Kinder Morgan: I prefer KMR to KMP

As discussed in this article, Kinder Morgan has four publicly traded entities, depending on the investor’s goal; Three of the four are fine investments and widely discussed in the dividend investors’ circle: KMP, KMR, and KMI.  In this article, I’ll focus on KMP and KMR.  Between the two, I prefer KMR to KMP.  Why?

Firstly, KMR is trading at discount of KMP, which present opportunities to KMR investors.

Let’s look at the relationship between KMR and KMP.  Some investors may feel confused about their relationship.  In order to make it easy to understand, I summarized their relationship in one chart.

 

KMR has no significant business purpose other than to be a vehicle for institutional investors to effectively participate in KMR without having the paperwork and tax consequences that would result if they owned KMP units directly. KMR shares are pari passu with KMP units; if you own a share of KMR you effectively own a unit of KMP.  So if you believe in the future of KMP, you should also believe in the prospects of KMR.

In case of additional public stock offerings, the proceeds of KMR are used to benefit KMP. The mechanism for this is for KMR to sell stock in itself and use the proceeds to purchase the equivalent number of I-Units from KMP. Since the I-Units have full value and are issued immediately to KMR, there is little or no dilution to KMR stockholders.

Since KMR is the shadow of KMP, the share price of KMR should be exactly the same as that of KMP since it is the reflection of the latter.  Historically, however, KMR shares have been traded at a discount to KMP share prices.  There is no logical reasons why KMR shares are priced lower.  KMR trading discount to KMP represents an attractive opportunity to investors. KMR has generated a 15.2% compound annual total return since 2001 IPO, vs. 14.6% for KMP.  As a result, Kinder Morgan directors and officers purchased more shares of KMR ($14.7 millions) than KMP shares ($4.5 million.)

Recently KMR market price is much closer to that of KMP. As of 07/01/13, KMR was closed at $84.68, and KMP was closed at $86.62.  KMR unit price is at around 2.24% discount.  From the mechanism we’ll see that any discount is a bonus to KMR investors.  Of course, the more discount, the better.  For me, I’ll wait for 5% discount, which means their market prices difference should be around $4 which will make KMR very attractive.

source: KM investor presentation Jun13.

Secondly, KMR’s dividend equals to KMP’s cash distribution, but paid inadditional shares, which is effectively a dividend reinvestment program.

Calculation of KMR share dividend is as follows: KMP quarterly cash distribution per unit divided by KMR 10-day average price prior to x-date = fractional share paid for every KMR share owned, e.g. $1.30 / $88.015 = 0.014770 share; this example reflects actual KMR share dividend calculated for 1Q 2013 paid on 5/15/2013.

According to Kinder Morgan’s website, the basis of each individual unit held by KMR stock holder becomes lower when the shares increase, which I believe is favorable to the shareholders.  It is recommended that you contact your tax advisor with specific tax questions.

Under IRC §305(a), stock dividends of Kinder Morgan Management, LLC (KMR) are not taxable upon receipt to the stockholder. However, the stock dividend does affect the basis of each individual unit held by the stockholder. Under IRC §307(a), the basis of such new stock and of the stock to which it is distributed (referred to as old stock), respectively, shall, in the shareholder’s hands, be determined by allocating between the old stock and new stock the adjusted basis of the old stock.

Example 1: A owned 100 units of (KMR) on July 1, 2010 with a basis of $65/share, or $6,500 total. A received an additional 1.8336 shares (100 x 0.018336) of KMR shares on August 13, 2010, giving A a total of 101.8336 shares. A’s basis in the old stock of $6,500 would be allocated between A’s old stock of 100 shares and new stock of 1.8336. A’s basis in the old stock ($6,500) is allocated between the old stock and the new stock. Thus, A’s basis in the old stock is $6,383 ($6,500 / 101.8336 x 100) and A’s basis in the new stock is $117 ($6,500 / 101.8336 x 1.8336). Therefore, A has 101.8336 shares with a basis of $63.83/share or $6,500 in total.

Subsequent distributions are treated in the same manner.

Example 2: Assuming A in Example 1 still has the units described above on November 12, 2010. A received an additional 1.8171 shares (101.8336 x 0.017844) of KMR shares on November 12, giving A a total of 103.6507 shares. A’s basis in the old stock of $6,500 would be allocated between A’s old stock of 101.8336 shares and new stock of 1.8171. Thus, A’s basis in the old stock is $6,386 ($6,500 / 103.6507 x 101.8336) and A’s basis in the new stock is $114 ($6,500 / 103.6507 x 1.8171). Therefore, A has 103.6507 shares with a basis of $62.71/share or $6,500 in total.

 

Thirdly, As a C-corp, KMR has a simplified tax reporting (no K-1s, UBTI).

KMR is a LLC which has elected to be taxed as a C Corporation. Thus cash dividends would be subject to Federal Income Taxes. However, KMR, by design, issues only Stock Dividends of its own stock and thus its dividends are not subject to Federal Income taxes. You will not receive a 1099-DIV or any other tax form in connection with these dividends.

The only tax effect these stock dividends have is on the per share tax basis of all the KMR shares you own. The following computation, whether performed by you or your brokerage, may be necessary when it comes to selling any of your KMR shares.

Disclosure: None.  I am waiting an entry point to purchase KMR.