3 Reasons Kinder Morgan May Buy These 2 High-Yield Energy Companies

By Markets Fool.com

Kinder Morgan's recent $71 billion acquisition of its MLPs was the second largest merger in US energy history. The rationale behind it was a multipronged desire for faster dividend growth and lower costs of capital. However, there was another reason behind the deal, a way of helping the company achieve, what founder and CEO Richard Kinder said was plans"to pursue expansion and acquisitions in a target-rich environment."

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Let's explore just why Kinder's merger will allow them to better acquire competitors and why Targa Natural Resourcesand its general partner,Targa Resources Corp.,might be in Richard Kinder's buyout cross hairs.

$55 billion in tax benefits
There are two specific ways that Kinder's merger might help it become a stronger merger partner in the MLP industry. First, through a loop hole in acquisition accounting it will be able to revalue the assets of its former MLPs to represent those of the merger purchase price, as opposed to the amount of money it actually invested to build these assets.

Why is that important? Because it allows Kinder Morgan to depreciate those assets faster, which now that these assets are owned by a C-corporation, means substantial tax savings. Management had previously estimated that it expected to benefit from $20 billion in additional depreciation tax benefits over the next 14 years,but that estimate doesn't factor in ability to revalue its new assets at the merger price. According to Richard Kinder, that extra depreciation means that Kinder Morgan could benefit from $55 billion in tax savings over the next 14 years, or almost $4 billion per year.

Those savings could then be used to help fund acquisitions, as could new capital, which thanks to the merger, Kinder Morgan can access at a much lower cost.

Cost of capital cut in half
Kinder Morgan's merger helped to eliminate the incentive distribution rights that resulted in its MLPs having to pay 50% of marginal distributable cash flow to their general partner. Those extra costs meant that any project those MLPs considered had to be profitable enough to grow distributable cash flow, or DCF per unit while paying 50% of marginal DCF to Kinder Morgan and having additional units it was obligated to pay. This was because part of the growth capital came from selling additional equity to fund new projects. Thus the bar a project or acquisition had to clear to make economic sense was much higher than many of its competitors.

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This is both because of a lack of incentive distribution rights, and also because interest on debt is tax deductible for corporations, but not for MLPs, since they are pass through entities whose tax benefits go to investors instead. In other words, Kinder Morgan's status as a corporation, as well as its enormous scale, will greatly decrease its borrowing costs.

According to Jason Stevens, an analyst for Morningstar, the merger should decrease Kinder Morgan's borrowing costs from 4.6% to 2.9%, and lower its overall cost of capital from 8% to just 4.2%.

Thus the bar for new projects and acquisitions is now much lower for Kinder Morgan, vastly expanding the potential sea of opportunities it has to grow into. But just what may Kinder be eyeing when it comes to its next acquisition?

3 Reasons Kinder may buy Targa Resources
There are three reasons I think that Kinder Morgan might want to acquire Targa Natural Resources andTarga Resources Corp.

The first reason is Targa's excellent presence in key shale formations, including the Bakken, Barnett, Tuscaloosa shale, and Permian basin.

Source: Targa Resources Investor presentation

These assets will only grow larger and more valuable after Targa closes on its $7.7 billion acquisition of Atlas Pipeline Pipeline Partners (NYSE: APL)and its general partner, Atlas Energy .

Targa's strong presence in the fast growing natural gas liquid, or NGL market, which is at the heart of a $176 billion petrochemical boom along the Gulf Coast, is something I think Kinder would be very interested in. Specifically I'm referring to Targa's Mont Belvieu NGL fractionator, a joint venture with Kinder, and the second largest such facility in the city, with a capacity of 518,000 barrels/day.

In combination with the Galena Park export Terminal near Houston, Kinder could gain valuable assets to both generate and market NGLs, whose production is expected to double to 6 million barrels/day by 2025 according to a study by the INGAA Foundation.

A second reason for Kinder Morgan to acquire Targa is because it would greatly grow its EBITDA, or earnings before interest, taxes, depreciation, and amortization. For example, Targa Resources Corp. and its MLP had combined EBITDA of nearly $2 billion in the past 12 months.

Combined with the EBITDA from Atlas Energy and Atlas Pipeline Partners, that means Kinder's EBITDA would grow by $2.8 billion,or 34% over the $8.2 billion Kinder's management expects for 2015 EBITDA.That kind of growth would likely greatly help Kinder Morgan meet or even beat its goal of 10% dividend growth through 2020.

My final reason for Kinder to consider buying Targa is that the recent collapse in oil prices has left Kinder's stock largely unaffected while Targa's has crashed.

KMI Chart
KMI data by YCharts

This means that today Targa Resources Corp. and Targa Resources Partners are trading at enterprise values, which represents the cost of acquiring them, of $7 billion and $7.9 billion, respectively. Add in the $7.7 billion that Targa paid for Atlas Energy and Atlas Pipeline Partners and a 15% to 20% premium and you have a potential total acquisition cost of between $26 billion to $27.1 billion, representing a valuation of 9.3 to 9.6 times EBITDA.

While that sum may seem staggering it represents just half the amount of the recent $50 billion merger between Williams Partners and Access Midstream Partnersand is 62% smaller than the merger Kinder just completed.

Bottom line: Merger leaves Kinder better positioned for growth through acquisitions and Targa Resources is a prime candidate
Thanks to its merger Kinder Morgan now has a substantially lower costs of capital and shares that represent America's largest pipeline assets. This makes for great currency should it want to acquire competitors such as Targa Resources which is now trading 30% cheaper thanks to the collapse in oil prices. While we at The Motley Fool aren't proponents of investing in companies simply because they may be buyout targets, Targa represent a quality long-term income investment in America's energy future and potential investors may wish to consider its potential future acquisition premium by Kinder Morgan as a speculative "cherry on top" of its already generous 6.7% yield.

The article 3 Reasons Kinder Morgan May Buy These 2 High-Yield Energy Companies originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.