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Kinder Morgan Does the Midstream Two-Step

The merger with El Paso will create value for almost all stakeholders.

Jason Stevens, 11/30/2011

The merger of Kinder Morgan Inc. KMI and El Paso EP will work out very well for their shareholders as well as those holding Kinder Morgan Energy Partners KMP and Kinder Morgan Management KMR, in our view. Prospects are somewhat less rosy for unitholders of El Paso Pipeline Partners EPB, as the partnership will no longer be the sole recipient of asset drop-downs from El Paso.

Investing in EP, KMI, and KMR are the best ways to play the deal, in our opinion. Our merger-case valuation for KMI implies a $30 per share value for EP, or 19% upside to current prices. KMI is trading 15% below our merger case currently. We think this deal may help KMR close its discount to KMP, suggesting 7% upside.

The Midstream Two-Step
We've seen this playbook demonstrated twice, with Energy Transfer Equity's bid for Southern Union and now with Kinder's purchase of El Paso. Step 1: A general partner buys a C corporation with lots of pipeline assets. Step 2: The general partner sells the assets to its controlled master limited partnerships, realizing three distinct benefits.

First, the drop-downs move the pipelines to a more tax-efficient structure at the MLPs, in effect securing a higher multiple on future cash flows for the assets. Drop-downs are priced at a level that guarantees cash flow accretion for the MLPs, enabling the MLPs to raise distributions at a faster rate. The general partner benefits directly from increased distributions on the limited partner units it owns and from increased incentive distributions.

Second, to finance the drop-down, the MLPs come to market and raise fresh debt and equity, typically in roughly equal measure. For a $1.0 billion drop-down, the MLP typically raises $500 million in new equity. The increase in units outstanding at the MLP elevates the general partner's incentive distributions, which are calculated based on the total dollar value of distributions paid to limited partners.

Third, the general partner takes the proceeds from the asset sale and pays down its acquisition debt, with a goal of holding zero parent-level debt upon completion of asset drop-downs. The math works as long as a general partner doesn't pay more for assets than it can charge its MLP and still have the drop-down be cash flow accretive.

Kinder Morgan's Bid and Valuation
The accounting for the deal is complex, as there are five publicly traded entities involved, and our final valuations are based on path-dependent assumptions. The size, pace, and pricing of asset drop-downs, and the share of assets sold down to KMP versus EPB, can greatly affect the valuations of not only KMP and EPB, but also KMI. The reason these assumptions are critical has to do with KMI's ownership of limited and general partner interests in each MLP, which affords KMI significant cash distributions. As assets are dropped down to either KMP or EPB, the MLP will finance the deal with both debt and equity (we assume a 50/50 split). Drop-downs have two effects on the MLPs. First, drop-downs increase distributable cash flow (based on our assumed transaction prices, which keep drop-downs accretive to distributions for both KMP and EPB), which allows the MLPs to raise distributions at a faster rate than otherwise possible, increasing KMI's cash inflows from distributions. Second, the new equity issuance required to finance transactions also increases KMI's cash inflows, thanks to incentive distributions that are based on the total cash payout of each MLP. As the size of the payout (limited partner units times declared distribution) increases, so does the size of incentive distributions.

The merger math for this deal is premised on drop-downs. We think KMI is worth $34 per share in our base merger case, versus our $28 predeal fair value estimate. However, if we were to assume that KMI does not drop down El Paso's assets to the MLPs and instead keeps them at the KMI level indefinitely, our valuation would decline to $26, unless we factor in aggressive cost savings. Similarly, drop-downs account for $8 of the $9 per unit fair value increase for KMP (and KMR), to $75. Were KMI to drop 100% of El Paso's pipes down to KMP, our fair value estimates would increase to $80 for KMP and KMR.

Jason Stevens is an associate director of equity research at Morningstar.

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