Quicksilver Gas Services: It's All About the Dividends

Aug.17.10 | About: Crestwood Midstream (CMLP)

This investment recommendation is based on information in a July 2010 conference call during which Quicksilver Resources (NYSE:KWK) announced it was selling its stake in Quicksilver Gas Services (KGS) to a private equity firm. During the call the CFO volunteered some information, the meaning of which the market seems to have missed. But first, what does Quicksilver Gas Services do?

KGS is an MLP engaged in the gathering and processing of natural gas in the Fort Worth Texas Basin. Assets include a couple of gas processing plants and gas gathering facilities. It provides services to its former parent, Quicksilver Resources (KWK), and other third parties. KWK is an independent oil and gas exploration and production company with a presence in the Fort Worth Basin, which is part of the Barnett Shale natural gas play. All services are provided under fee based contracts. KGS does not take ownership of the gas it gathers and processes, thus revenue is not directly exposed to commodity prices.

KGS began operations in 2004 and IPOed in August 2007. In December 2009 KGS completed a secondary offering of 4 million units for approximately $84M in proceeds which it used to purchase the Alliance Midstream Assets from KWK. The new Alliance assets accounted for 45% of production last quarter, and this is expected to grow as more wells are connected to it.

What is the market missing? During the conference call in July 2010 the CFO gave out some information that implies KGS will raise its dividend to approximately $0.54 per quarter from the current level of $0.42. In response to a question asked by an analyst, the CFO stated that the company expects to pay out about $15 million to the general partners (GPs) in 2011. To date, no sell-side analysts have published a piece discussing this and they did not seem to hone in on it during the call. Even if sell-side analysts do not buy the CFO's projection, it seems like it would worthy of discussion. The price has not made a significant move to indicate that enough investors have figured this out to move the stock.

The stock is currently trading at a dividend yield of approximately 7.0%, which is actually a little high compared to the rest of the MLP universe. Assuming the dividend is increased to $0.54, the stock would be trading at a yield of approximately 10%. If the dividend is increased to $0.54 and the market continues to value KGS at a 7% yield in late 2010, it should trade at a price of approximately $30, which is my price target for the end of 2010.

Naturally, if the stock trades significantly above $30, it is time to sell. As an aside, owning shares in an MLP will increase the complexity of filing one's taxes, so it is worth looking into that before making a decision to own one of these animals.

I modeled the financials to check whether KGS will have the cash flow to increase the dividend. I used the midpoints of management's guidance for the rest of 2010 and consensus numbers for 2011 to help project revenue and capex. Under these assumptions, KGS will not have a problem funding a quarterly dividend of $0.54. Take a look at the free cash flow to equity (FCFE) and Total Distributions lines in the Financial Results and Projections table below.

For those who are unfamiliar with the MLP payout structure (this is crucial to understanding my thesis), the amount distributed to the GPs is directly based on the dividends paid to the limited partners (LPs). However, there is not a 1 to 1 relationship between an increase in the dividend and the payout to the GPs, the payout is based on a grid. In short, as the dividend hits specified levels, the payout to the GPs increases. MLP structures are set up this way to incentivize the GPs to grow the dividend paid to the LPs before they start receiving significant payments from the structure.

Below is the KGS incentive distribution table. When the quarterly dividend is increased from $0.42 to $0.54, the amount paid to the GPs increases from 25% to 50%. This dividend increase will take the GP into what is called the high splits. To pay $15 million to the GPs in 2011, the company has to increase the dividend to about $0.54, it is formulaic.

In other words, when the CFO said he is projecting a $15M payment to the GPs, he may as well have said he expects to increase the dividend. To figure out what level of dividend KGS has to pay for the GPs to receive $15M in 2011 I modeled out the incentive distributions and dialed the dividend up until GP payouts hit $15M. I have included a snapshot of projected LP and GP payments in an exhibit at the end of this article to help illustrate the payout structure.

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Payout Grid

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Financial Results and Projections

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Performance Statistics

In modeling the capital structure, I tied the level of debt the company carries to its Debt/EBITDA ratio. Thus, as EBITDA grows, so does the level of debt. Currently, KGS has a revolver with a borrowing base of $297M and with $226M drawn. Under my assumptions, KGS will need to increase the size of the revolver sometime in 2011. I do not expect this to be a problem as the company is in good financial shape.

Historical Dividend Yield

Payout Waterfall

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As you can see in the last three lines of the above table, increasing the dividend to $0.54 in 2011 will turn on the high splits. This is what GPs and the new owner of the GPs, Crestwood, wants.

No investment recommendation is complete without a discussion of risks. KGS may not achieve production levels that can support a higher dividend. In the last couple of calls the company has complained that the permitting process is slowing its growth. Most of its revenue comes from KWK and it is dependent on KWK drilling more wells and producing more natural gas for it to move and process. A pipeline could blow up. KGS' assets are concentrated in the Fort Worth basin. The New York Senate recently passed legislation to ban fracking for a year to study its environmental effects. It seems unlikely that Texans would be as unfriendly to the energy industry as New Yorkers, but you never know. Finally, production of natural gas is sensitive to the price of natural gas. If the price falls too low it is not economical to produce it, and if the price rises too high, demand for it falls.

Disclosure: Author holds a long position in KGS