Vanguard Natural Resources Shareholders Could Be In A World Of Pain

| About: Vanguard Natural (VNR)

Summary

Banks are usually willing to make amendments to credit facilities.

However, this is not safe to shareholders.

Due to the scheduled step down of the allowed leverage ratio, the company may be looking at another amendment in the near future if oil continues to languish.

I think most E&P companies are now "distressed" so to speak and Vanguard Natural Resources (NASDAQ: VNR) is no exception. As oil continued its bloodbath, both equity and debt have fallen.

Common

Preferred

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Source: Interactive Brokers

Bond

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Source: Interactive Brokers

However, what's important to investors is to understand just how distressed the company is. Surely if we can say with reasonable certainty that the company will go bust in the next quarter, then the stock is not investable. On the other hand, if the company has sufficient resources to last many years, then the stock may have a place in your portfolio.

Previously I wrote about why I thought that Vanguard will not rebound and how the Eagle Rock transaction improved it. Given how the price has changed recently, it's clear that the market still don't like Vanguard's prospects. Of course, the persistence of a low oil environment was a big factor as well. Regardless, I believe that it's important for equity investors to understand that Vanguard may be under the mercy of creditors very soon.

If you are active in the E&P space, you've probably noticed that quite a few companies have amended the terms of their credit facilities. Since the credit facility has the highest priority on the capital structure, banks are generally eager to do business. Sentiment among banks are still fairly optimistic despite the oil bloodbath, after all, credit facilities are some of the safest investments that they can make. From an equity holder's perspective however, the reliance on banks makes the stock riskier. Although banks are usually willing to make amendments to covenants even if they are breached, each time a company needs to make an amendment, it puts the ball in the lender's court. That is a big no-no for equity investors, especially when the bank's sentiment could change at any time.

For Vanguard Natural Resources, I believe that it is just a matter of time before another amendment would be required, significantly increasing the risk to equity holders. At the end of the third quarter, the company had $1.32 billion outstanding on the credit facility, so the covenants are in full effect. One of the most important covenants is the limit on the consolidated leverage ratio. The consolidated leverage ratio is calculated as debt/ TTM EBITDA, this prevents the company from incurring too much debt that it may not able to service.

According to the company's merger presentation, the pro forma leverage ratio for VNR in Q1 was 3x, quite far away from the 5.50x that was in effect in 2015. However, keep in mind that oil has declined significant from Q1 2015, hence EBITDA will likely decrease in future quarters. Furthermore, hedges will start to fall off in 2016. At the end of Q3, only 50% of 2016's production was hedged. Furthermore, the hedged price (>$70/bbl) is more than double the current market price of crude, so there may be a significant decline in EBITDA should oil continue to hover at the current price of around $35/bbl.

What makes things worse is that the credit agreement contains two scheduled step-downs for the leverage ratio. From March 31st, 2016 to December 31st, 2016, the leverage ratio declines to 5.25x. The ratio then falls further to 4.5x in March 31st, 2017. Fortunately for shareholders, the leverage ratio is calculated on a trailing twelve month basis, so the company still has some time left. Even if EBITDA drops significantly in Q1 2016, there are still three quarters of higher EBITDA (supported by better hedges) that will decrease the impact. However, given the current oil outlook, I believe that there is a good chance that the company will require further amendments to the credit facility within 18 months, as quarters with higher EBITDA would no longer be used in the calculation of the leverage ratio. There is certainly the likelihood that lenders may still allow the necessary adjustments, but doing so won't improve the company's value at all. On the other hand, if the lenders decide to disallow the amendments, then surely equity holders will be in a world of pain.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.