What Investors Should Expect From Legacy Reserves

| About: Legacy Reserves (LGCY)

Summary

In its next quarterly release, Legacy Reserves should show some positive signs for investors that will help it survive in the long run.

Chief among these should be asset sales as the firm tries to slim down its operations and reduce costs.

Cash from these asset sales should be allocated toward paying down debt; some argument can be made that credit facility debt might be best.

If this quarter is anything like that quarter, we should also keep an eye out for a lower cost structure for the enterprise.

Lately, shares of Legacy Reserves (NASDAQ:LGCY), as well as the firm's preferred units, have been somewhat depressed compared to where they were a little earlier this year. After seeing an initial decline thanks to a change in executive compensation, the company's stock has remained under pressure due largely to falling oil prices. As the firm's second quarterly release date for this year nears, I decided that it would be a wise idea to look at what investors should probably anticipate for the quarter.

Asset sales should be on the books

If management can live up to its goals during the quarter, some additional asset sales should have been made during the quarter. Previously, the firm announced that, during their first quarter, they sold assets worth $68.46 million in order to reduce debt outstanding. This was followed up by about $5.4 million in additional asset sales during the second quarter but management said that, during the first half of the year, their objective was to sell assets worth $100 million.

Based on these numbers, if management can achieve these sales, Legacy should have extra asset sales during the quarter totaling $26.14 million (excluding the $5.4 million they already disclosed). While it is unfavorable to sell assets, doing so for assets that impair Legacy's financial performance could actually be beneficial down the road and will make the entity more lean in the months and years to come. I do not have any evidence for my suspicion, but I believe that it's likely total asset sales during the quarter will be higher than what management hoped to see. This is due to the fact that, with oil and natural gas prices materially higher than they were earlier this year, the firm was still able to sell off so much during the first quarter, so finding buyers for additional assets should be easier.

Debt reduction should continue

In addition to seeing more asset sales during the quarter, I believe it's probably that Legacy will have bought back debt in the second quarter just like they have been doing this year. Through May 4th of this year, management paid back, using proceeds from asset sales, combined with cash flow, $48 million of their credit facility debt, $52.01 million worth of their 8% Senior Notes, and $117.34 million of their 6.625% Senior Notes. At current prices, every $10 million allocated toward debt buybacks of the firm's 8% debt would reduce total borrowings by $20.68 million, while the same amount allocated toward its 6.625% debt would reduce borrowings by $22.82 million. The implied return of this, from an interest rate perspective only, would be 16.5% and 15.1% per year, respectively.

Honestly, I would love to see Legacy continue buying back Senior Notes at the sizable discounts they are trading for, and if history is any guide, they likely will do just that. However, given the risks associated with the firm's credit facility and a coming redetermination this Fall, it would be prudent, in my mind, to allocate as much of its cash as possible toward paying this type of debt down. Of course, if management has engaged in additional hedging during the quarter, which can be used to satisfy credit facility lenders to some degree, I would be perfectly happy with them buying back Senior Notes instead.

Cost reduction should continue to be stressed

The last item I'm expecting to see from Legacy during the quarter relates to cost structure. During the first quarter of this year, the firm's lease operating expenses averaged $11.26 per boe (barrel of oil equivalent), a decrease of 25.5% compared to the $15.11 per boe the firm averaged during the first quarter of its 2015 fiscal year. Given the tough environment, select asset sales, and a few other factors, I believe it's probable that the firm's cost structure will drop in this year's quarter as well.

The same can be said, I believe, of Legacy's general and administrative costs. Excluding transactions costs and LTIP-related expenses, the firm's general and administrative costs last quarter averaged $1.86 per boe. This represents a meaningful decrease of 27.1% compared to the $2.55 per boe reported the same quarter a year earlier. Unfortunately, general and administrative costs can be relatively sticky because a nice chunk of the expense comes from employee salaries, but such a large decrease year over year in the first quarter already seems to provide a good probability that a similar decrease will happen for the firm's second quarter.

Takeaway

Based on the data provided, it seems as though investors have some interesting things to look forward to. I do not know what the future holds regarding these particular items, but if management's statements, combined with historical performance, serve as any indication of the future, I'd say that the future is looking up. This is especially true in the event that management can focus on the most important of the three items, debt reduction. By reducing leverage accordingly, the firm's prospects could improve materially.

Disclosure: I am/we are long LGCY.

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 am long LGCYO, not LGCY