February built on January’s sharp equity market rebound as the Federal Reserve affirmed its commitment to a neutral posture that would not jeopardize the economy’s health simply for the sake of monetary normalization. Further, progress with the US-China trade negotiations has continued on a positive path. A material change in China’s systemic theft of American intellectual property and forced technology transfers would provide major long-term benefits to the United States. The US decision not to raise tariffs on March 2ndsuggests an escalating worldwide tariff war is unlikely and that the negotiations are moving in a positive direction.
Nevertheless, concerns of an economic slowdown persist due to weakness in the emerging markets and Europe. This economic weakness has led to lower interest rates with 10-year US Treasury Note yields having dropped from 3.23% in November to 2.77%. The S&P 500 appears fairly valued at 17 times trailing earnings and 15.3 times 2019 earnings as shown in the table below.
The chart series below of the Fed Model Risk Premium model shows, in the middle chart, a modest contraction in earnings growth (red line) in recent weeks. With the equity markets now balanced at fair value, the trend in earnings will be a critical indicator in the coming months while economic momentum remains uncertain. In light of the significant rebound in the S&P 500, improving trade prospects and dovish Federal Reserve monetary policy, we are reducing our US equity investments.
Sentiment has grown complacent since the fear-filled fourth quarter that peaked on December 24th, 2018–“Mnuchin Monday”. The chart below of VIX option volatility index is now 14.5 down from 36 in late December. If the volatility index continues to drop and/or S&P 500 earnings estimates continue to weaken, further defensive allocations would be prudent.
An Inconvenient Liquidity Event:
See Last Month’s Note “MLPs at a Crossroad” on Seeking Alpha for an overview.
Earlier this year we highlighted the unusual 75% distribution cut by American Midstream Partners, LP (AMID) on July 26th and the distribution elimination on December 31, which were followed by bids by ArcLight Capital entities at extremely beneficial prices to ArcLight, but potentially imposing sizable losses on retired investors who had followed AMID CEO Lynn Bourdon’s enthusiastic recommendation 14 months previously at unit prices two and three times ArcLight’s recent bids.
Two activists, as well as our own research, suggest that the bids by ArcLight appear opportunistically timed, highly profitable and meritorious if it were not to come at the expense of panicked elderly retail investors’ precious retirement savings. Equally troublesome, AMID’s management had asserted that ArcLight was a “supportive sponsor” and ArcLight is the majority owner of American Midstream GP. Consequently, AMID’s board of directors–who one would expect to protect AMID unitholders retirement investments–now finds their interests conflicted.
Craig Thomas, a former head of research at SAC had contacted me and shared some insight into this liquidity “crisis” that appears to be a combination of one-time factors, accounting subtlety and a corporate governance matter that puts “MLPs at a Crossroad”. Recent conflicts of interests between GPs and sponsors and their elderly unitholders at SunCoke Energy, Summit Midstream and American Midstream is problematic for the MLP sector’s long-term health.
AMID’s Delta House is a key cash-generating asset in the Gulf of Mexico. Delta House’s 2018 EBITDA was artificially low because it was under repair. Delta House’s operation is ramping back up – Q3’s volume increased to 90k BPD from Q2’s 60k BPD. Further, LLOG which operates Delta House reported on January 14th, 2019 that Delta House is already back to full capacity of 120K BPD.
Since AMID’s management has become strangely silent after it announced its 75% distribution cut on July 26th–without a conference call–it seems problematic that ArcLight has bid for these assets at $6.10 and $4.50 when Lynn Bourdon had told investors to “get on board quick” at $13.15/unit on November 8, 2017 and units closed at $11.55/unit on July 26th, 2018, the eve of the distribution cut.
If Delta House volumes are 120k BPD and with AMID’s increased ownership of 35.7%, Delta House will contribute $22mil EBITDA per quarter or $88mil annualized EBITDA. This is a material jump from the estimated $35mil annualized EBITDA for last year. With the distribution cuts and asset sales, AMID’s leverage is dropping materially with Delta House now operating at full capacity.
Green Eyeshades Please!
AMID’s 2018 Q1 and Q2 adjusted EBITDA were stable at $52.4mil and $51.2mil. The reason was that ArcLight entered into a “Capital Contribution Agreement” with AMID in order to offset the expected shortfall when Delta House was not at its full capacity. When you compare the Q3’s to Q2’s Adjusted EBITDA reconciliation section, ArcLight’s contribution is notably absent – line item (“General Partner contribution”).
The Lagged Release of Delta House’s Recovery.
Below is a link to a January 14, 2019, Operational Update from LLOG Exploration. In it, LLOG’s CEO Phillip LeJeune stated, “At our Delta House FPS, our continued discoveries and new well productivity has exceeded our expectations, resulting in our Delta House platform currently operating at maximum capacity.” As indicated by AMID’s CEO on the two most recent conference calls, “full capacity” is approximately 135,000 barrels per day. As such it would be difficult to allow a banker writing a Fairness Opinion or ArcLight to argue anything different in valuation discussions.
LLOG Exploration Provides Operational Update:
Announces Successful Deepwater Exploratory Discovery in Mississippi Canyon 387, Five New Fields Online in 2018 and Three New Fields Expected Online in 2019
However, the lack of conference call Q&As or a “non-deal” roadshow which is typically provided by a management team seeking to enlist new investors or to restore confidence in shell-shocked elderly investors in addition to the fact that Delta House numbers hit on a lagged basis, has created an illusion of a liquidity crisis of a prime Gulf of Mexico natural gas property. Sadly, these circumstances create an inequitable and inefficient market pitting a sophisticated private equity firm against retired investors looking to cover their retirement expenses. Retired investors do not generally read EDGAR filings or attend institutional roadshows. While MLPs often disclaim their fiduciary duties to their limited partners, we hope the independent directors act in the best interest of the minority shareholders.
MLPs are hard assets which produce recurring revenue streams much like real estate. Comparatively and hypothetically, if a kitchen fire makes a multi-million dollar asset unrentable until the kitchen is replaced, the asset itself should not drop 50% or 75% when the repairs will return the rental income back to normal in 6-9 months for a multi-decade lived asset. However, most unsophisticated investors might conclude from the deafening silence following the 75% July distribution cut and the December 31 distribution elimination from a “covenant renegotiation”, that their investment has been permanently impaired.
It is especially disturbing that ArcLight wrote the independent board stating that business was impaired on January 2, 2019 “As you are aware, since the date of the Original Non-Binding Offer, the U.S. financial and M&A markets and the commodity markets have all experienced a significant decline, which have negatively impacted AMID’s business and leverage situation, as evidenced by the significant collapse in the trading price of AMID Common Units materially below the price set forth in the Original Non-Binding Offer.” This statement is debunked by LLOG CEO Philip LeJeune on January 14 stating “At our Delta House FPS, our continued discoveries and new well productivity has exceeded our expectations, resulting in our Delta House platform currently operating at maximum capacity.”
It is noteworthy that ArcLight justifies their $4.5 bid on the trading price of AMID Common Units in the immediate wake of a December 31, 2018 distribution elimination, on the day most likely to instigate maximum portfolio window dressing and tax loss selling during the year. Clearly, all but the most wired professionals would understand that this distribution cut was not an indication of an operating disaster. Due to the disproportionately elderly representation of AMID holders, a potentially avoidable panic occurred on December 31 which ArcLight then used as justification for a lower bid, when Delta House’s volumes are robust and much higher valuations can credibly be argued. This justification shows the inaccuracy of using stock price as a valuation metric and should not be any part of future AMID Fairness Opinions.
Further, in light of the unusual set of circumstances since July 26th, the use market price as a valuation metric is debunked by the late US Supreme Court Justice Harry Blackmun.
“It is hard to imagine that there is ever a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?”
U.S. Supreme Court Justice Blackmun Basic Inc. v. Levinson
The independent board members Mr. Peter A. Fassulo, Mr. Donald R. Kendall Jr., and Mr. Gerald A. Tywoniuk may be listening. The independents did not accept the $4.5 bid by ArcLight which expired on January 31. Shareholders are reaching out to the independent board of directors who are the last line of defense against what appears to be a rotten deal on the heels of a self-induced panic. The distribution cut panic was met by a curious pattern of behavior by the sponsor and the management that could allow Arclight to scoop up AMID at a bargain price. ArcLight Capital could then leverage those assets in their private equity partnerships, while the elderly retail investor would be forced to suffer costly losses that one would think CEO Lynn Bourdon could find a way to prevent.
We are buying AMID units. AMID could issue a distribution of $1/unit by year end. We estimate AMID could earn $208mm in EBITDA. At a 10x multiple less debt, preferreds and other obligations, we estimate $707mm in equity value. Divide that by 54mm shares and AMID is worth $13.09/unit.
It would not be surprising if ArcLight were to negotiate a buyout at $7-8/unit before mid-March when the 10-Ks and 10-Qs start reflecting the pickup in volumes at Delta House which were already reported by LLOG. Given the problematic fact pattern, ArcLight may back away, allowing the time needed for the cashflows to return and the AMID units to appreciate back to $10-13/unit by year end.
Below is a snapshot of a spreadsheet of AMID that Craig Thomas shared with me that we believe accurately reflects the inevitable rebound in EBITDA and the resulting leverage reduction. Based on previous guidance on distribution prospects, stock price appreciation could be on the order of 100 to 200% over the next year.
We see AMID as a unique special situation where there is an asymmetric risk reward. We believe the units at current price levels are highly attractive assuming that nothing untoward happens. Renowned investor Michael Price owns AMID and has increased his position. We think the numbers tell a very compelling story.
Please contact us if you have any questions.
Tyson Halsey, CFA