Flash Alert: Taking Gains

Three months ago, the senior management team of Proven Reserves Portfolio recommendation Kinder Morgan (NYSE: KMI) offered to take the pipeline firm private by purchasing the outstanding stock for $100 per share. The ringleader of the deal was Richard Kinder himself, the CEO who also owns nearly 20 percent of the outstanding shares of the stock.

In the June 5, 2006 issue of The Energy Strategist, I recommended that subscribers already in the stock continue to hold on. I further recommended that new investors steer clear of the name. My reason for continuing to hold the stock was an expectation that management would ultimately have to raise its buyout offer considerably above that $100 price tag. The board and shareholders simply wouldn’t be able to accept such a low premium for the stock.

That’s exactly what’s happened this week. Kinder’s board approved a deal to take over the company at a price of $107.50 per share, about 7.5 percent more than the original offer. The deal is still pending approval from federal regulators and shareholders.

While I think the stock is worth more than $107.50, I don’t believe there will be a higher offer. Kinder’s near 20 percent stake in the company means that it would be difficult for a consortium of investors to take over the company without his support; I just don’t see him supporting an alternate bid under any conditions. Moreover, if another group were willing to get involved in a bidding war over Kinder, I suspect they would have already made a play at the company.

The stock is trading between $104.00 and $104.50 at this time, a discount of $2.50 to $3 per share. The deal is expected to close early next year; I’ve seen little to expect there would be a regulatory delay for the deal, and shareholders are likely to endorse it. After all, Kinder’s consortium controls a big chunk of the stock.

If we assume that the deal closes in January, shareholders could expect one additional dividend payment of 87.5 cents per share in October. Factoring in all of that, the stock is trading at a discount of roughly $3.50 (3.3 percent) to its eventual takeover value. This represents basically the time value of money plus a small risk premium.

I’m not a merger arbitrageur, so I don’t believe it’s worth holding on to the stock any longer just for the sake of collecting that final nub of premium. Therefore, I’m recommending you sell Proven Reserves holding Kinder Morgan. Use a limit order to sell out, and make sure you receive no less than $104.20 when selling the stock. Based on my initial recommendation at around $88–including dividends–our total profit on this stock is roughly 20 percent in just less than four months.

Another point about Kinder is worth noting: There are actually three publicly traded entities that are part of the Kinder Morgan group, and it’s important to understand and distinguish between these three entities. The company I recommended in the portfolio is Kinder Morgan (NYSE: KMI), a corporation, NOT a master limited partnership (MLP).

This company acts as the general partner for Kinder Morgan Energy Partners (NYSE: KMP), an MLP with significant natural gas pipeline assets. Kinder Morgan Energy Partners is, in fact, the largest pipeline partnership in the US. To make a long story short, the general partner acts as a manager for the partnerships assets, receiving a fee for that management service.

Another company called Kinder Morgan Management LLC (NYSE: KMR) owns a stake in KMP and performs management functions for certain assets. Kinder Morgan Management is the least liquid of the three publicly traded entities.

Neither KMP nor KMR own the Terasen pipeline; this asset is owned directly by KMI. As my recommendation was originally conceived as an indirect play on the Canadian oil sands, I recommended KMI–NOT KMP or KMR–as a play in Proven Reserves.

However, KMP does have some attractive natural gas pipeline assets, and I do track it as a buy recommendation in How They Rate. Because KMP is a partnership, it has a much higher yield than KMI, a traditional, plain-vanilla corporation.

While this structure may seem a bit complex, it does make sense. Basically, KMP and KMR are income-oriented investments that are designed to hold slow-growing pipeline assets, which throw off tremendous cash flows. It’s those tremendous cash flows that allow the partnerships to pay out high distributions to unitholders.

KMI, in contrast, tends to hold more growth-oriented assets; the focus of the corporation is on growth and less on generating massive cash flows.

Partnerships aren’t taxed at the entity level. Instead, MLPs simply pass their cash flows through to unitholders, who then pay taxes on those distributions. The catch is that, in order to avoid paying taxes on the corporate level, MLPs are severely limited as to how much of their earnings can be retained to fund growth and expansion. It’s the ideal structure for those highly profitable but slow-growing assets.

Corporations are more suitable vehicles for holding growth assets as they’re able to retain earnings and use that cash to fund expansion. This is why KMI holds certain assets separate from KMP and is traded separately. I don’t see the KMI deal as having any significant effect on the KMP partnership; I will continue to track KMP in How They Rate.

Tanker Tumult

Another point worth noting is that recent Gushers recommendation Frontline (NYSE: FRO) is down to just more than $2 today. This is, however, due primarily to the fact that the stock went ex-dividend today. If you bought into the stock on my recommendation last week, you will receive a $1.50 cash dividend on or around September 18.

Therefore, don’t be alarmed by today’s move in Frontline; this is typical for companies going ex-dividend. Factoring in those dividends, the stock is basically flat to slightly lower on today’s session. My recommendation and outlook for the stock remain unchanged from last week’s issue. Keep buying Frontline.

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