Kayne Anderson Energy Development Company (NYSE:KED)
F1Q10 Earnings Call
April 7, 2010 9:15 am ET
Monique Vo – Investor Relations
Kevin McCarthy - President and Chief Executive Officer
Terry Hart – Chief Financial Officer
Gabe Moreen – Merrill Lynch
Chris Harris – Wells Fargo
(Operator Instructions) Welcome everyone to the earnings conference for Q1 2010. Thank you, Ms. Vo, you may begin your conference.
Welcome to the earnings call for the Kayne Anderson Energy Development Company for the quarter ended February 28, 2010.
Before we begin this afternoon I’d like to remind you that our call will include statements reflecting assumptions, expectations, projections, intentions or beliefs about future events. These and other statements not relating strictly to historical or current facts are intended as forward looking. Generally words such as believe, expect, intend, estimate, anticipate, project, will, and similar expressions identify forward looking statements which generally are not historical in nature. Forward looking statements are subject to certain risks and uncertainties that could cause actual results to differ from the company’s historical experience, its present expectations or projections.
For a description of the factors that may cause such a variance I would direct you to the forward looking statement discussion in our annual report on Form 10-K and our quarterly reports on Form 10-Q. These reports are available free of charge through our website at www.KayneFunds.com and at www.SEC.gov.
You should not place undue reliance on forward looking statements. The company undertakes no obligation to update or revise any forward looking statements. There is no assurance that the company’s investment objectives will be obtained.
With that, I will now turn the conference over to our President and Chief Executive Officer, Kevin McCarthy.
First I’d like to review market conditions for both the MLP sector as the broader energy sector, and then I’ll provide a quick look at our portfolio and review the performance of our private investments. Next, Terry Hart will go through the details of our new credit facility and discuss our financial performance and guidance based on our most recent portfolio. Then we’ll open the phone lines for our Q&A session.
With that, let’s turn to a review of market conditions. When looking at market conditions in the energy sector, one really needs to look at crude oil and natural gas separately because at least for now they’re quite different markets. On the oil side, global demand for oil is expected to grow in 2010 driven largely by economic growth in Asia. On the supply side, crude production is expected to grow this year as companies shift their drilling budgets to more oil related projects. But production increases are not expected to keep pace with demand growth. As a result, most analysts are projected continued strength in oil prices.
On the natural gas side, it’s been a very strange three months. On the one hand we had a very strong helping hand from Mother Nature as weather was substantially colder than normal. If you remember, on the last call we spoke of the record levels of gas storage. No one thought that we could work off the excess before 2011 but we did. Gas storage is not at levels similar to last year at this time. On the other hand, production hasn’t declined nearly as much as expected if at all. With a continued focus on ramping up drilling activity in the major shale plays, there’s increasing concern that we may be entering into a new supply bubble.
Drilling activity has increased from a trough of less than 670 gas rigs in July of last year to almost 950 gas rigs as of last week. The increases come in large part from horizontal rigs which are much more efficient than traditional vertical rigs. As a result, in spite of the good news on the gas storage front, natural gas prices have been crushed. Near month gas prices have fallen from the $6.00 range in early January to under $4.00 as recently as last week. While most energy professionals expect that gas prices will recover during the rest of 2010 few believe that gas prices will return to the $6.00 range anytime soon.
The slow down in domestic economic activity has made a very difficult market for the refiners. Weak domestic demand for their product, mainly diesel, jet fuel and gasoline, has caused refined product prices to remain weak. Coupled with very strong oil prices, which is the raw material for the refiners, we’ve seen very weak profitability for the refining segment. We believe that this sector will return to more normal profit levels as domestic economy continues to recover.
In the coal markets, we’ve seen a substantial improvement in the market for metallurgical coal, driven by strong demand in China, Japan and India. We’ve seen domestic met coal prices increase from the $70 to $80 per ton range last year to $140 per ton range currently. Most analysts are projecting that this market will continue to strengthen into 2011.
The strength of the met coal market as well as the cold weather has eased the oversupply problem in the steam coal market and caused steam coal prices to strengthen slightly. While prices have recovered from the lows seen in 2009 this market still has a long way to go. Demand is expected to strengthen but only modestly in 2010. In 2011 and 2012 steam coal prices are expected to increase significantly as domestic electricity demand recovers and steam coal supply continues to decline in light of the difficult permitting environment.
MLPs continued to perform very well in our first fiscal quarter with total returns of 10% during the quarter compared to a return of slightly less than 1% for the S&P 500. This out performance has continued since quarter end. MLPs are up just over 9% since January versus a return of just under 7% for the S&P 500. MLPs also outperformed other energy sub-sectors as retail investors continued to look for stable yield based investments.
With a strong performance year to date, the Alerian MLP index is now trading at levels last seen before the financial crisis in September 2008. As MLP prices continue to climb, MLP yields have declined but are still at attractive levels compared to other yield securities. Currently the average yield is over 7% and this compares to an average yield of 4.5% for utilities and under 4% for REITs.
With the continued strong performance of MLPs the question I get asked most frequently is whether or not MLPs are overvalued. We firmly believe that MLPs are attractively prices and below fair value. With current yields averaging 7% and annual distribution growth of 4% to 5%, MLPs are positioned to deliver low double digit returns. We believe this compares very well compared to the expected returns of the broader equity markets, especially in light of the high cash distributions and lower risk profile of MLPs.
MLPs also look attractive when compared to traditional yield benchmarks. On an absolute basis MLPs are roughly in line with the five year average for the sector but that average is skewed by the significant increase in yields during the financial crisis. When compared to a five year average before September 2008 current MLP yields are approximately 45 basis points higher than historical averages. On a relative yield basis the story is the same.
The current yield of MLPs relative to the yield on treasury bonds is roughly in line when compared to the five year average but is approximately 100 basis points higher than the five year average before the financial crisis. We believe this cushion relative to historical averages should provide MLPs some insulation from potential impact of rising interest rates.
Turning now to MLP distributions, we continued to see signs that distribution growth was returning to the MLP market. During the quarter, 19 MLPs increased their distributions while 35 MLPs kept their distributions flat. We believe the number of MLPs that raise their distributions will increase steadily during 2010. Our research analysts currently project that distribution growth will be in the 4% to 5% range for the midstream MLPs that they follow. From speaking to MLP management teams, it’s clear to us that distribution growth is once again a top priority in 2010 now that the financial markets are stabilized.
Activity in the capital markets has picked up significantly in the first quarter as a broad range of MLPs accessed the debt and equity markets. Strong retail demand for MLP securities led to a significant increase in the average size of the equity offering. The M&A market for midstream assets is picking up steam as well. We believe that more sellers will come to the market as acquisition multiples have returned to levels seen before the financial crisis. As MLP valuations improve and their access to capital markets become more certain we believe management teams will increasingly look to M&A as another way to fund fuel distribution growth.
I’d also like to note that the IPO market is finally make a comeback, it’s been almost two years since the last IPO. Thus far this year there’ve been four IPOs that have been filed with the SEC and we expect more to be filed over the next several months. Three of the four deals filed thus far are traditional MLP assets focusing on either natural gas storage or natural gas gathering. We believe it will be a good sign for the MLP market if these deals are priced at reasonable levels and trade well afterwards.
Turning now to our portfolio, during the quarter our overall portfolio mix did not change significantly. Our portfolio weightings on February 28th were as follows:
45% Private MLPs
34% Public MLPs
21% Second lien debt
During the quarter, our portfolio of public MLPs performed very well with a total return of 14.7%. This performance was significantly better than the Alerian MLP Index which had a total return of 12.2%. Our debt securities also performed quite well again this quarter with a total return of 7.9%. Our private MLPs generated a positive total return during the quarter but did not keep pace with the other two categories. The total return on our private MLPs of just under 1% reflected a slight decline in the overall market on these securities offset by distributions received on these investments.
I’d now like to provide a more detailed discussion of these private MLPs. Our three largest investments, International Resource Partners (IRP), Direct Fuels and VantaCore make up the majority of our private MLP holdings. These three investments represent 41% of our portfolio as of February 28th.
Our largest private holding is IRP a fully integrated coal producer in West Virginia. IRP was by far the top performer among our private companies in 2009 and this strong performance continued in the first quarter 2010. As we discussed on the last call, IRP exceeded its budget for 2009 by over 30% and was well above budget for January and February 2010 as well. This was the result of improved operating results at its underground mines as well as the strong results in its coal marketing business.
IRPs outlook for 2010 is even more positive than we had our call in February due to better market conditions for met coal as well as improved prospects for the recently acquire surface mining operations in Kentucky. With respect to IRPs West Virginia operations, the outlook for metallurgical coal is substantially stronger in 2010 than it was in 2009. The company recently finalized pricing for its Indian met coal shipments for the second quarter and these prices were substantially in excess of the spot market prices in 2009.
Worldwide demand for met coal is expected to continue to strengthen in 2010 as China, India, and Japan have been active buyers. Operating rates at domestic steel plants are also substantially higher than last year so domestic demand is recovering as well. We believe there’s additional up side to the partnership’s budget both in terms of met coal prices as well as additional production that can be brought online if demand continues to be strong.
As we discussed in our prior call, IRP closed on its first acquisition, a deal to purchase coal reserves and operating equipment of Miller Bros Coal in Eastern Kentucky. This deal added approximately 35 million tons of proven steam coal reserves and significantly improved IRPs surface mining operation. While the partnership had initially assumed that production on the acquired properties would not commence until 2011 the partnership is now planning to ramp up production as 2010 progresses. By gearing up operations earlier than originally planned, the partnership is positioned to increase production to the extent that steam coal prices recover from current levels.
On February 28th valuation for IRP increased 4% from $23 per unit to $24 per unit. This was based on strong performance during 2009, strong performance in January and greater certainty regarding the 2010 forecast. It was also driven by higher multiples for comparable C-corps and coal MLPs. I’d point out that this valuation represents five times multiple of estimated 2010 EBITDA and closer to four times multiple of estimated 2011 EBITDA.
Our second largest private holdings is Direct Fuels, a specialty refiner and wholesaler of refined products in the Dallas/Fort Worth area. As you’ll recall, Direct Fuels was hurt by weak diesel demand in 2009. While we’ve made significant progress in providing financial flexibility for the partnership, the operating results continue to be weak. On the operating side, domestic diesel demand has been hurt by the economic recession. Likewise, refining margins have hurt by the relatively strong crude oil prices combined with weak prices for refined products.
During the quarter we started to see modest improvements in diesel demand, a reduction in distill at inventories, and a recovery in domestic refining margins. That being said, demand and margins are still far from normal.
During the first quarter, Direct Fuels financial performance was well under budget primarily due to weak results from the Trans Mix and wholesale diesel businesses. The partnerships bio-diesel facility and ethanol terminal continued to exceed budget.
I would point out that the first quarter is traditionally a weak quarter for the partnership due to lower seasonal demand for gasoline and diesel. We’ve seen results improve in March and expect better results in the second and third quarters as seasonal demand for gasoline peaks during this period and diesel demand continues to recover as the economy improves.
While Trans Mix’s margins have been weak, the partnership has been successful in attracting new Trans Mix volumes to its facility. These volumes were previously refined by one of the partnerships main competitors which has recently had some reliability issues. This competitor has a significant amount of volumes that roll off contract during 2010 and Direct Fuels is aggressively targeting these customers.
As we discussed on the last call, as a result of the partnerships operating results in 2009, Direct Fuels does not meet its financial covenants under its bank facility as of year end. In December of last year Direct Fuels hired a placement agent to raise $15 million of subordinated debt. In this process, Direct Fuels received what we believe was an attractive proposal from an experienced energy lender. When we approached the banks to receive their consent for this proposal the banks countered with a package of new covenants which results in substantially greater financial flexibility going forward.
As part of this transaction, the principal shareholder of the general partner has agreed to purchase $5 million of subordinated debt. In addition, the common unit holders have agreed to receive their quarterly distribution in the form of additional preferred shares for the first two fiscal quarters of 2010. This transaction is expected to close within the next several weeks.
Based on our current view of the market and our projections for Direct Fuels for the remainder of the year we currently expect the partnership to resume cash distributions in our third or fourth fiscal quarter.
Our February 28th valuation of Direct Fuels common units has been reduced from $12 per unit to $11 per unit a decrease of approximately 8%. The decrease was driven by weak operating performance in the lower projections for 2010. The impact to the lower projections was partially offset by an increase in equity prices and valuation multiples for comparable public MLPs. Our $2.9 million investment in preferred units declined by approximately 5% as well.
VantaCore, our third largest private MLP is engaged in the aggregates and asphalt business. VantaCore operates in two geographic areas, Clarksville, Tennessee, and Southern Louisiana. The biggest news for VantaCore is that it’s very, very close to signing an agreement with a large private equity investor that would provide the partnership with $100 million equity commitment.
We’re extremely excited about this development because it will allow the partnership to execute on its acquisition strategy as well to pay off high cost subordinated debt. Upon closing the equity commitment, VantaCore will also enter into a new revolving credit facility. This facility will replace the existing facility on more favorable terms and will provide additional debt capacity to finance acquisitions.
From an operating standpoint, VantaCore’s strategy of geographic diversification continued to pay off in the first quarter as a strong market in Tennessee was largely offset by very weak operating results in Louisiana. In Tennessee the partnership continued to benefit from the final phase of its contract for the Hemlock semiconductor plant and began to supply aggregates on its new Highway 79 contract. It also continues to grow its business at Fort Campbell, a large military base near its Tennessee operations.
The strength in the Tennessee results was offset by weakness in Louisiana where the recession is significantly slowed construction activity. We expect overall results to improve in 2010 as there is evidence that the housing market in both operating areas has begun to improve. In addition, we expect that VantaCore, like many other infrastructure companies will benefit in 2010 from increased spending under the Federal Stimulus Program and other transportation spending bills.
Our February 28th valuation for VantaCore decreased by approximately 3% from $17.50 per unit to $17.00 per unit based on the slower than expected recovery in Louisiana market.
Before turning the call over to Terry to review KEDs financial results, I’d like to provide a brief update on recent events in our two smaller private investment; ProPetro and Quest Midstream.
ProPetro is an off hill service company with operations in the Uintah basin, the Permian Basin and the Mid-Continent area. ProPetro’s performance has improved dramatically over the last few months. Revenues have increased from approximately $2 million per month in the fourth quarter to a current rate of approximately $5 million per month. The company believes that current activity levels are sustainable and we’re optimistic that the company can show a steady improvement in results as the year progresses.
As a result of this improvement in results, our February 28th valuation for ProPetro is $4 million up from $2.5 million on November 30th.
On our last call we discussed the proposed combination of Quest Midstream Partners, a private MLP and its two publicly traded affiliates. I’m happy to report that this transaction was completed on March 5, 2010. The resulting entity called PostRock Energy is a publicly traded C-Corp with operations in the Cherokee basin and the Marcellus Shale. PostRock trades on the NASDAQ under the ticker symbol PFTR. PostRock currently trades at $10.67 per share. The 145,000 PostRock shares that KED owns are freely tradable and we’ll look to monetize those shares as they approach our estimated fair market value.
With that I’ll now turn the conference over to Terry Hart, our Chief Financial Officer.
First I’d like to provide an overview of our new credit facility then I’ll spend a few minutes reviewing our performance for the quarter and our current guidance. We are very pleased to announce that we entered into a new revolving credit facility on March 30th well in advance of the June 4th maturity date of the previous facility. The new facility has a three year term and the covenants are substantially the same as the previous facility. The commitment size of the new facility is $70 million which is $30 million less than the previous facility. We’re comfortable that this commitment amount will adequately support the needs of the fund given that current borrowings are $55 million.
At this time we don’t foresee a need for a larger facility and having a smaller facility will reduce our commitment fees. Additionally, the new facility has an accordion feature that allows us to increase the size of the facility if we have the need in the future and are successful adding new lenders to the syndication.
Consistent with our comments during our analyst day, pricing for the new facility reflects the realities of the credit markets after the financial crisis of 2008 and early 2009. Under the new facility the interest rate on borrowings is Libor plus 2% so long as borrowings are less than the borrowing base attributable to quoted securities. Quoted securities are generally defined as equity investments in public MLPs and investments in bank debt and high yield bonds that are traded. If borrowings exceed the borrowing base attributable to quoted securities then the interest rate increases to Libor plus 3%. Based on current borrowings we are currently paying the lower rate of Libor plus 2%.
While our interest costs will increase under the new facility we don’t anticipate a material impact on KEDs distributable cash flow. The impact of the higher interest costs has been incorporated in the guidance that we’re providing today.
The maximum that we can borrow under the credit facility is limited to the less of $70 million and our borrowing base. Our borrowing base is generally calculated by multiplying the fair value of each investment by an advance rate. The advance rates in the new credit facility are substantially the same as the previous credit facility with the exception of the advance rate on our private MLPs. The advance rate on our private MLPs was reduced from 40% to 20% and lenders have the ability to adjust the borrowing base values of our private MLPs using their reasonable discretion.
The total contribution to our borrowing base from private MLPs is also limited to no more than 25% of the total borrowing base. Our borrowing base is slightly lower under the new facility due to the lower advance rate on our private MLPs. As a point of reference, as of February 28th the borrowing base under our previous facility was $85.7 million compared to $81.6 million under the new credit facility. As of April 5th, we had $55 million borrowed under the facility which represents 72.8% of the borrowing base of $75.6 million.
Now turning to our results and performance. KED had a total return of 4.5% for the quarter as measured by the change in adjusted NAV which includes the impact of our distribution to stockholders. Our net asset value increased $5.1 million or $0.45 per share representing a 2.7% increase for the quarter. As I’ll discuss in more detail, the increase was driven primarily by the realized and unrealized gains on our public MLP portfolio.
Investment income totaled $1.4 million for the quarter which is lower than previous quarters because KED did not receive a cash distribution from its investments in Direct Fuels. In lieu of the cash distribution on its common and preferred units, Direct Fuels is paying a distribution to its unit holders in additional preferred units.
The preferred units being issued are a new series senior to the existing preferred units. The $1.2 million preferred unit distribution accrued by KED during the quarter is not included in investment income but is included in the net change in unrealized gains. This treatment is consistent with the accounting treatment for the paid in kind distributions we received from Kinder Morgan and Enbridge I shares.
Operating expenses including management fees and interest expense were consistent with expectations at $1.7 million. During the quarter, net realized gains from KED investments were $3.2 million. KED monetized several of its investments in publicly traded MLPs to generate these realized gains. KED engaged in this strategy in an effort to fully utilize its capital loss carry forwards. KED also had unrealized gains of $4.7 million. The majority of these gains are attributable to KED publicly traded MLPs and to a lesser extent its investments in debt securities and the Direct Fuels preferred unit distribution.
Our increase in net assets resulting from operations was $7.7 million and was composed of the net investment loss of $200,000, net realized gains of $3.2 million and net unrealized gains of $4.7 million. During the quarter our share prices increased 11.4% to $15.07, outperforming both the Alerian MLP Index which increased by 10.3% and the S&P 500 Index which increased by only 0.8% over the same period. Since the end of the quarter our share price has gone up another 12.4% as of April 5th.
In comparison to the MLP closed in funds our share price outperformed by 4.3% during the quarter and this out performance has continued through March and early April.
Let’s now turn to our guidance and start with dividends, distributions, and interest income that we estimate can be earned from the portfolio. Based on our portfolio as of February 28th we estimate dividends, distributions and interest income to be approximately $4.8 million per quarter. This estimate includes a $1.2 million preferred pick distribution from Direct Fuels and we expect Direct Fuels to pay its distributions in additional preferred units for the next one to two quarters and resume its cash distributions by the end of our fiscal year. Please note that this estimate is not a projection of investment income since it includes pick distributions and it excludes the impacts of return of capital.
Let’s now turn to our estimates of interest expense and operating expenses. Based on $61 million borrowed under our revolving credit facility as of February 28th we estimate interest expense to be approximately $350,000 per quarter, assuming a Libor rate of 0.25% and spread of 2%. As noted, our current balance is $55 million and we believe this amount is representative of what our borrowings will be during the quarter.
We estimate our base management fees to be approximately $900,000 per quarter and our other operating expenses to be approximately $450,000 per quarter. We do not provide guidance on realized gains or incentive management fees. Based on these estimates our distributable cash flow is projected to be $3.1 million per quarter or approximately $0.31 per share.
I’d like to turn the call back over to Kevin.
That’s the end of our prepared remarks. Operator, at this time we’d like to begin the question and answer portion of the call.
(Operator Instructions) Your first question comes from Gabe Moreen – Merrill Lynch
Gabe Moreen – Merrill Lynch
Given your comments on the MLP IPO market and its potential opening up over the relatively near term, has that at all changed in your mind I guess the timeline for maybe IPO and some of your private companies. I’m specifically thinking about IRP here.
I think its encouraging that it appears that less of the IPO market is fully opened. As you probably know, one of the four IPOs are on file is for I call MLP. I think more than anything else though, its really positioning the company, get the right time in terms of operations. For IRP they made the acquisition of Miller Bros, they’re in the process of ramping up production and trying to contract out 2011. I think that will drive timing more than, in the overall coal market, more than anything else. I think right now we have the option, the IPO market is open but it’s not like we’ve been waiting for that to open to go forward. We’re really waiting for the right time operationally to go forward.
Gabe Moreen – Merrill Lynch
A couple on Direct Fuels, in terms of what’s being done with internal cash I assume that they’re not paying out in terms of cash distributions, I assume that’s all going to reducing debt at this point?
Gabe Moreen – Merrill Lynch
Your expectations for resuming the distribution in either your third or fourth fiscal quarter, two questions. Can you talk about maybe what covenant Direct Fuels kind of has to hit in order to resume cash distributions? Also, is that something where when the cash distributions do to resume are you going to expect them at the same level as you’ve been getting them prior to picking the distribution?
As part of the agreement we’ve agreed to a moratorium for two quarters, one of which has already passed. At a minimum we have one more quarter. After that the covenants effectively have a DCF test and you’re limited to paying out DCF. Based on our projections we believe that it will happen in the third quarter but to provide a little bit of cushion we’re saying it’s either the third or the fourth quarter we would expect them to resume at the MQD.
Your next question comes from Chris Harris – Wells Fargo
Chris Harris – Wells Fargo
On ProPetro, it sounds like things are getting a lot better there. I’m curious what the status of your investment is and when do you think that might move back to accrual status?
Certainly we’ve seen an improvement in operations; the revenue growth is the first thing that you look for. We still have a long way to go. I think it’s as likely that the company gets sold as it is that we start to get back on the accrual basis. Right now at $4 million it’s still a pretty big discount to face value. I think it’s going to be a while before we get back on accrual, I think it’s more likely it gets sold in the interim.
Chris Harris – Wells Fargo
My next question here is more of a macro question, as I’m looking at the financial model here and trying to project out what your results may be, if one is to assume that interest rates could potentially rise materially from here that could potentially mean much higher funding costs for KED. Just wondering if there’s anything that you guys are doing or can do to manage potential interest rate risk?
In some of our other funds we’ve engaged in interest rate swaps so that’s something that we look at. At KED some of our debt securities, and we have opportunities to invest in Libor based securities so we have a natural hedge in that respect. Right now we don’t own a lot of Libor based securities because frankly Libor is so low but we can easily shift over to those Libor based securities if rates start to increase.
I made a comment in the prepared remarks about the sensitivity to interest rates and the cushion for MLPs it’s a question that we get a lot now. We’ve looked at it historically and certainly for MLPs there is a short term impact when rates rise but over the last 10 years there’s really been two distinct periods when that’s happened. In both cases within a year the MLPs were back above the levels before the interest rate increases. MLPs even though they’re a yield security they trade a lot more like equity than they do like debt.
Chris Harris – Wells Fargo
I assume that distribution increases could potentially help to offset the risk as well.
Chris Harris – Wells Fargo
My last question, with the credit facility I apologize if I missed it, you mentioned an according feature. How large is that accordion feature?
It accordions up to $150 million in total size.
We are very happy to have that. We put a lot of focus on that over the last four months and that was critical to get it done because it’s a difficult lending market out there. We’re very happy.
Chris Harris – Wells Fargo
I was impressed with the costs, I was expecting something higher. Congratulations.
We worked hard on that too.
There are no further questions. I would now like to turn the call back to Kevin McCarthy.
With that I’d like to thank everybody for their time this morning and their continued interest in KED. Please refer to our website at www.KayneFunds.com for future updates and we look forward to future calls with you.
This concludes today’s conference call. You may now disconnect.
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