Legacy Reserves: Is the 17% Yield a Sign of the Market’s Mistake or a Pending Distribution Cut?
This article covers Legacy Reserves (Nasdaq:LCGY), a Dividend Hunter recommendation. Currently in the newsletter, I rate Legacy as a Hold and do not recommend that subscribers buy or add to their positions. The Dividend Hunter subscribers get first look at the article before I will submit it to Seeking Alpha for a broader release. It is my practice to let subscribers first see any articles I write on the newsletter portfolio recommendations.
It has been tough to watch the unit price erosion of upstream MLP Legacy Reserves LP (Nasdaq:LGCY). The upstream MLP space has suffered as a group, but LGCY has been hit harder that most of its peers. With Q2 earnings coming out in a month, is Legacy set up for a positive surprise or has the sell-off been justified? Here are some points that I think are relevant:
Unit Values vs Energy Prices
Upstream MLP values hit a short term peak in mid-April when first quarter distribution announcements and earnings reports started to come out. Since that time unit prices have dropped steadily. Here are the price changes of what I consider the four strongest upstream MLPs since April 22:
- Vanguard Natural Resources (Nasdaq:VNR): Down 4.1%
- Memorial Production Partners (Nasdaq:MEMP): Down 12.2%
- Linn Energy LLC (Nasdaq:LINE): Down 30.7%
- Legacy Reserves (Nasdaq:LCGY): Down 40.7%
Vanguard Natural Resources is so far the only upstream MLP to announce acquisitions in this new energy price environment, with its planned acquisitions of two smaller, troubled MLPs.
In the second quarter, the Henry Hub natural gas price averaged $2.75 MM/Btu, down 5.8% from an average of $2.92 MM/Btu in the first quarter. The Cushing WTI crude oil spot price averaged $57.90 per barrel in the second quarter, up 19.3% from the $48.54 per barrel average in Q1. Most likely, the upstream companies generated higher cash flow rates from any unhedged production amounts.
Legacy Distribution Coverage
Last quarter, Legacy Reserves reduced its quarterly distribution by 43%, and stated that forecast cash flow for the rest of the year would provide 1.3 times coverage on the new payout rate. With crude prices higher in Q2, it seems that the distribution rate should continue to be secure. In spite of this fact, the falling unit price has pushed the LGCY yield up to 17%.
Legacy is financially more secure that most of its peers, with a much lower than average debt to EBITDA ratio and only 16% of its revolving facility drawn. Revolver debt is just 0.50 times EBITDA vs. a peer average over 2.0 times EBITDA. The revolver provides current liquidity with $591 million available.
Let’s Make a Deal
Historically, Legacy Reserves has been a very active acquirer of production assets. From 2007 through 2014, the company averaged over 16 deals per year, investing on average $265 million each year. During his NAPTP Investor Conference presentation on May 21, CEO Paul Horne stated that Legacy has been looking at a lot of investment opportunities, but had not closed any deals. He did discuss that in Q1 more deals were getting done and that asset prices had become more reasonable in relation to energy prices.
Legacy would like to put together one or more “DrillCo” type of agreements, where a third party would pay all or most of the costs to drill in some of Legacy’s undeveloped assets. Horne illustrated a couple of examples where wells in the company’s acreage holdings would generate 35% to 40% IRR’s at current energy futures prices. If Legacy does ink and announce a DrillCo agreement, the company’s prospects would immediately improve.
I have been disappointed in the lack of acquisition or other accretive deal announcements out of the upstream MLP sector. So far only Vanguard Natural Resources has announced meaningful deals. It may be tough to find accretive acquisitions with energy prices at current levels, but forward thinking companies like Legacy need to find ways to put some agreements together.
A Bet on Management
Currently LGCY is a 17% yielding gamble on the potential for the Legacy Reserves management team to be able to repeat what they did in 2009 and pick up assets valued on current energy prices and ride those values higher when and if crude and natural gas prices recover. I think the bet is a good one with a high probability of success and almost zero chance of any distribution reduction through the rest of 2015. That gives Legacy three more quarters at least to prove that history can be replicated.