For investors looking to buy into Legacy Reserves (NASDAQ:LGCY), there's more than one way of doing so. While many publicly-traded companies give you the option to either buy common units or bonds, Legacy also offers two classes of preferred shares, Legacy Reserves Series A (LGCYP) and Legacy Reserves Series B (LGCYO). In what follows, I will weigh the benefits and hindrances of all five different ways you can buy into the company (with two sets of debt that can be purchased) and say which route I am finding the most attractive at this moment in time.
A look at the debt
From a capital preservation standpoint, the single safest opportunity for investors who feel the need or desire to be invested in Legacy is through the firm's two different classes of debt. The first class would be the business's 2020 Senior Notes. These have a yield of 8% (from par) and the total amount outstanding, as of the time of this writing, is $247.99 million if you look solely at the par value. At present, these Senior Notes are currently going for $0.4750 on the dollar, which implies that (if all investors were willing to sell their bonds back at these prices) management could acquire all of its outstanding notes under this class for $117.79 million. The yield to maturity on these notes is 30.66%.
The second set of debt that investors can buy into would be Legacy's 2021 Senior Notes. These have a yield (from par) of 6.625%, so the interest rate is lower, ceteris paribus. Furthermore, there is $432.66 million in debt outstanding under this class. However, the price of these notes is slightly lower than the 2020 Senior Notes, trading for $0.4500 on the dollar. This suggests that all debt outstanding under this class can be picked up for $194.70 million. The yield to maturity on these notes, due to the lower interest rate and similar market price, is lower than the 2020 Senior Notes at 26.41%.
From a debt perspective, I personally like the 2020 Senior Notes more than I do the 2021 Senior Notes. The yield to maturity being higher is one positive here, but the other positive is that their due date is sooner so their probability of being paid off is likely greater than the 2021 Senior Notes. It should be mentioned, though, that there's no guarantee note holders under either set of debt will be paid in full. As of the time of this writing, Legacy also has $560 million in credit facility debt, which cannot be purchased on the open market, and these lenders must be made whole before the owners of Senior Notes can be paid back.
In addition, as we've seen with now-defunct rival Linn Energy (NASDAQ:LINEQ) / LinnCo (OTCPK:LNCOQ), management could always attempt to issue Second Lien Notes to accredited investors that would come between the credit facility debt and the remaining holders of Senior Notes in terms of seniority. Under such a situation, the investors with Senior Notes in their portfolios would see an even smaller chance of being paid off, but this doesn't mean they wouldn't be. It would ultimately depend on the value of Legacy's assets upon a liquidation or a reorganization or some other corporate event. Keeping all of this in mind, though, there is no doubt that this is still the safest route for investors in the business.
A look at the preferred units
Just like in the case of Legacy's publicly-traded debts, the firm also happens to have two different types of preferred units investors can buy into. Both the Series A and the Series B are fixed-to-floating rate cumulative redeemable perpetual preferred units. What this means is that until mid 2024 (April for the Series A and June for the Series B), investors are paid a fixed distribution. This comes out to $2 per unit each year (paid monthly) on a price of $25 per unit, which implies a rate of 8% each year.
Once mid-2024 hits, this rate turns into the 3-month LIBOR rate plus 5.24% (5.26% for the Series B) and all amounts in paid forever unless management chooses to redeem them. This can take place on or after the five-year anniversary of the debt being issued (which would be 2019) and management could then elect to buy back the units for $25 apiece, plus any distributions that have been accrued but not yet paid.
The real value right now for investors comes from the fact that units are cumulative in nature. You see, at the start of this year, the company elected to stop making payments on these units given the tough energy environment but because they are cumulative, the amount that is supposed to be paid to investors is kept track of by management and must eventually be paid back should the company decide to begin paying common unitholders distributions again. In fact, because the units are preferred, their owners must be paid these amounts before one red cent can be sent to investors in Legacy's common units.
So far this year, this is starting to show up in the value of Legacy's preferred shares. Right now, the Series A Preferreds are trading for $4.59 apiece while the Series B Preferreds are going for $4.53 apiece. However, if you count the current month of July, each unit is owed approximately $1.17 right now ($0.1667 x 7 months), so it can be argued that this is already built into their current market prices. If, for instance, Mr. Market assigns a 100% probability that distributions will be paid at some point in the future, $1.17 per preferred unit is baked into current market prices so Series A Preferreds would have a value of $3.42 apiece, while Series B Preferreds would have a value of $3.36 apiece right now. When you compare this all to the $25 price that the units will eventually be redeemed for (assuming the company does not go under, which could happen if energy prices retreat meaningfully), the upside potential is significant.
The one thing investors need to be cognizant of, however, is that there is some risk here from a tax standpoint. While Legacy has suspended distributions and is allowing them to accrue, their partnership agreement states that they will be treated as guaranteed income to the holders of the units. This means that even if investors in the preferred units do not receive payment today, they will still be taxed as though the holders did receive payment. For distributions accrued prior to the month in which they were purchased, the prior owner is taxed accordingly but investor relations also mentioned that any amount eventually received will lower an investor's basis in the units, which could have tax implications upon selling the units some day.
A look at the common
Without a doubt, the highest return opportunity (assuming the oil market turns around and we see prices of $60 per barrel or more again in the future) appears to be in the common units. Priced at $1.66 per shares, the common units are the way investors want to go if they are very bullish about Legacy and if they want potentially unlimited upside. This is because the units have no price at which they are redeemed and they receive value not from guaranteed distributions and seniority over other units in the event of a bankruptcy, but from the profitability of Legacy as a whole.
In the past, shares of Legacy have traded above $30 apiece, so investors have a lot of potential should the oil market rebound, but they have also traded as low as $0.61 apiece. This gives a vast range of likely prices, but it's important to know that, in the event of bankruptcy, there is virtually no protection for investors so downside could easily amount to everything you place in, while the upside could be any amount that properly conveys the business's long-term prospects following an oil market recovery.
Similar to the preferred units, the common units also have interesting tax consequences. As opposed to investors being taxed on assumed distributions that have not yet taken place but that are guaranteed if the company comes out of this downturn, the common units are taxed on any income (not to be confused with its net income) generated by the business, even if that income is not distributed to investors. Furthermore, as the distributions (which have also been canceled) are not guaranteed and are not cumulative, investors could be hit with a big tax bill at the end of the day, even if value on the common units are lost entirely.
The other risk here is that investors in the common units can see a big tax bill even in the event that Legacy sees cash outflows, largely thanks to the effects of debt buybacks. When debt is repurchased at a discount, GAAP (Generally Accepted Accounting Principles) requires that a gain is to be recorded in the amount of the debt that is canceled out. During the first quarter of this year, that gain was $130.80 million. Keeping all else flat, this would equate to taxable income for investors of about $1.90 per share, about 114.5% of the firm's current share price. If you have an effective tax rate of, say, 20%, this would mean a bill of $0.38 per unit.
At this moment, there are merits to buying into any of the five different investment vehicles that allow investors to get a piece of Legacy, but there are also drawbacks. For investors who are interested in safety, buying into the Senior Notes (especially the 2020 ones) seems to be the best opportunity and their upside is significant should the market recover and the business survive. The common units also make sense to me but only for investors who are comfortable with the tax issues associated with them. For me, however, what makes sense is to buy into the preferred units (which I have already done). Both classes of preferreds offer nice upside and they will (if the business survives without restructuring) guarantee the payments investors are being taxed for today on.
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 own LGCYO, not LGCY