Kinder Morgan IPO: Largest Energy IPO in More Than a Decade

Everyone wants to buy into a big yield. The trouble is most people aren’t willing to put in the time to tell the good from the bad and ugly.

Roger Conrad, Big Yield Hunting

Kinder Morgan (NYSE: KMI), the second-largest energy pipeline company in the U.S., was taken private back on May 30, 2007 for $15 billion ($22 billion including assumption of debt). Last Friday (Feb. 11th), the company went public again in the largest private-equity-backed initial public offering (IPO) in U.S. history. In fact, the Kinder Morgan IPO is the largest energy-related IPO of any type since Dupont spun off Conoco in October 1998! Based on the prospectus filed with the SEC (p. 48), Kinder Morgan plans on paying a $1.16 annual dividend ($0.29 quarterly starting in May), which equates to a 3.9% annual yield.

The company is a regular tax-paying corporation, not a master limited partnership (MLP), but it owns the general partnership (GP) interest in Kinder Morgan Energy Partners (NYSE: KMP) and all of the voting stock in Kinder Morgan Management LLC (NYSE: KMR). Both KMP and KMR are tax-advantaged, but KMR pays its dividends in stock rather than cash, which allows investors to avoid the hassles of K-1 partnership tax reporting.

The underwriters initially planned on pricing the Kinder Morgan IPO in a range of $26-$29 per share, but demand was so strong that it actually priced above this range at $30. Even with this elevated starting price, the IPO still performed reasonably well on its first day of trading, rising 3.5 percent. The fact that such a large IPO could be so easily sold speaks volumes about both the frothy nature of the current stock market and investor enthusiasm towards all things energy. As usual, private equity investors waited for an opportune time to sell – in this case, soon after the Alerian MLP Index (^AMZ) had risen for two consecutive years by an astounding 76.5% in 2009 and 35.9% in 2010 (including dividend reinvestment). 

Private Equity Did Well With Kinder Morgan

I’m always interested to see whether private equity investors are smarter than the rest of us, so let’s first take a look at how well they did between the time they announced their intent to take Kinder Morgan private in May 2006 and the actual closing of the buyout in May 2007. In May 2006 when the buyout proposal was announced, the $107.50 per share buyout price was a 27% premium over Kinder’s market price. At the time, it sounded like a great deal for investors, but the offer price did not include any interest until closing, so public investors received only $107.50 despite the fact that the deal didn’t close until a year later in May 2007. Between May 2006 and May 2007, the Alerian MLP Index rose 33.3%, Kinder competitor Enterprise Products Partners (NYSE: EPD) rose 25.3%, and KMP rose 23%. So, the 27% premium wasn’t much of a premium after all. Advantage: private equity.

Lesson to be learned: public investors should always take into account the time-value drag between a takeout offer and when they are actually scheduled to receive the money.

The next question is how well did the private equity investors do between the time the buyout closed and last Friday’s IPO. On May 30, 2007, Kinder Morgan had about 134 million shares outstanding, so multiplying that number by the $107.50 buyout price yields a total buyout price of $14.5 billion. The newly-issued Kinder Morgan IPO has 707 million shares outstanding, so multiplying that number by the $30 IPO price yields an IPO valuation of $21.2 billion.

Consequently, on a price-basis alone (i.e., dividends not included), the private equity investors made a profit of 46.2 % on the buyout ($21.2 billion/$14.5 billion). Over the same period, the Alerian MLP Index rose 12.8%, Enterprise Products Partners rose 37.6%, and KMP rose 29.2%. (Keep in mind that these numbers are price-only and don’t include dividends, but since I’m not sure what dividends the private equity folks paid themselves while Kinder Morgan was private, the comparison has to be on a price-only basis). Once again, the private equity group’s return beat the return available to public MLP investors.

Does this analysis suggest that Kinder Morgan investors would have done better if the company had never gone private? Not necessarily, since the private equity investors may have provided some managerial expertise that would not have been available if the company had remained public. It makes you wonder, however, why a company’s public managers can’t perform as well as private managers.

Which Kinder Morgan Investment Vehicle is Best?

The last question is what income investors should do now. Which investment is better, the new Kinder Morgan parent (KMI),  the KMP MLP, or the KMR “i-share” LLC? From the perspective of current yield, KMP and KMR are better since they are paying 6.3% versus the 3.9% of KMI. But as the owner of the general partner, KMI has valuable incentive distribution rights (IDRs) that provide it with much higher dividend growth potential. KMI’s general partnership (GP) interest is only 2% of KMP, yet KMI gets 50% of all future dividend growth! According to the KMI prospectus (p. 4), a 4.5% increase in the dividend distribution for KMP and KMR would be matched by a 9.7% dividend distribution by KMI – more than double! 

Consequently, if you are bullish on energy prices and Kinder Morgan’s business, KMI will provide you with more leveraged upside. No doubt about, IDRs can be a boon to GPs like KMI and a drag for MLPs like KMP, but Roger Conrad of Big Yield Hunting recently wrote that he still likes KMP:

IDRs are basically how a GP gets paid, other than from ownership of LP units. And considering this is basically a fee for running the LP’s assets, it’s definitely worth paying for an MLP with a very strong long-term track record, such as Kinder Morgan Energy Partners LP (NYSE: KMP).

That said, IDRs can definitely be abusive, as some critics have charged Kinder Morgan’s are. And if there are alternative MLPs with a lower IDR structure–or, better, none at all–I prefer them.

As I said, I’m willing to make an exception for Kinder Morgan, which has thrown off an average annualized total return for investors of 16 percent the past 10 years.

Furthermore, even after Friday’s IPO, investors in the formerly-private KMI own more than 85% of the company, so they continue to have a significant financial incentive for KMI to perform well. And CEO Richard Kinder did not sell a single share of his 30.6% stake in the IPO, which is a real vote of confidence. Only the private equity firms (e.g., Goldman Sachs, Carlyle Group, Riverstone Holdings) sold shares, which doesn’t bother me since their job is to periodically monetize their investments.

Many MLPs have bought out their general partners to eliminate the IDR drag on their future cash distributions. KMP could do the same with KMI, which provides KMI with some speculative takeover appeal. Between the KMP and KMR underlings, I like KMR more because it is currently selling at a 9% discount to KMP ($65 vs. $71) despite owning identical interests in the underlying energy assets. Of course, this 9% discount could remain, but some commentators believe that the Kinder Morgan IPO is the first step toward buying out KMR at its net asset value, which would provide KMR investors with an immediate 9% profit boost.

Big Yield Hunting Has an “Income Plus” Investment Philosophy

The three investment choices for Kinder Morgan (KMI, KMP, KMR) are all solid, but their yields are not super-high. For double-digit yields, check out Big Yield Hunting, the high-yield investment service from Roger Conrad and David Dittman. Roger and David take an “income plus” approach to their recommendations. High yield alone is not enough; they demand high yield “plus” a healthy and growing business:

High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.

In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.

An “income plus” investment standard disqualifies many high-yield companies from Roger and David’s consideration. So far, Big Yield Hunting has recommended two Canadian income trusts, three telecommunications companies, and an MLP. All of these top-notch stocks sport very high yields that are stable and sustainable.

Give Big Yield Hunting a try today!