Consolidation Considerations in Kinder Deal Aftermath
We see upside for Kinder and an exit strategy for other master limited partnerships.
The Kinder Morgan deal announced last month will result in a consolidated midstream behemoth capable of sustaining 10% dividend growth at least through the end of the decade and positioned to become a natural consolidator in the industry. The single-largest benefit of the deal is a reduced cash cost of capital, which will make growth much more affordable and lower the threshold for accretive acquisitions.
This, combined with founder Rich Kinder's supportive remarks on mergers and acquisitions, suggests upside to our base-case fair value estimate if the consolidated Kinder Morgan goes on a buying spree. We think Kinder is most likely to look for companies and assets that extend its reach geographically or within the midstream value chain, but the most strategically attractive firms today appear richly valued. In our view, the Kinder deal provides a new road map for other maturing master limited partnerships looking to restructure capital costs, and we think Energy Transfer is the next most likely firm to consider such a transaction. However, we do not think Kinder's move spells the end of the MLP as a structure, and we look for continued robust growth and hefty valuations from the industry.
Here's Why the Deal Makes Sense
Kinder Morgan suffered from a growth problem. The incentive structure at Kinder Morgan Energy Partners , common to most MLPs, shunted an increasing share of total cash distributions to general partner Kinder Morgan Inc. (KMI) each quarter, creating a significant headwind to distribution growth. To understand the rationale for the deal, it's important to grasp why this growth problem existed and how the transaction eliminates the overhang.
For most MLPs, general partners hold incentive distribution rights, set in place in partnership agreements to align the incentives of the general partner (managers) and its limited partners (passive investors). IDRs compensate the general partner for increasing quarterly cash distributions per unit to limited partners according to a predefined schedule. As LP distributions per unit climb past certain thresholds, IDRs grant the GP an increasing share of the total cash paid out by the partnership. In Kinder's case, with the most recent quarterly distribution of $1.39 per unit, the GP collects 46% of the total cash paid out to all partners.
This creates a mighty headwind over time. Effectively, for each incremental $1.00 in distributable cash flow generated by KMP, LP unitholders have to split $0.54, while the GP takes $0.46. Put another way, to increase distributions per LP unit by 5% annually, KMP would need to raise distributable cash flow per unit by almost 10% each year. It gets worse--to fund that increase, KMP has to put new projects in service that generate new cash flows. Projects tend to be financed roughly 50/50 debt and equity, meaning that the LP unitholder base expands each year, increasing the number of units with a claim on the LP's incremental $0.54. All this adds up to slower distribution growth.
Another way of looking at the IDR burden is through the lens of equity cost of capital, represented by the stock yield. MLP yields discount distribution growth prospects and perceived safety of cash flows; all else equal, a faster-growing MLP trades at a lower yield than slower-growth peers. Before the announcement, KMP traded at a 6.8% yield, relative to an MLP average around 5.8%. But we also have to account for the GP take, and therefore gross up the yield on LP equity to include the GP's share. For KMP, this results in an equity cost of capital of 11.4%.
Consolidating KMP into KMI gets around this issue by eliminating incentive distributions. Before Kinder's announcement, the typical "GP simplification" deal involved the MLP issuing additional common units to the GP in exchange for redeeming and canceling the GP's incentive distribution rights. For this to work, the relative valuation between entities has to be favorable to the MLP; otherwise, such a transaction could be massively dilutive to LP distributions. The Kinder deal turns this idea on its head; by buying out the MLP, it causes the incentive distributions (already owned by KMI) to simply cease, and the equity cost of capital of a consolidated KMI is reset much lower. At our $40 fair value estimate, KMI would yield 5.0%, 790 basis points lower than KMP's pre-deal yield (at our pre-deal fair value estimate of $90 per unit).
As a standard corporation and not an MLP, KMI will also benefit from the interest tax shield impact on its debt. Currently, KMP and El Paso Pipeline Partners do not derive a tax shield benefit because they are pass-through entities, but upon consolidation KMI directly assumes these liabilities, and even after accounting for the incremental $4 billion debt to finance the cash portion of the transaction, we expect Kinder's consolidated effective aftertax cost of debt to decrease from 4.6% to 2.9%. In addition to lowering its cost of capital, this also reduces cash interest, freeing up more of the cash generated by the business to be distributed to KMI shareholders. Taken together, then, the consolidation will reduce Kinder's cash cost of capital by 420 basis points, from 8.0% to 4.2%. This will make growth significantly more affordable for Kinder Morgan.
The last element that makes this deal work stems from a nuance in acquisition accounting. When a company acquires another in an equity deal, it can elect to step up the tax basis of the acquired entity's assets. Effectively, this revalues the acquired assets at purchase price rather than historical cost for the purpose of tax accounting. The step-up in tax basis results in higher tax depreciation, which offsets taxable income and reduces cash taxes. In Kinder's case, the company estimates that the basis step-up saves $55 billion over 14 years, or nearly $4 billion a year.
The combined effect of eliminating IDRs, lowering equity and debt capital costs, and enacting the step-up in depreciation will enable KMI to increase its dividend at nearly twice the rate KMP could have managed with the same assets and projects. The fundamental cash-generating power of Kinder's assets hasn't changed, but the financing strategy that allocates this cash among stakeholders is much more favorable to equity investors under the new structure.
Upside: Potential for a Buying Spree
With a lower cost of capital, we expect Kinder Morgan to be among the consolidators in midstream energy. Indeed, even burdened with a higher cost of capital, KMP acquired Copano Energy in 2013 and Jones Act shipping companies late last year. With its mammoth asset footprint touching most activities in the industry, we think a consolidated KMI may come out swinging. Moreover, as a C-corporation and not an MLP, Kinder Morgan no longer has to worry about qualifying income rules to preserve its tax status, meaning that it is now free to shop assets and companies outside the traditional bounds of midstream, and outside the United States as well.
One way to see how much more competitive Kinder will be in new deals is to compare costs of equity across midstream peers. Our analysis shows that KMP suffered from relatively high cash equity costs, surpassed only by Williams Partners. The simplification transaction shifts Kinder's operating entity from KMP pre-deal to KMI pro forma, where it will enjoy equity capital costs below all other peer MLPs, except Enterprise Partners and Magellan (neither of which have incentive distribution rights), and slightly higher than other C-corps or GPs. In our view, this is the key rationale for Kinder's simplification transaction; it will now be highly competitive with peers for acquisitions and new projects. Combining lower capital costs with Kinder's unsurpassed asset portfolio positions the firm to be a major player in the midstream consolidation we see emerging.
At present, we do not factor a more aggressive stance to M&A into our base-case fair value estimate. The 15% increase in our fair value estimate in August was due solely to the structural impact of a financing strategy that fosters higher dividend growth. We left our assumptions for organic and acquisition capital spending at KMP and EPB unchanged. But with a lower cost of capital, we believe Kinder will be competitive in bidding on many more projects and deals in the future and will probably be in a position to increase spending and accelerate dividend growth beyond the stated goal of 10% a year. Our high-case scenario, valuing KMI at $50 per share, contemplates 12% distribution growth.
In the aftermath of the deal, many names in the midstream sector popped on speculation that a newly consolidated Kinder Morgan may come after them. In our view, the majority of midstream names are fully valued, if not a bit frothy, challenging acquisition math in the near term. However, valuation may not be the only factor in Rich Kinder's mind, especially with a much-reduced cost of capital. We think key strategic considerations will favor companies and assets that fill out Kinder's map, strengthen its competitive position outside its core natural gas pipelines business, or provide a beachhead into new segments along the midstream value chain.
Though our crystal ball is hazy, we think MarkWest and Targa are among the most likely acquisition targets among larger MLPs. Smaller MLPs, such as Genesis Energy (GEL), may offer good tuck-in growth opportunities. North of the border, Keyera (KEY) or Pembina (PBA) could be strategically attractive, though significantly overvalued, in our view. Our dark-horse candidate for a takeout is Magellan Midstream Partners (MMP), a wide-moat refined products pipeline franchise currently priced at a modest discount to intrinsic value. Outside of existing firms, we think Kinder is now in the catbird seat for acquiring remaining infrastructure assets from the majors, and we view a series of smaller asset acquisitions as more probable than a megadeal. Also, we caution investors that major deals seem unlikely to us before the dust settles on the Kinder simplification. We're thinking 2015-16, not next quarter.
Who Else Can Play?
We think Energy Transfer and Williams stand to benefit the most from a similar simplification transaction, but Energy Transfer is most likely to execute a deal. Both suffer from high cash costs of equity capital as a result of above-average LP yields and high incentive distributions to their general partners, and both possess publicly traded GPs with competitive equity yields around 3%. However, we think the math is more favorable for Energy Transfer, and Williams is currently pursuing a different strategy to lower the cost of its incentive distributions.
Williams (WMB) is in the midst of a deal to simplify its organization by merging high-growth Access Midstream (in which it recently acquired a controlling interest) with its own Williams Partners in a unit-for-unit exchange later this year. Because Access will be the surviving partnership for accounting purposes (though not in name) and has a lower GP take than Williams Partners (18% currently, versus 32% for WPZ), the merger will result a lower overall GP burden, fostering more rapid distribution and dividend growth for Williams Partners and Williams. However, as part of the ACMP/WPZ merger, Williams plans on boosting the surviving entity's distribution aggressively, to $3.38 per unit in 2015. This would put the combined entity's GP take at 26% in first quarter of 2015, rising to 32% by the fourth quarter of 2015, essentially leaving Williams back where it started. For WMB and WPZ, we like the deal, as it will add distribution growth and coverage to WPZ, but it looks to us like it comes at the expense of ACMP.
Energy Transfer has at least as much going on. Energy Transfer Partners has just completed the acquisition of Susser Holdings, general partner of Susser Petroleum Partners, which it plans to combine with its retail marketing business acquired last year from Sunoco. Add on top of this plans for an initial public offering of the Trunkline LNG facility at some point next year, plus ownership of Sunoco Logistics and cross-holdings with Regency Energy, and you've got a complicated mess in many investors' "too hard" bucket. We think investors would probably cheer if Energy Transfer Equity (ETE) acquired ETP in a simplification transaction along the lines of what Kinder is doing, and by our math, such a deal would be even more beneficial for Energy Transfer than it would for Kinder Morgan.
Kinder Morgan pioneered the modern form of the MLP. Like it or loathe it, the ability to expand natural resources businesses in pass-through entities capable of accessing public debt and equity markets has changed the financing landscape for energy firms. For many years, a majority of investors have accepted the MLP growth story at face value, without fully grasping the structural headwinds embedded in incentive distributions. But the math has always been clear--the more successful an MLP is at increasing distributions, the more difficult it will become to sustain that growth because of the cost of supporting a general partner with a claim on as much as half of incremental cash flows. Kinder Morgan managed to deliver impressive growth despite its GP burden for more than 15 years, but as the partnership matured, LP distribution growth began to lag that of peers. We think it's only fitting that the granddaddy of MLPs be the one to devise an exit strategy to the MLP growth dilemma.
The impact of a GP burden on LP distribution growth has been well understood, and many MLPs sought to address this over time by buying out their GPs' incentive distribution rights. Kinder's deal turns the previous exit strategy around and provides mature MLPs with a new way out of the growth trap, and we think it's likely that we'll see other MLPs embrace this option. However, we do not view Kinder's move as a repudiation of the MLP structure--it remains a highly attractive operating and financing structure for high-growth MLPs, for MLPs lower down in the splits, and for MLPs used as funding vehicles for their parent companies. Rather than repudiation, then, we see Kinder's move as an evolution.
We expect MLPs will continue to be an attractive financing vehicle for appropriate assets held in C-corps and to finance and operate new midstream assets. Given the amount of plumbing needed to provide market access for unconventional oil and gas, there's considerable running room for investment, and most MLPs should be able to maintain high-single-digit distribution growth. But as MLPs move deeper into the high splits, we think similar "simplifications" are likely, and we peg Energy Transfer as our top choice to follow suit. Mature MLPs with significant asset footprints are well positioned to become consolidators, especially after lowering cash capital costs like Kinder is doing. In our eyes, this could accelerate MLP consolidation by creating a handful of natural buyers for midstream assets, supporting robust industry valuations and prompting smaller MLPs to get bigger or get bought. The midstream space has always had a thriving M&A scene; we think it could get busier.
Jason Stevens does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.