Is Kinder Morgan’s Restructuring a Bad Deal for Income Investors?

kinder-morganA pioneer in high-yield energy master limited partnerships (MLPs) renounces the concept. How will a new corporate structure impact Kinder’s MLP investors?

If Richard Kinder is anything, he is his own man. Kinder pioneered the use of the MLP structure in the energy sector. By forming his businesses as MLPs instead of as standard C-corporations, the businesses avoided paying corporate income taxes, thus avoiding double taxation.

To qualify as an MLP, a business must generate at least 90% of its income from what the Internal Revenue Service (IRS) deems “qualifying” sources. For practical purposes, sources include activities related to producing, processing, and transporting oil, natural gas, and coal.

This alone doesn’t account for the high yield most MLPs provide. Management is motivated to make high quarterly distributions: The higher the distributions to the limited partners (unitholders), the higher the management fee paid to the general partner (those who run the enterprise).

Kinder’s MLP properties were certainly high-yield investments: Before Kinder Morgan announced it was changing course, Kinder Morgan Energy Partners LP (NYSE: KMP) paid a distribution that generated a 6.9% yield. Another MLP property, El Paso Pipeline Partners (NYSE: EPB) offered a 7.6% yield.

But like I said, Kinder is his own man. Today, he believes his enterprise has grown too big and too financially complicated to operate within the MLP structure. For efficiency sake, he wants all the constituent parts melded into one giant C-corp. The consolidated Kinder Morgan – Kinder Morgan Inc. (NYSE: KMI) – will pay a $1.72 per-share dividend, which yields 4.2% at the prevailing share price.

It appears KMP and EPG investors are taking an income hit, but the hit is mitigated by a pop in unit value. Both KMP and EPG popped over 25% when the takeover and restructuring was announced last week. KMP and EPG yields have subsequently dropped to 5.7% and 6.1%, respectively.

Interestingly, KMI also popped 25% when it announced that it was bringing KMP and EPG into the fold. KMI’s dividend is expected to rise to $2 a share in 2015. Investors should expect a 4.9% yield next year based on the prevailing $41 share price. What’s more, KMI expects to increase the dividend 10% annually through 2020.

By the end of 2020, KMI investors should receive $3.22 in annual dividends, which hikes the yield to 7.9% on today’s cost basis.

A 7.9% yield is certainly nothing to wrinkle your nose at. But keep in mind, both KMP and EPG have continually hiked their distributions as well.

Over the past five years, KMP’s distribution has grown at a 5.8% average annual rate; EPG’s has grown at a 13.2% average annual rate. If these growth rates were extended through 2020, KMP unitholders would realize a 9.7% yield on the pre-acquisition unit price of $80; EPG unitholders would realize a 16.1% yield on the pre-acquisition unit price of $34.

Taxes further roil the water. I assume KMI’s dividends will be qualified, which means they will be taxed at the lower qualified-dividend tax rate. For KMP and EPG unitholders, much of their distribution was not taxed all the year they were received, because much of distribution was composed of a return of capital, which lowers cost basis.

Let’s roil the water even more. The roll-up into KMI will be taxable to KMP and EPG unitholders, who will be treated as selling their units, even if they accept KMI stock. This will result in a big tax hit for long-term KMP and EPG unitholders. As I noted, a return of capital lowers cost basis. Many long-term KMP and EPG unitholders have seen their cost basis materially reduced.  The lower the cost basis, the larger the gain. What’s more, any gain will be taxed at the investor’s ordinary income tax rates.

The closer I look at Kinder Morgan’s roll-up of its constituent enterprises, the less convinced I am that its a good deal for KMP and EPG income investors.

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Published by Wyatt Investment Research at