Kinder Morgan-El Paso Merger a Massive, Savvy Deal

On Sunday,  Kinder Morgan Inc. (KMI) announced the $38 billion acquisition of  El Paso  in the largest energy deal of the year. The combined company will be by far the largest midstream energy and pipeline company in the United States, with an enterprise value around $94 billion. It will be the largest transporter of natural gas, petroleum products, and carbon dioxide and the largest independent operator of refined products terminals in the country. This is a massive and, we think, savvy deal that should facilitate more rapid growth of  Kinder Morgan Energy Partners , the master limited partnership controlled by KMI, as well as provide clear upside for El Paso shareholders.

The deal consideration works out to $26.87 per El Paso share, or a 37% premium to Friday's closing price. El Paso shareholders will receive $14.65 in cash, 0.4187 share of KMI, and 0.640 KMI warrant for each EP share. That works out to $11.5 billion in cash, $9.6 billion in KMI equity (including the warrants), and $16.7 billion in assumed debt. The merger will require shareholder approval from both companies and is expected to close in the second quarter of 2012.

Kinder Morgan has no intention of owning El Paso's exploration and production business long term, which we estimate is worth in the neighborhood of $10 billion, and will begin shopping these assets immediately. Proceeds will be used to pay down consolidated debt. El Paso has a roughly $3 billion net operating loss on its books, which will help minimize the tax consequences of the E&P sale. Kinder also estimates that the combined KMI-EP entity can achieve $350 million annual cost savings by consolidating operations and eliminating duplicative overhead.

The biggest bang for the buck, in our view, comes from continuing (and broadening) the drop-down strategy that has worked so well for El Paso and its MLP subsidiary,  El Paso Pipeline Partners . EP has sold $4.8 billion worth of interests in four of its pipelines and a liquefied natural gas facility to EPB since its 2007 initial public offering, helping EP pay down debt and fund its E&P business. There are five major pipelines still held at the EP level today; following the merger, KMI intends to drop down all of these assets to KMP and EPB by 2015. This strategy will have three major impacts.

First, proceeds from asset drop-downs will be used to deleverage KMI's balance sheet. We estimate that approximately 60% of El Paso's pipeline EBITDA of $2 billion remains at the EP level. Assuming an industry transaction multiple of 10 times EBITDA, dropping down these assets should generate roughly $12 billion for KMI.

Second, the drop-downs, by Kinder's current plans, should accelerate KMP's long-term distribution growth rate from 5% to 7% (versus our premerger five-year estimate of 4.5% annual distribution growth) and allow for EPB to target a 9% distribution growth rate. That benefits KMI, which will own significant limited partner stakes in each MLP, in addition to ownership of each MLP's general partner and incentive distribution rights.

Third, and most intriguing, Kinder plans to pay for a portion of dropdowns to KMP with equity from  Kinder Morgan Management . Since KMR pays stock dividends rather than cash distributions, KMP retains the cash that otherwise would have been paid. By issuing KMR stock to help fund asset drop-downs, KMP will effectively increase the amount of cash its retains, and it looks as if Kinder is targeting a level of KMR issuance that would enable KMP to meet its annual equity capital needs through KMR dividends. This could allow KMP to fund growth without having to raise new equity capital, becoming the only "self-funding" MLP.

We're placing our fair value estimates for KMI, KMP, KMR, EP, and EPB under review, with a positive bias for all companies, while we model the combined KMI-EP entity and the impacts of Kinder's asset drop-down strategy on KMP, KMR, and EPB.

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