Vanguard Natural Resources (NYSE:VNR) is an upstream gas-weighted MLP. Like its peers, Vanguard has certainly had a tough time during the lower commodity price environment over the past 18 months.
I've looked at VNR in the past and was turned off by its very large ($1.425 billion) bank debt, which makes up about 73% of its total debt. In an environment where banks are forcing E&P companies to restructure, the last thing you want to see is a large amount of bank debt making up the majority of the long-term liabilities. This alone makes an investment in VNR highly speculative. After running the numbers, I started wondering whether others have gotten this name wrong and are missing a golden opportunity because of their aversion to the bank debt.
Points to Note
I used a modified version of the model I built for Legacy Reserves (NASDAQ:LGCY) to evaluate the cash flow of VNR. A couple of differences I noticed as I was going through the analysis:
- Costs are listed per Mcfe, not BOE, which is more appropriate for a gas-weighted MLP.
- Differentials are higher than LGCY, but LOEs are much lower.
- Cash flow looks good, but much of it is from the hedge proceeds.
- Every penny of natural gas price increase adds $1 million to VNR's unhedged annual free cash flow (this one had me intrigued).
- VNR uses Full Cost method of accounting. Most of its peers utilize Successful Efforts. This doesn't affect the cash flow.
Recent Bank Redetermination
The most recent event for VNR was the borrowing base redetermination. As a result of this redetermination, VNR has a $103.5 million borrowing base deficiency. This deficiency does not count VNR's cash on hand of $40 million, nor does it take into account that the company needs to maintain a $50 million cushion as at 9/15 to pay its bond interest without triggering a default. The company is required to make six monthly installments of $17.5 million starting 6/27. Management has stated that it expects to be able to pay these from the available cash flow.
However, much of this cash flow is coming from VNR's hedges and is not a sustainable source of revenue. The company's hedge value also directly impacts its borrowing base. Like selling assets to pay down the bank line, using hedge proceeds does generate cash, but it also has a direct negative impact on its future borrowing base.
Based on Vanguard's guidance, it expects free cash of $150 million through the remainder of 2016. This will give the company just enough to stay in compliance with the banks, but not give it any cushion if there is another large borrowing base reduction in the fall.
I'm not going to pretend to know how the banks will react in the fall, but if I had to put my money on the line (and I have), I'd say that a further 10% reduction in the borrowing base is likely, but a much greater reduction is a definite possibility. If the reduction is anything greater than 10%, I'd imagine that some kind of restructuring through Chapter 11 is squarely on the table.
It should be now clear that an investment in the common units is probably only for the most speculative part of your portfolio, and to be honest, I just can't see any reason to put the money to work there. In a full recovery, the preferred would see 10x gains. But this doesn't mean the preferred is a good investment either.
If the common units and the preferred are extremely speculative, is there any value even in the debt?
2017 Unhedged Cash Flows
To help with answering the above question, let's take a look at what 2017 cash flows look like (unhedged):
Here are the assumptions:
|Revolver||$ 1,314,000,000.00||4.00%||$ 52,560,000.00|
|2020 bonds||$ 381,800,000.00||7.875%||$ 30,066,750.00|
|2021 bonds||$ 51,000,000.00||8.375%||$ 4,271,250.00|
|2023 bonds||$ 75,600,000.00||7%||$ 5,292,000.00|
|Lease||$ 20,000,000.00||4.160%||$ 832,000.00|
|Total||$ 1,842,400,000.00||Total Interest||$ 93,022,000.00|
|Bonds interest||$ 40,462,000.00|
Costs and Capex
I'll lay out two scenarios which are highly subjective, but each is going to assume a 2017 oil price of $60 and nat gas at $3.25. Let's also assume for ease of calculation that management locks in these prices with hedging for the full year of 2017.
- Fall 2016 borrowing base is cut by 10% to $1,192,500,000
- 2017 FCF of $167,219,733
This is optimistic on the borrowing base, and my view of only a 10% drop is based on the assumption that management hedges most of its production and the recent rises in the price of natural gas. Management has six months to pay $121,500,000 with approximately $75,000,000 in cash flow. While it's likely some rabbits are pulled out of hats, it would seem at this point there is a greater than 50% chance that VNR enters some kind of restructuring that would be bad for holders of the common and preferred.
In this case, the fall 2016 borrowing base is cut by 25% to $985,500,000. VNR starts looking at "strategic alternatives" and Chapter 11 follows.
Firstly, if you own the common or preferred, you've lost a lot of money and are hoping for the bankruptcy gods to award you something in the restructured organization.
If you are a bondholder, you're starting to wonder whether there is any value left over for you. The good news is that there is value depending on what your assumptions are regarding the exit. I'll lay out mine here:
- First-lien loan is rolled over to newco with a 1% rate increase.
- Second-lien loan is rolled over to newco with terms unchanged.
- $350 million of new financing is secured at 8% interest.
- Unsecured bondholders receive most of the new equity.
- Total debt is reduced by $400 million in addition to the preferred equity liability that's wiped out.
- Free cash flow is estimated at about $175,000,000 for 2017.
There are a ton of variables here, like whether new financing could even be secured or whether a rights offering or other injections of capital might be needed. All of these would dilute the current bondholders' stake in any newco.
Time is the biggest issue for many energy producers. For VNR, the latest move in natural gas is critical, but time is not on its side. If you think there is a strong chance of a restructuring in October, then should you invest now? The answer depends on how much risk you want to take on. Any investment now is largely hoping for a recovery, although the bonds were attractive enough for me to take a position. I did have a position in the preferred, but my analysis here led me to a decision to exit that position at a loss. It was previously a "lottery ticket" holding, but I've decided that I don't need the extra risk in my portfolio at this time.
When I started writing this article a couple of days ago, I was actually much more upbeat about VNR's prospects having done the cash flow calculations at the start of the process. Seeing how quickly revenue can increase with better oil and nat gas prices was encouraging. However, the bank debt is so large (and fully drawn) that any meaningful reduction in the borrowing base could trigger a default.
Any investment in VNR is highly speculative. With the preferred trading at 10 cents on the dollar and the bonds at 30 cents, both are fully valued or overpriced right now based on the risk.
Even if VNR makes it through the fall redetermination, one has to be pretty optimistic about commodity prices to see a full recovery, which would be needed to see a meaningful recovery in any of the equities.
Disclosure: I am/we are long VNR UNSECURED BONDS.
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.
Additional disclosure: I exited my VNR preferred position within the last 24 hours.