This article discusses Azure Midstream L.P. (NYSE:AZUR), which closed Monday at $1.51 a share. At the very outset, I want to note that this is a risky investment. The dividend has been suspended and the management has disclosed a possible covenant issue with the lender. The stock has dropped precipitously. Last summer a public offering of 3.5 million shares at $14.17 was effected. The current price reflects a perception of extreme risk. While I believe that the market has overreacted, the market is definitely correct in perceiving significant risk here.
AZUR is in two businesses. The first business is the typical midstream gathering, pipeline and natural gas processing business which we frequently see in the master limited partnership (NYSE:MLP) sector. AZUR facilities are located in East Texas and Northwestern Louisiana in the Haynesville shale and the Cotton Valley areas. The second business is transloading oil onto railroad tank cars and is located in Utah, Wyoming and New Mexico. The first business accounts for roughly 80% of AZUR's revenue. Both businesses are fixed fee and almost completely independent of commodity prices. Both businesses have minimum utilization contracts with customers so that payments have to be made even if actual utilization falls below contract minimums.
3Q 2015 - AZUR has postponed the release of its 4th quarter 2015 numbers until March 30 so that the most recent numbers we have are for 3Q 2015. This quarter is important because it is the first quarter which represents the system as it exists today. There was a significant "drop down" addition to the system in early July 2015 and the 3Q numbers include results for this addition. I will refer primarily to "Adjusted EBITDA" because this calculation is important in connection with the covenant issue. For 3Q 2015, adjusted EBITDA was $10.5 million (all data is based on the 10-Q filed with the SEC for the third quarter of 2015). I calculate that quarterly interest runs at about $2 million and maintenance capital expenditures average about $2 million per year or $500,000 per quarter. Thus, distributable cash flow (DCF) was roughly $8 million. AZUR declared a dividend for the third quarter, payable in the fourth quarter, of 37 cents per unit for a total of roughly $8.2 million (there are 21.7 million units). At this rate, AZUR would be paying a dividend of $1.48 per share and would now be trading at a dividend yield of 98%.
4Q 2015 - In the conference call (available on AZUR's website) for the third quarter, an analyst extrapolated some numbers and asked management if he was correct in assuming that adjusted EBITDA for the fourth quarter would be $13.5 million. Management certainly did not give him a table pounding affirmation but it did not tell him he was wrong either. After the end of the fourth quarter, management announced it was suspending the dividend and indicated that it wanted to resolve leverage issues through a "one and done" solution. There was subsequently a disclosure that there may be a covenant issue with respect to the first quarter of 2016 but no mention was made of a covenant issue in Q4 2015. Thus, we are probably safe to assume that adjusted EBITDA in Q4 2015 satisfied the covenant requirement - which was that debt could be no more than 6.00 times annual EBITDA. With debt at the level of $226 million, this would mean that annual adjusted EBITDA could be no less than $37.7 million or $9.4 million per quarter. I think we are probably safe in assuming that Q4 2015 adjusted EBITDA was at least $9.4 million.
1Q 2016 - All we really know about the first quarter of this year is that there is a possible covenant issue. For this quarter, the leverage ratio drops to 5.00 times annual EBITDA. That means that quarterly EBITDA has to equal $11.3 million to avoid a covenant issue. We are, therefore, safe in assuming that adjusted EBITDA is NOT going to be significantly more than $11.3 million. I am bracing myself for bad news and assuming that it will be below $11.3 but it is unclear how far below that level it will hit.
Cash On Hand - AZUR had about $8.4 million in cash at the end of 3Q 2015 but almost all of this went to pay the distribution. Assuming that adjusted EBITDA for each of 4Q 2015 and 1Q 2016 was roughly $10 million and subtracting $4 million in interest payments and $1 million in maintenance capital expenditures, AZUR may have roughly $15 million cash at the end of this quarter. This would allow it to pay down debt but still could leave it in a situation of covenant violation.
Capital Structure - AZUR has roughly 13 million common units and 8.7 million subordinated units. The subordinated units are paid distributions if and only if the common units receive distributions of at least 35 cents per unit quarterly. There are also incentive distribution rights which kick in at various levels, the lowest of which is 40.25 cents per unit per quarter. The debt agreement has a complex leverage provisions with varying ratios at different times. At some time in the future not clearly set forth in the latest financials, the permissible leverage ratio will decline to 4.5 times adjusted EBITDA.
Risks - Of course, there is the general business risk that AZUR's business will decline to the point at which no distributions can ever be made and interest payments become impossible. This would require a very steep decline in adjustable EBITDA from $10.5 million to below $3 million per quarter. While this is unlikely, it is more plausible that a covenant violation could lead to an acceleration of the maturity of the debt and ultimately a default leading to bankruptcy. AZUR's cash flow seems to allow for interest payments to be made with a substantial cushion so that the debt could be slowly reduced through quarterly principal payments. Thus, a default/bankruptcy outcome seems unlikely. Another possible outcome some form of recapitalization which adversely affects unitholders. A dilutive offering could take place or a "senior" form of unit could be created which would leave common unitholders with less prospect of receiving distributions.
Likely Scenarios - I have tried to game plan this one and here is an optimistic possible scenario. Let us assume that AZUR finds itself at the end of Q1 2016 with $15 million in cash and adjusted EBITDA declining to $8 million per quarter on a sustainable basis. It offers to pay the $15 million to the lender and further reduce debt through a capital raise. AZUR issues senior units which have the right to receive $1.00 in distributions per year before common unitholders receive any distributions. It sells 10 million of these units for $6.00 a unit (or nearly a 17% yield). It pays the debt down by an additional $60 million so that the debt is reduced to $150 million. In exchange for the debt reduction, the lender agrees to a higher leverage ratio of 5.5 times EBITDA so that EBITDA can fall as low as $6.8 million per quarter without creating a covenant problem. Each quarter, after paying $1.5 million in interest, $2.5 million to the senior unitholders, and $.5 million in maintenance capital expenditures - distributable cash flow is $3.5 million or $14 million per year allowing for distributions to common unitholders of more than $1 per share. The stock gradually trades up to $5.00 per share as the dividend appears to be stable.
Of course, there are a number of pessimistic scenarios. The adjusted EBITDA could be on its way to a level well below $6.8 million per quarter. It could turn out to be impossible to sell the senior units for any reasonable price. The lender could be adamant and demand immediate repayments. Management could decide that they should "blow up" the current capital structure and turn the keys over to the lenders or try to maintain control through a chapter 11 and ultimately earn money on incentive options with a much, much lower level of debt. I would feel better about this situation if there were more insider ownership and if more insider purchases were going on at this price level. However, I think that there is an asymmetry between a 300 or 400 percent upside and a downside limited to the current price for buyers getting in here.
As always, the price can go down from here. There is an important earnings release and conference call coming up and in 10 days we could easily be below $1.00 per share. The sector is getting badly beaten up so that pessimism is in order. Still, netting out risks and rewards, I am a buyer at this price level.
Disclosure: I am/we are long AZUR.
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.
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