Legacy Reserves Is Your Best Upstream MLP Bet

| About: Legacy Reserves (LGCY)

Summary

Legacy Reserves is often misunderstood and underfollowed.

Investors can be scared off by the weak hedges.

There are many positives that are not apparent until you look deeper.

Preferred stock and bonds present the best risk/reward.

For investors looking for solid investments in an environment where oil experiences a sustainable recovery, it can be difficult for new investors to understand enough about the highly complex oil market and the equally complex organizations that operate within it. There are many investment options in the upstream oil MLP space, such as Legacy Reserves (NASDAQ:LGCY), Linn Energy (NASDAQ:LINE)(NASDAQ:LNCO), Breitburn Energy Partners (NASDAQ:BBEP), Vanguard Natural Resources LLC (NASDAQ:VNR), Memorial Production Partners LP (NASDAQ:MEMP), and Mid-Con Energy Partners LP (NASDAQ:MCEP).

For many, the upstream MLP space was their choice due to the very generous distributions. But it's become a great place to shop for beaten-down bargains if you are bullish on the price of oil. The most popular name is undoubtedly Linn Energy. Linn has been on a wild ride lately, and anyone who follows me knows that I highly recommend staying away from that name. Breitburn Energy Partners is another popular name that garners a lot of attention and, in my opinion, is an equally poor investment.

Investors New to MLPs Are Lured by the Hedges

If you ask many investors why they find the units of LINE and BBEP so attractive, they will tell you about the strong hedges that each of these companies possess. When some of the same investors evaluate a company like LGCY or MCEP, they can almost immediately be turned off by the lack of hedges. Even sophisticated investors -- including some contributors here on Seeking Alpha whom I deeply respect -- have written (here and here) somewhat critical articles citing poor 2016 cash flow as an issue. In my prior article here, I explain why hedges don't mean nearly as much as an efficient low-cost operation.

Source: Legacylp.com

Five Reasons to Be Bullish on Legacy

The biggest reason is its low operational costs. Its break-even cost of oil production is around $43/barrel. In my opinion, the average all-in break-even cost is the single most important metric. This was less of a focus for some investors in 2015 when it looked like oil prices might rise above $75, but in a lower or medium for longer price environment, this is absolutely critical. Based on this metric alone, I find LINE, BBEP and MEMP completely uninvestable. An excellent breakdown of Legacy Reserves' cash flow at various prices can be found here. For reference, I am assuming $50 oil and $2.50 natural gas in the second half of 2016 and slightly higher beyond. While it's true that many operators highlight select assets that break even at $40 oil, very few have an average break-even this low.

The second reason is the company's excellent leadership. This is a little more qualitative and requires some time following the company to fully understand. I'd recommend starting by listening to the conference call audio and going over the 10-K. Legacy leadership owns 15% of the outstanding common units, giving them additional incentive.

Third is LGCY's acquisition timing. Many of the companies that are now in trouble made large acquisitions when prices were over $100 a barrel. If you look back at the timing of Legacy's acquisitions, they have been done when oil is in the low $60s or at a multi-year low (like in November 2012). It's often very uncomfortable to make acquisitions at this time, but moves like this are part of the reason why it has such low costs. This also shows the strength of Legacy's leadership.

Fourth is the hidden value. You can look at this in two ways: Legacy is either a quiet achiever, or just terrible at marketing itself. One example is its Midstream assets that were part of the 2015 East Texas acquisition. These assets were purchased inexpensively because they were underutilized, but could represent significant value in the future. Legacy plans to unlock this value over time, but it provides valuable cash flow in the interim. The other lesser known item of note is the drilling joint venture with TSSP. Details can be found here, in the most recent investor presentation.

The fifth and final reason is plainly the risk/reward at the current prices. I'll cover this more below, but there are options for 5x, 10x and greater than 20x possible rewards in this name if oil can see a sustainable recovery.

Capital Structure

During the last earnings call, Legacy had $620 million drawn on a $725 million bank line. It also has $300 million in 8% senior notes due in 2020 and $550 million in 6.625% senior notes due in 2021. These are very long and desirable maturities in this kind of environment. If oil does not recover quickly, this gives it plenty of time. Additionally, it has two outstanding preferred equity issues with a total par value of $237.5 million. This equates to $25 per preferred share. Per the latest 10-K, it recently purchased $104 million of its own bonds in February 2016. At the time, they were valued at around 11 cents on the dollar.

Theoretically, Legacy might have repurchased this debt for less than $15 million, and it will immediately reduce their interest expense in the $6-$8 million range annually. These savings were not accounted for in the cash flow charts I referenced above and ensure positive cash flow even in 2016. The board has set aside $75 million for future bond purchases, but their covenants do not allow for this unless their bank line has 20% or more undrawn. Legacy plans to sell $50 million in assets during Q1 2016 and another $50 million in Q2 2016.

Based on their covenants, expect half of the proceeds from these asset sales to go to paying down the bank line. Some have speculated the other $50 million may be available to repurchase debt or equity on the open market. However, I would not count on any additional debt purchases. It is interesting to note that management did not mention the bond buybacks in the conference call; the details were buried in the 10-K. It could be that management is trying to keep this information hidden to avoid speculators trying to front-run them on the bonds. The 8% bonds have already doubled in price since their recent lows, so I'm not sure this plan has worked.

Risks and Issues

I'm not going to spend too much time on the risks as they have been very well-covered. The biggest one is the price of oil and natural gas. Even though a lot of Legacy's production is natural gas, the largest component of its revenue is oil. As such, shares are most sensitive to movement in its price. Legacy has suspended the distribution on the common stock well as the preferred stock. This brings me to the issues that both revolve around tax. Due to the bond buybacks, there might be a cancellation of debt income attributable to common unit holders, which could result in income tax for the unitholder. This issue only affects the common stock (NASDAQ:LGCY).

The second tax issue relates to the suspension of the preferred dividend. Both of the preferred issues have a cumulative payout of $2 per year, which will be back paid if and when preferred distributions resume. Due to IRS rules, the amount is considered a guaranteed payment (although it's not actually guaranteed) and is taxable in the year it would have been paid. This is being referred to as the "phantom income tax," and will result in preferred unitholders being required to declare this income. No such issues exist for the bonds, and the coupon payments continue to be paid. So I don't consider those payments at risk.

How and Where to Invest in Legacy

I can't tell you where to invest in LGCY, but I certainly have my opinion on the best place. If you look at risk/reward, the bonds are certainly a strong bet. With a full recovery you can make 5x your original investment plus coupon payments, and the downside risk is the lowest with the bonds. The preferred equity (LGCYO)(LGCYP) has potential 10x upside plus back paid dividends with greater risk than the bonds. The preferred equity represents the best value investment in the entire upstream space, in my opinion, with great value at current prices. The common stock arguably has the most upside, potentially 20x or greater within five years, but also has the most risk and will likely be more volatile than the bonds and preferred.

Conclusion

Legacy might not be the absolute best in class on any particular metric, but it is very strong across a broad range of metrics. There is an incredible amount of hidden value here that will eventually be realized if oil can remain above $50.

Disclosure: I am/we are long MCEP, LGCYO, LGCYP.

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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