Kinder Morgan Warrants (ticker: KMIIV) - $2.37 (as of 3/12 when this was written… was travelling all day yesterday so didn’t see the close, but as of Thursday, KMI and KMIIV were lower than 3/12, but the risk reward was about equally attractive, but with less deal risk)

Disclosure: We and our affiliates are long KMIIV, KMI and KMR, and may buy additional shares or sell some or all of our shares, at any time. We have no obligation to inform anybody of any changes in our views of KMIIV.

As part of KMI’s acquisition of El Paso, EP shareholders will receive around .6 of a 5 year (from closing), $40 strike warrant on KMI. With KMI trading  ~$37, this look very cheap to me. This is the classic “Greenblatt” special situation of a “merger security” that often trades inefficiently. While the KMI-EP deal isn’t expected to close until the mid May, these warrants have recently started to trade on the when/if issued market.

Simply put, these warrants trade somewhere between cheap to very cheap compared to what they are likely to be worth over time. Where else can you get a security that trades $10-20 million a day, run by an A++ management team, and there’s a reasonable case to be made that these will be 5+ baggers over time???

I think there is room for a lively debate on how to value these warrants. I’ll throw out a number of ways to try to get at this…

Black – Scholes method: Using reasonable vol assumptions, we come to a Black – Scholes value of ~$3-4 today. This value can reasonably be projected to increase over time as KMI compounds. If you project what these would be worth 1 year forward (assumes 12% distribution growth and flat KMI yield, but 1 year less of option value), you get $5-6 per warrant.

5 year forward projection method: The company had guided to a multi-year distribution growth rate of 12%. I see someone else wrote KMP up as short, I obviously disagree with that view. This company has an incredible track record for consistent distribution growth and exceeding guidance. If one were to start with the current stock price and grow that by the 12% expected growth, the warrants would be worth $25 in year years. PV-ing that at 10% gets $15. My goal here isn’t to be precise about valuation, but to show a valuation methodology. I would argue that $25 is too aggressive, given that the yield that KMI trades at stands a reasonable chance of needing to increase over time, given a) we’re in a very low interest rate environment (though the spread between KMI/KMP’s yield to the 10 year treasury is wider than normal, so that would probably counter some of an rise in rates) and b) the forward growth prospects will likely be lower in 5 years given the merger lead them to increase their growth expectations. They are very much running into the law of large numbers. There is also a strong case to be made that the current price of KMI is artificially high due to risk arb factors, so one may want to discount the starting point. I encourage you to play around with different growth expectations and higher interest rates so you can see the sensitivities to the 5 year forward value. My hunch is that they’ll exceed their guidance over time (they have a very strong track record of doing this), but the required yield will rise over time offsetting that.

The market price method: There are no 5 year calls that trade regularly, but the longest dated calls that do trade are Jan ‘14s. The last trade for those are was $1.85 on 3/2 (KMI was $36.29). Eyeballing the time value, I’d say that that implies $4-5 for 5 year options.

“The Rich Kinder said” method: At the time of the merger Rich said that he felt the warrants were worth $1.50. KMI was $27 then vs. $37 now. I don’t think it’s hard to say that with KMI $10 higher that the warrants should be more than $1 higher today, if that base valuation was correct.

In short, it looks like the warrants are pretty cheap at $2.37. Keep in mind however that the valuation is very sensitive to interest rates and while there’s a lot of potential upside here, these warrants could expire out of the money.

Risks:

-          The value here is very sensitive to interest rates.

-          While very small, there is some risk that the deal doesn’t close.

-          Execution risk to KMI’s anticipated dividend growth.

-          KMI stock price may be temporarily propped up by risk arb factors.