Description

This is not a sexy idea, but something we view as pricing in a worst-case scenerio (thanks to retail holders puking up units), with a high likelihood of near term catalysts for substantial appreciation...

SUMMARY:

Eagle Rock Energy Partners, LP units have fallen in price by 58% over the last twelve months.  This relentless decline in unit price, driven by lower distributions to unit holders, was punctuated by a 17% drop last Thursday after the announcement of a temporary suspension of distributions to unit holders.  Eagle Rock now trades at a substantial discount to our estimate of intrinsic value as yield-seeking MLP investors are now indiscriminately selling.

Eagle Rock is a master limited partnership, a class of flow-through income securities that has enjoyed substantial appreciation over the last few years, but also some controversy.  This controversy has centered on a number of master limited partnerships that may not actually be earning the amount of cash they distribute to unit holders, which can lead to overvaluation if investors base their valuation on current “yield”[1]. 

Over the last year, Eagle Rock’s unit price steadily declined on the perception (and then the reality) that the over-levered and under-performing MLP would have to cut its distribution.  After cutting the distribution in late 2013, the company made the decision to sell-off its “midstream” (gathering, transportation, and storage of oil & gas from wells) segment in order to de-lever the balance sheet.  This will leave an under-levered “upstream” (producing wells) MLP.

The sale of the midstream unit has been delayed slightly by HSR review, which led to the suspension of distributions.  Because Eagle Rock is close to breaching leverage covenants and burdened with $550 million in expensive high-yield debt, it likely had no choice but to suspend distributions.  We believe this suspension will also allow management to reinstate the distribution at a more manageable level.

At the current price, we believe Eagle Rock units represent a compelling value both on an absolute asset value basis and on a relative basis as an MLP.  We believe Eagle Rock will reinstate distributions within six months and that the units conservatively have upside of 12-44%, not including distributions.  Because the reinstatement of distributions is the proximate catalyst for appreciation in the price of the units, we will reevaluate the investment at that time and do not assume we will receive any distributions.  We believe that the longer-term (1-2 year) upside to the units is more than 100% including distributions.

KEY INVESTMENT STRENGTHS:

• Low leverage if deal closes:   Eagle Rock will have a debt/EBITDA ratio of 1 - 1.5X, compared to peers (and management’s own target) of 3X.

• Significant optionality from under-earning assets:   Non-producing E&P assets are worth $82.5 - $447.5 million.

• Attractive assets trading at a substantial discount if deal doesn’t close:   The average sell side fair value, despite negativity on the units, is $5.63.  A competitor offered to purchase the company in the last six months for $5.49 per unit.  Our own conservative fair value on an asset basis is $5.34.  The current unit price is 25-28% below these three conservative metrics (the sell side values have been lowered substantially and the acquisition offer was opportunistic).

KEY INVESTMENT WEAKNESSES:

• Deal risk:   It is possible that the deal with Regency will be unfavorably renegotiated (captured in our “low case”) or even called off.  We do not believe it is in the interest of either party to call off the deal, nor do we believe that anti-trust issues – if any arise – will be insurmountable.

• Operational risk:   Eagle Rock has not proven to be the most capable operator of either its upstream or midstream assets.  We capture this through our higher yield assumption and through the use of conservative guidance.  In the longer run, this might be cause for the sale of the company.

BUSINESS HISTORY:

Eagle Rock Energy Partners was formed in 2002 and went public in 2006 at $19.00 per unit (down 79%) as a midstream MLP sponsored by Natural Gas Partners (NGP), a $10 billion energy private equity company.  At the time of the IPO, Eagle Rock had no producing oil and gas assets and NGP served as the general partner, giving the private equity sponsor control as well as well as a favorable interest in the economics of the partnership through incentive distribution rights (IDRs). 

In 2007, with energy markets on the rise, Eagle Rock more than doubled its enterprise value through $734 million worth of acquisitions, both in the midstream space and diversifying into the ownership of “upstream” interests in producing oil and gas properties.  These acquisitions were financed with debt and the issuance of new units.  After 2008, with the collapse in natural gas prices Eagle Rock was forced to cut its quarterly distribution from $0.41 per unit in 2007 to just $0.025 per unit in 2009 (causing a corresponding 75% collapse in the share price to ~$5 per share).

In 2010, Eagle Rock completed a series of transactions which streamlined and de-levered the company, although at some expense.  First the company sold its minerals division for $174.5 million.  This asset consisted of mineral rights, which are equivalent to ownership of minerals as opposed to the “working interest” commonly owned by exploration and production companies that have leased mineral rights from the owner.  Mineral rights generate cash flow without any associated cost and assets of this type have increased in market value substantially over the last few years.  Next, the company launched a rights offering to purchase shares at $2.50 per share, a deep discount to the trading price, which raised an additional $54 million.  Eagle Rock also traded additional “common” units to NGP in return for the general partner interest and associated IDRs.

The net result of the 2010 transactions is that the company was able to de-lever itself through the loss of a very valuable asset and also able to cancel the IDRs through dilution.  Overall, these transactions were a positive in the short term (but probably destroyed substantial unit-holder value in the long term).  As a result of these transactions and a recovery in energy markets, by year-end 2010, the quarterly distribution had risen to $0.15 per unit and the units themselves traded back to $8.82 by the end of the year.

In 2011, Eagle Rock made a major acquisition, spending $563.7 million (financed with debt and the issuance of new units) to acquire producing natural gas and NGL properties in the mid-continent and Texas from NGP.  This acquisition increased proved reserves by 200% and increased production by 142%.  The primary assets acquired were proved producing natural gas properties in the Woodford Shale in Oklahoma, the Arkoma Basin in Arkansas, and the Barnet shale in Texas.  As a result of this acquisition, Eagle Rock was able to raise their quarterly distribution to $0.21 per share by year end 2011.

In 2012 Eagle Rock made an additional $231 million acquisition in the midstream segment and was able to make quarterly distributions of $0.22 per share.  However, as a result of falling natural gas and NGL prices, earnings from both the upstream and midstream segment failed to live up to expectations.  As a result of lower natural gas prices, Eagle Rock was forced to record a $132 million non-cash impairment to natural gas related midstream assets and a $45 million non-cash write-down of natural gas reserves, including a loss on the sale of the Barnett shale asset, which was sold for $15 million.  With natural gas and NGL markets in recovery by the end of 2012, unit holders and the sell side sponsors of the MLP looked forward to improved performance and renewed growth, both organic and through acquisition.

In April of 2013, one year ago, Eagle Rock units traded as high as $10.38 per share (up 158% from current) and the units had strong sell-side support as a growing upstream (oil and gas production) and midstream (gathering and processing) MLP.  When the partnership reported Q1 earnings at the end of that month, the investors were dismayed to see that the company had earned distributable cash flow of only $22 million, falling far short of the $33 million in quarterly distributions it was then paying to unit holders ($0.22 per unit per quarter).  In October Eagle Rock announced the distribution cut the market had anticipated and the shares continued to fall. 

Poor results in 2013 were the result of continued weakness in the market for natural gas liquids (NGLs) which negatively affected both the upstream and midstream segments.  In addition to low pricing, operational stumbles caused a number of “one-time” expenses.  In 2013, Eagle Rock recorded a non-cash impairment charge of $207 million, substantially writing down the natural gas properties they had purchased in 2011.  A large portion of this write-down related to the relative unattractiveness of these higher-cost natural gas fields to other operators (Eagle Rock primarily owns working interest that are operated by large E&P companies) that have shifted activity to higher return assets elsewhere within their respective portfolios. 

In December of 2013, Eagle Rock announced that they would sell their midstream segment to Regency Energy Partners, LP (RGP $27.42) for $1.27 billion.  This transaction is expected to close in Q2 of 2014 and the total consideration will be paid through the assumption of $550 million in debt (through an exchange offer), $226 million in RGP at the current market price (8.25 million units, which Eagle Rock has benefited from the market appreciation of in the meantime), and $520 million in cash.

MIDSTREAM SALE:

Eagle Rock is selling its midstream segment for total consideration of $1.27 billion to Regency Energy Partners, LP.  This includes an exchange offer in which the holders of $550 million of Eagle Rock unsecured notes can exchange these notes for new Regency notes with identical terms and the same coupon.  For any portion of the $550 million of Eagle Rock note holders who do not choose to exchange for Regency notes, Regency will pay additional cash to Eagle Rock equal to 10% of the face value of the notes which do not exchange (up to an additional $55 million, or 10% of the total issue face value).

Given that Regency is a better credit whose unsecured notes trade ~200 basis points tighter than Eagle Rock’s debt prior to the exchange offer, we expect the vast majority, if not all, of Eagle Rock note holders to accept this exchange offer.  Assuming 100% of notes accept the exchange, Regency will pay total cash consideration of $520 million.  Because the value of RGP units have risen ~11% since the total amount of units to be issued as consideration was set at 8.25 million, these units are worth $222 million today, or 11% more than when the deal was made.  This takes total consideration up to $1.29 billion (assuming full exchange of the notes).

The deal is expected to close in this quarter and we do not believe there is material risk either from the Eagle Rock unit holder vote on April 29^th (NGP has agreed to vote its 32.2% stake in favor) or from the anti-trust review, despite a request for additional information from the FTC in late February.  Eagle Rock has received waivers on its debt covenants to avoid tripping any leverage ratios before the deal closes. 

The recently announced suspension of distributions has caused some concern in the market that RGP will back out of the deal.  We do not believe this makes sense.  RGP is controlled by Energy Transfer Equity, LP (ETE $47.48), which controls the general partner of RGP and has incentive distribution rights (IDRs) which give Energy Transfer a disproportionately large cut of the increase in RGP distributions this deal will create.  We do acknowledge the weak bargaining position Eagle Rock currently finds itself in, so in out “low case” we assume that RGP is able to lower the deal price by 5% or $64 million. 

While the proximate cause of the midstream sale was overleverage and poor operating performance of Eagle Rock, the proxy statement gives a lot of interesting detail into a number of transactions that were previously considered over the last few years.  Among a number of potential transactions related to the midstream assets, upstream deals – both acquisitions and divestitures – were also considered.  Among these potential deals, it is disclosed in the proxy that Eagle Rock marketed its “SCOOP” acreage to approximately 100 parties in the second quarter of 2013, but despite a number of indications of interest, “none of them met the value expectations of Eagle Rock and the Eagle Rock Board.”  We believe acquirers were likely at the low-end of the $5,000 - $15,000 per acre valuation used by some sell side analysts, while Eagle Rock was at the high end. 

When an official sale process for either the midstream segment, upstream segment, or both was initiated in August of 2013, “the indications of interest on the upstream business did not reach valuation levels satisfactory to the Eagle Rock Board,” but Regency’s indication of a $1.3 billion for the midstream business ultimately led to the transaction that is being consummated.

At this time, Eagle Rock instructed its bankers to continue to pursue a simultaneous sale of the upstream business, if a combined sale could be done at a premium to the current unit price (the units traded in a range of $6.00 - $6.50 during this time).  In October, another potential suitor, “Company E” indicated an interest in acquiring all of Eagle Rock “at a value up to $6.00 per outstanding Eagle Rock common unit”. 

In final negotiations with Regency, Eagle Rock proposed either a primarily cash acquisition of the midstream business for $1.356 billion or an alternative transaction at a lower price of $1.275 billion, that would include the assumption of the high-cost Eagle Rock notes by Regency through an exchange offer.  Ultimately a deal was done with the assumption of notes at $1.27 billion, but Eagle Rock was able to remove the requirement that it hold the RGP units it would receive for a specified time period. 

Before Eagle Rock agreed to the Regency Deal, “Company E” proposed a “unit-for-unit exchange of units of Company E for units of Eagle Rock at an exchange ratio that implied an offer at the then-current trading price of Eagle Rock.”  Eagle Rock was trading at a price of $5.49 per unit on that day.  In further negotiations, “Company E” was unwilling to offer a higher price, but expressed a willingness to close a transaction quickly and was working from public information only, so we view this offer as opportunistic. 

PRO FORMA ASSET OVERVIEW:

After completion of the midstream sale, Eagle Rock will have three primary assets: producing oil and gas properties, non-producing oil and gas properties, and 8.2 million RGP units.

Producing Oil and Gas Properties 

At year-end 2013, Eagle Rock had proved reserves of 346.3 Bcfe with an estimated reserve life of 13 years.  The present value discounted at 10% (PV10) value of these properties was $650.5 million. 

Eagle Rock has 16,500 net acres in the South Central Oklahoma Oil Province or “SCOOP” play, an area in which the Woodford shale is very thick and oil rich.  This is an area where super independent Continental Resources (CLR $136.08) has leased 400,000 net acres and is currently operating 18 rigs.  Continental reports 50% IRRs for its wells and average IP rates of 1,300 Boe/day.  Newfield Exploration (NFX $32.96) has acquired 75,000 net acres in the play and reports slightly higher IP rates and IRRs. 

Based on comparable plays like the Eagle Ford Shale, even at this early stage in development it is likely that Eagle Rock’s acreage could fetch $10,000 per acre in a sale or trade.  Eagle Rock has begun developing this acreage and is participating in a number of non-operated wells.  While this acreage could be a key source of growth for Eagle Rock and ultimately be worth a multiple of $10,000 per acre, we believe it makes more sense to trade this acreage to another (better) operator. 

Importantly, many E&P companies get little credit from the market for smaller conventional producing assets they own, while Eagle Rock gets little credit as an MLP for this unproved acreage.  It would likely make sense for both companies if Eagle Rock can trade this acreage to a public E&P for a developed producing asset.

Eagle Rock also has significant long-term upside to the price of natural gas.  If natural gas prices rise above the price predicted by the futures curve in the coming years (which we believe is depressed by technical factors), Eagle Rock could recover the ~$200 million in reserve value that was written down as a result of low natural gas prices.  We ascribe no value to this upside, but it does present some optionality, particularly in the Cana Woodford area.

Regency Energy Partners, LP Units

As part of the consideration for the sale of its midstream assets, Eagle Rock will receive 8.25 million units of RGP.  At the current unit price of $26.74, this holding is worth $220 million.  Importantly, these units are unrestricted and could be sold (or traded) to acquire developed producing oil and gas properties.  These units have a current yield of 7.2%, which is substantially less than the 12.2% yield Eagle Rock traded at prior to the distribution cut.  In our “high case” we make the assumption that these shares are sold at a 5% discount to market and the proceeds invested a producing oil and gas property at a higher implied yield.

VALUATION:

Sum of the Parts Valuation

MLPs, almost by definition, trade above the value of the assets they own.  This is how these vehicles are able to grow through “accretive” acquisitions of cash flow producing assets that they have purchased at full price in a competitive market.  MLP’s add “value” in three ways, which justifies (at least for the majority of investors) the premium to NAV that these vehicles trade at. 

First, MLPs are flow-through entities, which avoids double taxation at the corporate level for the ultimate owner of cash flowing assets – assuming the owner would like to receive the cash rather than capital appreciation through share repurchases.  Secondly, this structure creates a yield vehicle in an environment where yield is very hard to come by.  The average retiree doesn’t get excited about a business trading for 10X FCF, but he certainly does for a company paying a 10% annual dividend.  Finally, MLPs “add value” through the ability of these vehicles to grow distributions over time through “accretive” acquisitions.  Investors are often willing to pay a substantial premium today for an MLP that is growing its distribution, without regard to the fact that they are paying a substantial premium to NAV for the underlying assets. 

We do not take a stance on the correctness of paying up for the ability of these vehicles to grow through acquisition in the future, but we are willing to admit that in this environment, assets in an MLP are worth more than assets outside of an MLP.  For this reason, we believe that Eagle Rock shares are likely to trade at a premium to our sum-of-parts valuation of its assets in the future.

Yield-Based Valuation

The large upside we see in Eagle Rock units comes from the ability to reinstate and eventually grow the distribution after completing the sale of the midstream segment.  Specifically, Eagle Rock will be much less levered than upstream MLP peers following this transaction and may be able to significantly increase distributable cash flow without issuing new units.  This is very different than the way a typical MLP “adds value” by issuing expensive units and taking on new long-term debt to increase the cash flows available to the unit holders. 

Pro-forma for the midstream sale, we estimate Eagle Rock will have $200 million in net debt ($50 million more than assumed by some on the sell side).  The company should have revolver capacity of 60% of the value of its proved developed producing (PDP) reserves, or $312 million, with initial utilization of $200 million once the deal closes.  The cost of debt service for the revolving credit facility, including commitment fees, is roughly 3%. 

Eagle Rock is targeting acquisitions that are largely proved developed producing (PDP) – low-decline developed oil and gas properties throwing off cash that do not require costly exploration.  The company should be able to purchase such assets for 10-12% FCF yields, defined as cash flow net of the annual capital expenditures required to keep production flat.  In such an acquisition, Eagle Rock’s bank group should be willing to increase the revolver capacity by 60% of the PDP value of the new property concurrent with closing the deal. 

In our “base case”, we assume Eagle Rock purchases a $200 million PDP asset at a 10% FCF yield (utilizing $112 million in current excess revolver capacity and the assumed $120 million increase in capacity that will come from the deal).  In our “high case”, we assume Eagle Rock is able to make an additional $333 million in PDP acquisitions by selling its RGP shares and trading or selling its SCOOP acreage at a value of $7,500 per acre.  Importantly, these further acquisitions in the “high case” would add substantial unutilized revolver capacity, implying more future growth and a lower yield for the units.

We have created what we believe is a very punitive “low case”, in which RGP is able to lower the purchase price of the midstream assets by $63.5 million (increasing pro-forma borrowings and interest cost by that amount) and no further acquisitions are made.  We have further assumed lower cash flow levels and higher maintenance capex in this “low case”.  In all scenarios, we assume a distributions coverage ratio of 1.2X, which is management’s stated target and a level that we feel is “safe” and reasonable. 

We would note that we believe there could be substantial upside to our “high case” if Eagle Rock is able to resume growth as an upstream MLP.  Growing peers trade at 9-11% yields and reasonable estimates show that Eagle Rock could pay distributions of $0.80 next year through further acquisitions (implying $7.27-$8.89 per share valuations).  There is also further upside if the company is able to purchase producing properties at a higher FCF “yield” than the 10% we assume.  We further note that if no deal is completed, the company can slowly de-lever through the suspension of dividends and currently trades at a 26% discount to our NAV and a similar discount to peers on an EV/EBITDA basis (the sell side valuation metric).

CONCLUSION:

We believe Eagle Rock presents a very attractive risk/reward at these levels.  The current share price is discounting a worst case scenario and we believe a doubling in value is possible over the next twelve months.  This is not a great company and we don’t love the sector, but this is an investment that we see as timely and with positive near term catalysts.  We believe the most likely scenario, our “base case”, will be reached by the end of this quarter once the Regency deal closes.  We would note that our “base case” share price is approximately where the shares traded prior to the distribution cut, which was not an entirely unexpected event, but nonetheless led to “dumping” of shares by yield investors.

Catalyst