Decision Time At Memorial Production Partners

| About: Memorial Production (MEMP)

Summary

The recent announced property sales will increase the available credit to $190 million. More property sales are needed.

Cash flow from operations but before working capital effects more than doubled from the previous year to $77 million despite lower average selling prices after hedging.

The company still has one of the better hedging programs with most of its projected production hedged for at least the next three years.

The company paid a $.03/share quarterly distribution that is very well covered. Shareholders could have a tax gain if some of the company debt is repurchased at a discount.

Gains based on the ability of management to improve operations leading to a full recovery could be outstanding on the debt first, and then the common stock.

Memorial Production Partners (NASDAQ:MEMP) is one of very few limited partnerships still in its original form after the commodity price declines. Much of the competition including Linn Energy (NASDAQ:LINEQ) and Breitburn Energy Partners (OTCPK:BBEPQ) have gone broke or are in severe financial straits. This company, while in speculative shape appears to have realistic chances to survive and "live to fight another day".

But management needs to execute a qualifying plan for doing so, because the creditors are anxious. The recent credit line redetermination left the company with a $925 million credit line of which $134 million was left. So many lenders are jittery right now that the company cannot afford to go into the October credit line redetermination with that amount of liquidity. That is just asking for trouble.

So management has started to sell non-core properties and has already announced $56.5 million in non-core sales. However, the characteristics of these properties have not yet been disclosed. The market is anxious to know if these were high cost properties, and if so which costs were high. When the first quarter earnings were announced, operating costs in total decreased. Even though operating costs in total decreased, operating costs per MCF did not decrease from the fourth quarter. Sometimes that happens because operating expenses can be lumpy at times and hide true progress. But there really was not much discussion in the press release about the situation.

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Source: Memorial Production Partners BAML Energy Credit Conference Slides For June, 2016

The company needs to compare its results by project using competitors with similar results in each project. The company also needs to keep in mind and should definitely compare its results to low cost producers such as Peyto (OTCPK:PEYUF), Murphy Oil (NYSE:MUR), and Granite Oil (OTCQX:GXOCF). Comparing against other limited partners is taking the easy way out and avoiding the hard decisions. Plus company results are a mixture of several projects, so not much can really be learned from the above slides. If the product mixture changes enough, even among projects, the company may have not made the progress an investor was led to believe. When the lenders are nervous, management needs to produce, and slides such as this may show a lack of commitment to the cost cutting urgency. That urgency needs to be very publicly and specifically conveyed to reassure the lenders. Management needs to publicly disclose by project its cost controls and progress made. Some of those core projects may need to be sold if sufficient cost control progress is not made.

Cash flow from operations in the first quarter was $77 million with a $24 million favorable change in working capital. In the fourth quarter the cash flow was $31 million with a $32 million unfavorable change in working capital. So like the cost per BOE and the average selling price after derivatives, the cash flow did decrease slightly from the fourth quarter. To reassure its lenders, the company needs to increase cash flow each quarter, otherwise the management commitment to reducing costs will be in question.

More important was the $51 million gain in derivatives meant that the company had cash flow from operations of $2 million before changes in working capital. So without the derivative gain, the company had cash flow from operations before working capital. This is an important milestone that the company neglected to make the market aware of. Of course the market will be watching to make sure that the working capital from operations before derivative gains continues to increase so that when the derivatives are gone, this company will have a viable cost structure.

Management may well need to sell at least $400 million in properties to pay down the bank credit line enough to reassure the lenders. Or management can increase production enough to effectively increase the value of the properties that are securing the loan. The general platitudes about strengthening the balance sheet (etc...) are not going to reassure lenders that much.

Source: Memorial Production Partners BAML Energy Credit Conference Slides For June, 2016

The company clearly has one of the best hedging programs in the business. But the market and the lenders do not seem to care right now. The ratio of cash flow from operations (first quarter annualized before working capital effects) is about $308 million and long term debt is about $2 billion. The ratio of cash flow-to-long term debt is greater than 1:6. That ratio is probably now unacceptable to lenders, so the capital structure must change. Therefore the balance sheet needs to improve significantly in order for the company to meet the new lender requirements.

The distributions have been restricted by the lender covenants and the market appears to have focused on the new distributions. However, the cash flow covers the distribution several times over as shown by the larger distributable cash flow and the much smaller distribution. Wise use of the cash should enable the company management to oversee the strengthening of the balance sheet. When combined with a savvy asset sale program and some debt repurchases (the bank will allow up to $100 million for this purpose), this company could survive until the markets rebound sufficiently to end the lenders fears. These possibilities put the partnership in far better shape than many of its peers, although it will likely have to modify its practices in the future to avoid this liquidity situation.

  • "Average daily production decreased 5% to 243.3 MMcfe for the first quarter 2016, compared to 257.3 MMcfe for the fourth quarter 2015; due to a planned scaled back development program, flooding in East Texas and a temporary production curtailment at Bairoil. "

The company needs to explain the situation in the quote above much more than they have. The flooding alone could be responsible for some significant non-recurring charges in the future. The product curtailment could result in more non-recurring future charges.
Management needs to show the market the operational progress it has made separate from non-recurring events. The latest presentation is filled with charts showing geographic areas of operations and lovely descriptions of the advantages of each area. Now management needs to put numbers that reconcile to all of this to reassure the investment community.

In summary, management has clearly made some progress, but has failed to detail the progress made by project and the progress that needs to be made. Goals for the dollar amount of property to be sold are needed. Some general goals are out there, and like the property sales are signs that management is moving towards a permanent resolution of the key challenges. But a definitive and disclosed detailed plan is clearly lacking. Nonetheless, surviving the credit redetermination is a significant milestone and so is the cash flow without hedge gains and before working capital changes in the first quarter. There is enough there to make this investment a reasonable speculation on a total recovery of the company.

The current market cap of $160 million and stock price of $1.93 (based on the closing price of June 23, 2016) clearly have a lot of failure in the stock price. The latest commodity price rally if it is sustained could ease both investor fears and lender fears. Plus the company has one of the best hedging programs in the business.

At some point management should consider selling enough properties so that the lenders would allow management to drill or develop about $100 million worth of new production. That new production could significantly lower costs and ease lender fears. The current lack of drilling activity will definitely contribute to rising operating costs and the company may have a hard time significantly lowering operating costs unless it drills new wells.

Even so, the current situation demonstrates considerable coverage for the reduced distribution of about 6% ($.12 per share). It also demonstrates a fair amount of progress in a very hostile lending (and industry) environment. The market must have some faith in the recovery prospects of the company or that high yield would be far higher. That dividend provides a very respectable return until the balance sheet is significantly strengthened enough to raise the distribution. Like most partnerships, the taxes pass through to the unit holders.

Should the company buy back some debt at a discount, the unit holders may have some taxable gains on the extinguishment of debt depending upon the structure of the transactions. The bonds themselves also provide a speculative investment possibility for the suitable investor depending upon their temperament. As the company recovers the bonds may well appreciate first and provide a significant return before the common stock.

Sometimes a cyclical company is hard to value at the bottom of the market. In this case cash flow is reduced and the lenders are pressuring management for some significant changes. An investment in any of the securities is a bet on management to complete successfully the transformational changes that have begun without a bankruptcy filing or another form of a formal reorganization. In this case, the chances appear to be better than average. Therefore the returns on the company's securities should it recover could be outstanding.

Disclaimer: I am not a registered investment advisor and this article is not advice to buy or sell stock in any company. The investor needs to do his own independent investigation that includes reading the company governmental filings and press releases, as well as anything else relevant to determining if this company fits the investor's risk profile.

Disclosure: I am/we are long GXOCF.

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.