2.4849 KMI shares for each share of KMR they hold, or $89.75 per unit, a 16.5% premium based on the Aug. 8, closing price and a 16% premium over the July 16 closing price.

EPB unitholders will get .9451 KMI shares and $4.65 in cash for each EPB unit they own, or $38.79 per unit, a 15.4% premium based on the Aug. 8 closing price and a 11.2% over the July 16 closing price.

KMP and EPB unitholders will be able to choose cash or KMI stock subject to proration, which is 12% cash and 88% stock.

Simmons & Co. International wrote in a report Monday that aside from the quest for growth, there are plenty of significant questions raised by the transaction, including expectations for interest rates and the ability to continue capturing a generous valuation arbitration via the master limited partnership, or MLP, structure.

Bond research firm CreditSights said it expects the deal to be "very well received by the Street" as it kills two birds with one stone. "We can't help but point out Kinder Morgan is probably the only $10+ billion LBO [leveraged buyout] of the 2005-2008 LBO boom where legacy bondholders will now have their pre-deal investment grade ratings restored."

On a conference call with analysts and investors, chairman and CEO Rich Kinder said he was personally taking all stock in the transaction.

Kinder said in a statement that all shareholders and unitholders will benefit as a result of the combination, holding a single, publicly traded security with a projected dividend of $2 per share next year, up 16% over this year's expected dividend of $1.72. He said the company expects to boost the dividend by 10% each year from 2015 through 2020, with excess coverage expected to be more than $2 billion over the same period.

"This transaction dramatically simplifies the Kinder Morgan story, by transitioning from four separately traded equity securities today to one security going forward and by eliminating the incentive distribution rights and structural subordination of debt," Kinder said. "Further, we believe that KMI will be a valuable acquisition currency and have a significantly lower hurdle for accretive investments in new energy infrastructure. In the opportunity-rich environment of today's energy infrastructure sector, we believe this transaction gives us the ability to grow KMI for years to come."

Kinder said the combined entity will be the third largest energy company overall with an estimated enterprise value of $140 billion. "We will have a leading position in each of our business segments and operate in the rapidly growing North American energy infrastructure sector," he said.

On the call, Kinder said his goal is for Kinder Morgan to be the "biggest company in America" with the fastest growth rate and the largest dividend.

If the combination goes through, it would be supreme vindication for Kinder, who was passed over for the top job at now non-existent Enron Corp. and later bought assets from it to build Kinder Morgan into the colossal energy infrastructure complex it is today.

Still, KMP and KMI have been suffering recently from a high cost of capital, despite $40 billion worth of deals since 2012 meant to revitalize their growth rate. Rumors have circulated in the market that Kinder was considering taking the company private, as he did in 2006 (he took it public again in 2011).

Analysts have been raising the possibility of a different transaction: for KMP to buy KMI. Last month Tudor, Pickering, Holt & Co. Securities Inc. noted that while the deal would be dilutive to KMP initially (it was modeling a 10% to 20% takeout premium), its $16 billion backlog plus an EPB takeout would generate huge accretion in a general partner-free KMP. The firm estimated that insiders would have to waive some cash in years one through three, but the deal would create "significant value" for all parties involved by year four.

"We believe that concerns around Kinder's ability to find accretive M&A deals and projects and a deteriorating business mix have been major factors in three-year underperformance across the complex," TPH said. "With cost of capital that limits Kinder's reinvestment opportunities and forces KMI to give back economics anyway, why not consolidate KMI into KMP and form a company with a significantly lower cost of equity capital?"

A source close to the situation said the reasons KMI decided to buy KMP instead of the other way around were the depth of C-corporation market versus the master limited partnership market, meaning that it's tough to finance the growth of a $140 billion master limited partnership in a retail-weighted equity; tax inefficiencies (embedded taxes at the general partner); and more flexibility to pursue resources deals that don't generate qualifying income (giving it more growth options).

Kinder hinted at as much on the conference call, saying there were a number of M&A "situations" where the company couldn't play in the past because it couldn't meet its hurdle rate.

Kinder said on the call that the deal doesn't inhibit its ability to transact with another general partner or limited partnership. "We have a lot of optionality with a simplified C-corp structure," he said. "[We] could do all of the above. We'll only make [acquisitions] if they're accretive."

Kinder said the company plans to keep all the assets together and stressed that it doesn't have plans to divest anything right now.

Management said on the call that the combination will be a taxable event for KMP and EPB shareholders but not for KMR, but claimed that the small dilution in the first few years will be offset because of KMI's expected growth.

Wells Fargo analyst Ross Payne noted on the call that while KMI could use a lot of free cash flow to help delever its balance sheet, he wondered how Kinder's conversations went with the rating agencies, who have rated Kinder's entities higher than most C-corporations.

Kinder responded that they wouldn't have done the deal if they hadn't met with all three agencies and come away with assurance it would come away with ratings that were investment grade. "They like the simplified structure," he said. "I think they like the elimination of the subordinated structure."

Kinder expects Ebitda next year of $8 billion and a long term debt ratio of 5 to 5.5 times.

As for regulatory approvals, KMI doesn't foresee problems because all the companies will be managed under one entity.

One analyst asked if the deal was a function of KMP being mature and whether it's a verdict on MLP's long returns. Kinder said it's not a negative verdict on MLPs and that the new format makes a lot more sense given the specific circumstances around the Kinder Morgan companies.

Credit Suisse analyst John Edwards asked how the company was going to deal with warrants, and Kinder said the company currently has $290 million outstanding — a lot had already been bought back — and expects they will convert at the end of warrant period at the price of KMI at the yield at that time.

The Kinder Morgan companies plan to put in place cross-guarantees among and between the Kinder Morgan entities (with limited exceptions) effective at closing to create a single creditor class and eliminate the structural subordination. KMI said the transaction also provides big tax benefits for KMI shareholders from depreciation deductions associated with the upfront purchase and future capital expenditures.

Each transaction is conditioned on the closing of the others, which are expected by year-end. Shareholders must clear the deal.

The combined Kinder Morgan entities own an interest in or operate 80,000 miles of pipelines carrying natural gas, gaoline, crude oil, carbon dioxide and other products and 180 terminals that store petroleum products and chemicals and handle such products as ethanol, coal, petroleum coke and steel.

KMI owns the general partner interests of KMP and EPB along with limited partner interests in KMP and EPB and shares in KMR.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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