Recently, we have seen the share price of Kinder Morgan (NYSE:KMI) drop dramatically as a result of its dividend cut and the oil price erosion. Many dividend investors were badly hurt by this "unexpected" development.
As late as November 18th, in the shareholder meeting, Kinder Morgan still maintained that its 2016 dividend is expected to grow by 6-10% over 2015. However, the unthinkable happened, as Kinder Morgan announced a 75% cut in its dividend on December 8th.
For investors who do not want to abandon Kinder Morgan due to the dividend income and its potential in an oil price recovery, there is an alternative. On November 6th, Kinder Morgan issued series A mandatory convertible preferred stock. 32,000,000 depositary shares were issued. Each depositary share represents a 1/20th interest in a share of the series A mandatory convertible preferred stock and has a coupon value of $50 and coupon yield of 9.75%. This coupon yield is equivalent to a dividend of $4.875 per share per year. At the current price of $40, the prevailing yield is roughly 12%. It is even better than the yield of Kindle Morgan's stock before the dividend cut. Key data of this preferred share are listed in the table below.
KMI-A, KMI-PA, KMIprA
11th of Jan, April, July, Oct
What is the catch of Kindle Morgan's preferred A shares? Different from other preferred stocks, this preferred stock must be converted into KMI shares in three years at predetermined conversion rates. The conversion rate can vary from 1.544 to 1.8152, depending on KMI's stock price.
Currently, KMI's stock price is around $17. With the maximum conversion rate of 1.8152, it implies that KMI.PRA price should be around $30. However, KMI.PRA is trading at around $40. Does it mean that KMI.PRA is too expensive?
I have generated two tables for discussion. Table 1 is before KMI's dividend cut and Table 2 is after the dividend cut. The columns 4, 6 and 8 of these two tables are different due to different KMI dividends. The calculation assumes a range of possible KMI prices at the time of conversion (column 1). The published conversion rate for KMI.PRA is (column 2):
- At the time of conversion, if KMI's price is higher than or equal to $32.28, each share of KMI.PRA converts to 1.544 shares of KMI.
- If KMI's price is lower than or equal to $27.56, the conversion rate is 1.8142.
- If KMI's price is in between $32.28 and $27.56, each share of KMI.PRA is treated as $50 and converts to KMI shares by the conversion rate of $50 divided by KMI's prevailing price. The conversion rate will be between 1.8142 and 1.544. Therefore, it is expected that KMI.PRA share price will approach $50, when KMI's price range is between $27.56 to $32.28 at the end of three years.
The effective KMI.PRA price for conversion is in column 3. For example, if KMI is at $50, the KMI.PRA price should approach $77.20 to match the conversion ratio at 1.544.
Theoretically, when KMI.PRA price exceeds 1.8152 times of KMI price, it has a premium over KMI's price. But if we include dividends, KMI.PRA will have better performance (conversion price plus dividends) than KMI, as shown in the last column (Table 1), than the published conversion rate if dividends are included. This is especially true after KMI's dividend cut. Last columns of both tables show the equivalent conversion rates if dividends are included in the calculation for both before and after KMI's dividend cut.
Table 1: KMI.PRA to KMI price ratio before dividend cut
Table 2: KMI.PRA to KMI price ratio after dividend cut
The performance price ratio in the last column of the tables is the total return of these two stocks by including the final prices of KMI and KMI.PRA at the time of conversion plus the total dividend received by investors during three years.
The total dividend for KMI.PRA in three years will be $14.63, which is a fixed number. The total dividend for KMI in three years is $6.12 and $1.53 before and after the dividend cut, respectively.
By adding dividends to the price of stock at conversion, we have columns 6 and 7 for KMI and KMI.PRA. This represents the total performance at the end of the third year. The ratio of their total return is listed in the last column. We can see that it ranges from 1.78 to 2.36, which is much higher than the ratio in column 3.
Given the fact that KMI has cut dividend and KMI.PRA will not, the price ratio of KMI.PRA to KMI rises rapidly in the last few days after the dividend cut was announced. On December 1st, the ratio is 1.87 (KMI $22.42, KMI.PRA $41.85), and on December 9th, the ratio is 2.43 (KMI $16.81, KMI.PRA $40.94).
Over the next three years, when more dividends are paid, it is expected that the ratio will converge from the last column to column three. If KMI increases dividend, or even restores its original dividend, the converge will accelerate. This is possible if the oil price recovers in the next three years. But for now, the ratio of 2.36 seems to be justified. Today's ratio of 2.47 represents 4.6% of premium, rather than 36% per original conversion rate.
This calculation does not assume dividend reinvestment. If KMI and KMI.PRA prices stay low in the first two years and increase in the third year (as likely to be the case), investing in KMI.PRA is more compelling with dividend reinvestment.
Under the assumption that you really want to invest in Kinder Morgan, or if you already have KMI shares, you should buy new shares of KMI.PRA or convert your existing KMI shares to KMI.PRA when the price ratio of KMI.PRA to KMI becomes less than 2 during the next three months or so and hold it until conversion.
Disclosure:I am/we are long KMI.PRA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Preferred Share Description
Kinder Morgan Canada Ltd (KML.PR.C)
5.20% Cumulative, Redeemable, Fixed Minimum, Rate Reset, Preferred Shares, Series 3
Prospectus - December 8, 2017
Marketing Summary - December 6, 2017
DBRS Credit Update: August 15, 2017 - DBRS finalized its rating of Pfd-3 (high) with a Stable trend on Kinder Morgan Canada Limited’s issuance of Cumulative Redeemable Minimum Rate Reset Preferred Shares, Series 1.
DBRS has not assigned an Issuer Rating to KML; however, the Series 1 Preferred Shares rating is based on the credit profile of Kinder Morgan Cochin ULC (KMU; rated BBB (high) with a Stable trend). KMU is KML’s operating subsidiary, which operates the Company’s Canadian energy infrastructure assets, including the existing Trans Mountain Pipeline, the $7.4 billion Trans Mountain Expansion Project (TMEP), the Puget Sound pipeline, the Canadian portion of Cochin pipeline as well as various terminal, rail and storage facilities.
- DBRS Rating
- Pfd-3 (high) Stable Trend
- DBRS Rating Date
- Shares Issued
- Issued Date
- Shares O/S
- O/S Date
- $1.30 per share per year
- Dividend Dates
- Payable on the 15th day of February, May, August and November
- Dividend Details
- The dividend rate is fixed at 5.20% until February 15, 2023. The dividend rate will reset on February 15, 2023 and on February 15th every five years thereafter to a rate equal to the greater of i) sum of the five-year Government of Canada Bond Yield (GCAN5YR) plus 3.51%, and ii) 5.20% per year. The dividend rate will never be lower than 5.20% per year.
- The Corporation may not redeem the Series 3 Preferred Shares prior to February 15, 2023. On February 15, 2023, and on February 15th in every fifth year thereafter, the Corporation may redeem the shares at $25.00 per share, plus accrued and unpaid dividends.
- The holders of Series 3 shares will have the right to convert their shares into cumulative, redeemable, Series 4, Floating-Rate shares on February 15, 2023 and on February 15th every fifth year thereafter. The Floating-Rate, series 4, shares will pay a dividend rate equal to the sum of the Government of Canada 90-day T-Bill Rate plus 3.51%. Dividends calculated and paid quarterly. In addition, on February 15, 2028 and on February 15th every five years thereafter holders of the Series 4 Floating-Rate shares will have the right to convert their shares into an equal number of Series 3, Fixed Minimum Rate-Reset preferred shares.
- Lead Underwriter(s)
- Scotia Capital Inc., CIBC, RBC Dominion Securities Inc., TD Securities Inc.
- Transfer Agent
- Computershare Trust Company of Canada
- Computershare Trust Company of Canada
- Dividend Reinvestment Plan
- Not available to preferred shareholders
- Last Updated