Tuesday, September 30, 2014

How to buy Kinder Morgan at a discount

Back in August, Kinder Morgan Inc (KMI) announced that it was going to simplify its structure by acquiring the limited partner interests in its pipelines. The company expects plenty of benefits, which would enable it to pay close to $2 in annual dividends per share in 2015. After that, the company expects that dividends will grow by about 10%/year for five years.

As a result of the deal, unitholders of Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB) are going to receive shares in Kinder Morgan Inc, as well as some cash consideration. KMP unitholders will receive 2.1931 KMI shares and $10.77 in cash for each KMP unit. EPB unitholders will receive .9451 KMI shares and $4.65 in cash for each EPB unit. Limited partners are receiving some cash, because the act of exchanging their units for Kinder Morgan shares is a taxable event, which could trigger some tax liabilities to the IRS.

The holders of Kinder Morgan Management LLC (KMR) will receive 2.4849 KMI shares for each share of KMR. This will be a tax-free event, because those holders are exchanging one asset type for another.

The deal has to go through some regulatory hurdles, but I doubt it would not finish. The timeline is somewhere by the end of 2014, although in my opinion it might close by the first half of 2015.

Ticker
Price
KMI Shares
Cash
Value of bounty
Spread
Discount
KMP
 $    93.60
2.1931
 $  10.77
 $                   95.27
     0.9825
-1.75%
EPB
 $    40.34
0.9451
 $    4.65
 $                   41.06
     0.9824
-1.76%
KMR
 $    94.50
2.4849

 $                   95.74
     0.9870
-1.30%
KMI at $38.53/share

At the closing prices on Monday, it seems like there is an arbitrage opportunity for investors. It seems that if one believes that the deal in its current form will ultimately be consummated, they could purchase limited interests in KMP, EPB or shares of KMR, and then have those converted into KMI shares when the deal does close. Going forward, I will use the word investor, even though technically, the holders of KMP and EPB units are called limited partners. As a result, those investors will be able to effectively purchase KMI shares at a discount, when all is said and done. You might want to read this article, if you are unsure how each of those tickers differs from each other.

It looks like there is an arbitrage opportunity for those who wish to purchase shares of Kinder Morgan Inc at a slight discount today. If I were to do it, I would go for KMR, since it presents a complete tax-deferral of the arb opportunity. If I went with KMP or EPB, I would have to deal with partnership taxation, and K-1 forms, which scare the hell out of most dividend investors. Or at least the ones that have talked to me over the past seven years.

If I already owned enough Kinder Morgan Inc (KMI) stock in a tax-deferred account, I would simply sell it, and purchase shares of Kinder Morgan Management LLC (KMR). This of course assumes that my position is big enough, so that the commission does not erase the arbitrage opportunity. I would also not do this in a taxable account, because the capital gains taxes will make this arbitrage play not worth it. If you however expect to be in the 10 – 15% bracket for Federal tax purposes, this could mean that your dividends and capital gains will be taxed at zero. State taxes of course could apply however. So here is how it goes: If I had 1000 shares of Kinder Morgan Inc (KMI) in an IRA, I would sell it, and put the proceeds into Kinder Morgan Management LLC (KMR). Whenever the deal is closed, I would end up with approximately 1013 shares of Kinder Morgan Inc.

If I wanted to purchase 100 shares of Kinder Morgan Inc with new money however, I would put the money in Kinder Morgan Management LLC instead, and convert my stake in Kinder Morgan Inc when the deal closes.

The amount of 1.30% might not seem like a lot. However, this line of thinking ignores the basic truth that even a small seed can turn into a mighty oak. In other words, for those who have 1000 shares of Kinder Morgan Inc, the 13 shares could produce a lot of wealth over 40 or 50 years down the road. If you manage to compound those $500 at 10% for 50 years, this could turn into a cool $50,000 that produces $2,000 in annual dividend income at a 4% dividend yield. Those of you who train your minds to search for small, accretive investments, that improve your portfolio outcome, you will do really well over your investment career.

The added bonus in this exercise is that investors who purchase KMR rather than KMI, will likely be eligible for a $1.39 quarterly distribution paid in stock somewhere around November 15, 2014. This would be a tax-deferred dividend reinvestment, which would leave the investor of KMR today with more shares to tender for KMI stock. The tax-deferral of those reinvested distributions is really nice, and could widen the spread and potential accretion effect for those enterprising dividend investors. The yield on KMR is higher than KMI, and the KMR yield is entirely tax-deferred (until you sell KMR). The fact that dividends were automatically reinvested for me with KMR, the fact that distributions didn't cause any tax headaches and the fact that KMR always sold at a discount to KMP, made KMR an ideal investment for me. Unfortunately, once the acquisition closes, I will end up with a lot of Kinder Morgan Inc stock, the dividends of which would be fully taxable under the preferential tax rates for qualified dividend income. Hence, I do not plan on adding new cash to this position for the foreseeable future.

Since I hold most of my Kinder Morgan Inc in a taxable account, and since my dividends and capital gains will likely not be taxed at 0% in the foreseeable future, I would not do this exercise. I also do not plan on adding to any of the Kinder Morgan entities, given the fact that this is my largest position. I present this exercise not to provide you with specific investment advice, but to get you thinking about opportunities to increase wealth. This information is not advice for you to act on. The information I used is believed to be accurate, but could be incomplete. Therefore, please do your own analysis before you make an investment.

Full Disclosure: Long KMI and KMR

Relevant Articles:

Do not despise the days of small beginnings
Kinder Morgan to Merge Partnerships into One Company
Kinder Morgan Limited Partners Could Face Steep Tax Bills
- Kinder Morgan Partners – One Company three ways to invest in it.
Dividends Provide a Tax-Efficient Form of Income


14 comments:

  1. As someone just building a dividend portfolio, I find it generally overwhelming and have been curious about the KMI stocks I see in other investors' portfolios. I found this post very helpful in explaining the difference between each entity, and perhaps I'll be able to add some to my portfolio, too. Thanks!

    ReplyDelete
    Replies
    1. Hi Camille,

      If you find it overwhelming, it might be wiser to refrain from investing until you gain a basic level of comfort. Either way, the best way to learn is by putting a small amount of money to work, and then learn from experience.

      Best Regards,

      DGI

      Delete
  2. Great post, I was actually considering a KMI arbitrage post but you beat me to it (and did a much better job than I could've). Well done.

    ReplyDelete
  3. Yessir! I did the same thing for a relative in her account just last week. I was/am surprised at the gap, but perhaps it is due to the tax implications that some people will face?

    ReplyDelete
    Replies
    1. No tax implications for KMR/KMI, unless you count potential cap gains in taxable accounts, if you sold KMI at a profit

      Delete
  4. Would the wash rule apply for a purchase made within 30 days?

    ReplyDelete
    Replies
    1. what you describes applies to sales that result in a loss, and subsequent repurchase of the same security.

      Delete
  5. Don't you think the total value is going to even out because KMI share price will change to reflect that when the deal closes. It might be even be lower or better to wait until the deal is done.

    ReplyDelete
    Replies
    1. If you hold 1000 shares of KMI it will still be 1000 shares after the conversion. If you switch to KMR, you'll have 1013 shares of KMI after the conversion. Regardless of the price action of KMI, 1013 > 1000.

      Now, if you're talking about trying to time rises and falls in price, that's a completely different topic. But if your plan was to simply hold KIM through the conversion and are confident that the re-org will go through, switching to KMR is like being handed 1.3% more KMI shares for free.

      Delete
  6. There are many good opportunities in energy these days. The trouble I have in deciding to pull the trigger is diversity vs. risk. Do I continue to diversify my portfolio and pass up on opportunities in a sector or take the risk of heavy weight in energy?

    ReplyDelete
  7. DGI, I have a few hundred shares of both KMI and EPB in a tax-deferred account. I'm going to take sell the KMI shares to take advantage of the arbitrage opportunity, but I'm wondering if I shouldn't do the same with the EPB. Any thoughts?

    ReplyDelete
  8. I have read that the KMI dividend is expected to be largely ROC for a few years because KMI will have so much depreciation. If this is true then dividend taxation in a non-qualified account will also be deferred.

    ReplyDelete

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