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Kinder Morgan deal: Why investors should be wary

Richard Kinder made more than $1-billion (U.S.) on Monday morning – dramatic proof that most investors believe his latest deal will create value out of a nifty piece of financial engineering.

More skeptical observers may want to take a wait-and-see attitude. Mr. Kinder's plan, announced Sunday, aims for a consolidation of his sprawling and complex pipeline empire into a single, enormous corporation that will own or operate 129,000 kilometres of pipelines across Canada and the United States.

Mr. Kinder intends to spend $44-billion, mostly in stock, to acquire three businesses that he already indirectly controls: Kinder Morgan Energy Partners LP, Kinder Morgan Management LLC and El Paso Pipeline Partners LP. They will all become part of Kinder Morgan Inc., the parent company, in which Mr. Kinder holds a 24-per-cent interest.

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In a conference call with analysts on Monday, Mr. Kinder argued persuasively that the deal would result in a much lower cost of capital for Kinder Morgan Inc. That, in turn, should allow the flagship company to acquire other enterprises or invest in new expansion opportunities.

Kinder Morgan Inc. stock soared in the first hours of trading after the news, making Mr. Kinder richer by about $1.5-billion. The Houston-based lawyer and former Enron executive is now worth nearly $11-billion, according to Forbes magazine.

By all accounts, he richly deserves his wealth. Since going out on his own in 1997, with some cast-off assets from Enron, Mr. Kinder has regularly rewarded investors with double-digit annual returns.

In part, the eye-popping payoffs reflect his prescient bet on energy infrastructure, which was unpopular and cheap at the height of the dot-com bubble. But the big returns also stem from his ability to structure his businesses in a way that appeals to the market's growing demand for dividend-producing investments.

Rather than getting bogged down in the messy business of actually producing oil and gas, the Kinder Morgan enterprises focus on transporting the stuff. Their pipelines and storage facilities generate a dependable stream of fees, which can then be used to fund generous payouts to investors.

Pipelines, of course, are nothing new, but Mr. Kinder's particular genius was in being one of the first people to see the potential of what are known as master limited partnerships (MLPs), a form of business structure in the United States that is similar to the income trusts that used to be common in Canada.

MLPs, such as Kinder Morgan Energy Partners and El Paso Pipeline Partners, distribute money to investors without having to pay federal income tax. In recent years, as income-gushing investments have become rare, MLPs have enjoyed a burst of popularity.

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For Mr. Kinder, the new consolidation amounts to a U-turn away from MLPs. It will mean an end to the Kinder Morgan partnerships and their tax advantages.

There is, however, a big payoff in exchange. The new structure will "confer other tax benefits on the parent company, reducing income tax liabilities by about $20-billion over 14 years," according to Bloomberg News.

So far, so good. But investors who are counting on Mr. Kinder to produce returns under the new structure that will rival his amazing performance in the past should consider some possible negatives.

One is that Kinder Morgan Inc. is not cheap. It trades for more than 33 times earnings. The businesses it is acquiring are pricey, too. Kinder Morgan Energy Partners, for instance, changes hands for about 37 times earnings.

A second potential issue is that acquiring other pipelines may not be as simple as it looks on paper for the newly combined company. Other pipeline producers have seen their values bid up and takeovers will not be cheap.

Finally, there's the unimpressive performance in recent months of the Kinder Morgan clan of companies, which were the subject of an unflattering profile earlier this year in Barron's magazine that questioned their ability to sustain their past gains. Before this weekend's announcement, their share and unit prices had been roughly flat since January.

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So give Mr. Kinder credit for a nice bit of tax strategy. But don't assume that combining four lacklustre performers into a single big one will automatically result in big gains ahead.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More


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