Kayne Anderson Energy Development Company (NYSE:KED)
Q2 2012 Results Earnings Call
July 24, 2012 5:00 PM ET
Monique Vo – Vice President, Investor Relations
Kevin McCarthy – President and CEO
Terry Hart – Chief Financial Officer
Selman Akyol – Stifel Nicolaus
Good afternoon. My name is Hop, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2012 Earnings Call for Kayne Anderson Energy Development Company. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)
Thank you. Ms. Monique Vo. You may begin your conference.
Thank you, Hop. Good afternoon, everyone. And welcome to the earnings call for the Kayne Anderson Energy Development Company for the quarter ended May 31, 2011.
Before we begin, I'd like to remind you that our call will include statements reflecting assumptions, expectations, projections, intentions or beliefs about future events. These and other statements not relating strictly to historical or current facts are intended as forward-looking.
Generally, words such as believe, expect, intend, estimate, anticipate, project, will, and similar expressions identify forward-looking statements, which generally are not historical in nature.
Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ from the company's historical experience, its present expectations or projections.
For a description of the factors that may cause such a variance, I would direct you to the forward-looking statement discussion in our annual and quarterly reports. These reports are available free of charge through our website at kaynefunds.com and at sec.gov.
You should not place undue reliance on forward-looking statements. The company undertakes no obligation to update or revise any forward-looking statements. There is no assurance that the company's investment objectives will be attained.
With that, I will now turn the conference over to our President and Chief Executive Officer, Kevin McCarthy.
Thanks, Monique, and good afternoon, everybody. Thank you for joining us today for our second quarter 2012 earnings call.
I’ll start today's call with a review of the MLP sector in the broader energy markets during our second fiscal quarter, which ended May 31st. I will also touch briefly on market performance during June and July before we review KED’s performance. Then, Terry Hart, our CFO will discuss our financial performance and guidance before opening the line up to questions.
With that, let’s turn to review of market conditions. The optimism that we saw in the equity markets during the first quarter faded during the second quarter, as the U.S. economic data weakened and concerns about Europe intensified. The S&P 500 Index declined 4.1% during the quarter after rising 9.5% in the first quarter.
MLPs were much weaker in the broader market, with the Alerian MLP Index down 10.5% during the quarter. On a total return basis, which includes cash distributions, MLP returns were negative 9.2% for the quarter while the S&P 500 return was negative 3.5%.
In our view, MLPs faced selling pressure along with the rest of the energy sector as commodity prices fell during the quarter. In addition, MLPs were very active issuing equity in the first two months of the quarter, and as the market declined and the new deal was traded poorly, the sector came under additional selling pressure.
Since the end of our second quarter, MLPs in the broader markets have rebounded nicely. As of July 20th, last Friday, the MLP Index was up 9.5%. Since May 31st, while the S&P 500 Index was up 4%. As of last Friday, the MLP Index is now up almost 14% from its lows in early June and up almost 12% for the fiscal year on a total return basis.
While MLPs have performed quite well over the past six to seven weeks, we continue to find MLP valuations quite compelling. Currently, MLPs have an average yield of 6.1% and a distribution growth forecasted at 7% over the next year. With yield plus growth or y plus g prospects in the low double digits, we think MLPs compared very favorable relative to other equity investment alternative.
Relative to other income alternatives, MLPs are trading at higher than normal yield. The 10-year U.S. Treasury is trading at a yield of 1.5% and the yield spread to MLP is 460 basis points. This compares to the historical average closer to 220 basis points.
Relative to other income producing equity securities such as REITs and utilities, MLPs traded yield spreads at 270 and 250 basis points respectively, despite having much stronger historical and projected growth rates.
MLP distribution growth remained strong during the quarter with 41 MLPs increasing distributions, compared to 35 in the prior quarter. The average distribution increase was 6.4% on an annualized basis, which was the same level as we saw in the prior quarter.
Distribution announcements for the second calendar quarter have just begun but all signs point towards a continuation of the distribution growth. Based on our research, we continue to expect that midstream MLPs will increase their distributions by 7% in calendar 2012.
M&A activity in the MLP space continued to accelerate during the quarter with 31 announced transactions. Like last quarter, there were several very large transactions including Energy Transfer’s acquisition of Sunoco for $5.3 billion, Williams $2.5 billion acquisition of Caiman Energy, Suburban’s purchase of Inergy’s Propane operations for $1.8 billion and Penn Virginia’s $1.0 billion purchase of Chief’s Marcellus gathering assets.
Another multibillion dollar transaction was announced after our quarter end, as Chesapeake sold its interest in Chesapeake Midstream and other midstream assets for $4 billion.
As I mentioned earlier, capital market activity was brisk during the quarter as MLPs actively raise both debt and equity for growth projects and acquisitions. During the quarter, there were 12 follow-on equity offerings, totaling $3.4 billion, which happened mainly during March and April. Activities slowed in May as the market needed to digest all of this new equity.
In terms of IPOs, there was only one deal completed during the quarter, PetroLogistics, which is a variable payout MLP. That deal has struggled and is currently trading about 33% lower than its offering price.
On a more positive note, [Equitable] Midstream went public after quarter end and is traded very well, up 22% since its IPO. Right now, there's only one MLP on this roadshow, Northern Tier Energy, but the backlog of IPOs is as large as I can remember. This backlog has a diverse mix of businesses with most in non-traditional sectors such as refining retail gas station and oilfield service business.
While, all of these businesses have income that’s qualified for MLP treatment, we question whether or not several of these businesses are suitable for the MLP model. As we’ve stated in the past, we are going to be very selective in the IPO market and plan to focus on high-quality businesses for the appropriate structure and appropriate valuation.
On prior calls, we’ve talked about how the new supplies of oil and gas and the shale plays are changing the energy landscape in transforming the U.S. economy. While MLPs continue to benefit from this trend, they are not immune to concerns about the global economy.
We reminded this during the quarter, as prices for crude oil and NGLs were sharply lower, mainly because of concerns about slowing global demand. The prices for West Texas intermediate crude or WTI fell 19% during the quarter to $86 per barrel. Prices continued their selloff in June, with WTI falling below $80 per barrel for the first time in almost a year before recovering to over $90 late last week.
The sell off in crude was a global event with international crude prices falling 17% during the quarter. Global crude inventories reached a 22-year high, as Saudi Arabia continued to overproduce in anticipation of potential disruptions caused by Iran.
With such high inventories, the market is especially sensitive to changes in demand expectations and the market sold off hard as Europe's economy weakened and signs of a slowdown in China began to emerge.
Closer to home, MLPs continued to advance projects to transport the growing crude oil supplies to market. During the quarter, we saw the Seaway pipeline reversed and began flowing crude from Cushing to the U.S. Gulf Coast.
Enterprise and Enbridge are advancing plans to significantly expand this pipeline by 2014. After our quarter end, Magellan and Sunoco each announced plans for major new crude oil pipeline to transport additional West Texas oil to the Gulf Coast. Finally, it appears that the southern leg of the new Keystone pipeline project from Cushing to the Gulf Coast will also move forward.
So in spite of the volatile commodity prices, the growth story for MLPs remains unchanged. There is significant amount of new midstream assets that need to be constructed to facilitate the development of unconventional reserves.
On the natural gas side, prices fell sharply in March and April with Henry Hub prices falling below $2 for the first time in 10 years. In May, we saw an impressive recovery with prices rising 27% from the April lows to finish the quarter down only 8%. As we look at the forward curve, the price for calendar 2013 is $3.63, which reflects the improving fundamental.
When we spoke to you three months ago, natural gas looked hopelessly oversupplied and there are mounting concerns about reaching maximum storage capacity this fall. Since then, we've seen demand stronger than expected as more gas is being used for electric power generation.
We also continued to see decline in the gas rig count, as producers are shifting rigs to oil and NGL properties. As a result, the storage surplus is moderated somewhat and we may now not test the absolute limit of storage capacity this fall as we’d believe earlier this year. Notwithstanding these positive developments, we expect natural gas spot prices will continue to be volatile over the next several months.
I also want to touch on the price of natural gas liquids or NGLs which have declined more than any other energy commodity this year. NGL prices are very important to gathering and processing MLPs, as well as upstream producers that focus on what natural gas play.
We’ve known that supplies of NGLs are rising this year as more liquids rich natural gas is produced and processed. More recently concerns about NGL demand have weighed on pricing, this issue has been compounded by the impact of high propane inventory levels after very mild winter, as well as lower operating rates by the petrochemical producers.
Since the beginning of calendar 2012, NGL prices are down 32%, with ethane the weakest component down 50%. We expect the modest rebound in NGL prices over the balance of the year, but robust recovery will require normal winter demand for propane, the expected expansion of propane export facilities in the fourth quarter and operating rate by petrochemical producers.
Now let me turn to the performance of our portfolio. KED share price decreased 1.2% during the quarter, outperforming both the Alerian MLP Index and the S&P 500. Our adjusted NAV return, which includes reinvestment of dividends, was down 6% for the quarter, outperforming the MLP Index, which was down 9.2%.
During the quarter, KED’s portfolio of public MPL securities slightly underperformed the MLP Index, but this was more than offset by strong returns in our private MLP and high yield debt portfolio.
At quarter end, our portfolio mix remained little change from the prior period, with 56% invested in public MLP, 14% in traded debt securities and 30% in private investment including private MLP.
Our largest private investment is in Direct Fuels Partners, a private MLP that operates the specialty refining and fuel terminal business in the Dallas-Fort Worth area. Direct Fuels continues to perform very well. In the first calendar quarter of 2012, EBITDA was more than two times budget.
Second quarter is forecasted to be somewhat less in budget, but this is due to the effect of inventory losses in the rapidly declining pricing environment. The volumes and unit margins remained strong in the partnership based [transvic] business.
During the quarter, we received forecast distribution on our Direct Fuels common and preferred units, and we expect the partnership to continue to pay forecast distribution going forward.
Direct Fuels is still in discussions with its lender about modification to the credit agreement that would facilitate the use of additional leverage to redeem some or all of the outstanding preferred stock that we own. The extent and timing of those redemptions though hasn’t been determined.
As we discussed on the last call, KED and the other partners in Direct Fuels have been assessing the strategic direction of the partnership. To that end Direct Fuels along with two other energy-related businesses controlled by affiliates of the General Partner have tentatively agreed to combine such businesses to form a new MLP called a Merge and Energy Services.
During the second quarter, this new partnership submitted a confidential draft registration statement to the SEC related to a contemplated IPO. As this filing is confidential, I can’t go into more detail on the IPO, its valuation or the impact on KED of such a filing. I have to remind people that the terms of such combination are not yet finalized in any offer it would be subject to market conditions.
I had also cautioned you that sales of securities in the new partnership, Kayne occur prior to the time this registration statement is declared effective and this conference call is not an offer to sell or solicitation of an offer to buy any securities of the new partnership.
For the quarter, our valuation for Direct Fuels increased by $2.50 to $16.50 per unit based on the partnership’s strong operating results in the possibility of an IPO of the new uniform partnership. ProPetro Services, our second largest private investment is an oilfield service company with several different business lines including pressure pumping, flowback and well services.
The company -- company generated record results in the first quarter of 2012. The business easily beat the previous record for profitability, but results felts somewhat short of the projections we’ve made at the end of last quarter, as a result of lower operating margins and greater competition in the pressure pumping business.
The broader oil service factor has come under pressure recently, we believe the company is well-positioned to deal with current market conditions. Activity levels remain very strong in the Permian Basin, which is the company’s core operating region. Further unlike some of its competitors, the company does not have any exposure to dry gas basins.
While the company has seen some of its competitors move pressure pumping assets to Permian, we believe the company’s long history of operations in the Basin and track record of performance will give it a competitive advantage.
The company is currently focused on maximizing operating results and reducing its leverage level. The company has explored a variety of different strategic alternatives over the last 12 months and as market conditions stabilize, we plan to revisit some of those alternatives.
During the quarter, we reduced our 2012 and 2013 projections for ProPetro, as a result of the lower projections and the increasing headwinds for the factor. We reduced the value of our investment, both the firstly in debt and the common equity by $11.4 million to $20.3 million.
VantaCore Partners, our third largest private investment is an aggregate mining and asphalt business with operations in Tennessee, Kentucky and Southern Louisiana. VantaCore’s products are used in the commercial, residential and highway construction businesses.
While, construction spending remains weak, VantaCore continues to see modest improvements in aggregate demand and in pricing for most its market. To the first five months in the year, VantaCore has outperformed its budget and generally met sales revenue expectation.
In early June, after the end of our second quarter, VantaCore announced the acquisition of Laurel Aggregates, which operate the large limestone quarry in Southwest Pennsylvania. The majority of Laurel’s product is supplied to the oil and gas companies drilling in the wet gas areas of the Marcellus Shale. The purchase of Laurel more than doubles VantaCore’s EBITDA and further diversifies the partnership from both the geographic and market perspective.
KED invested approximately $5 million in VantaCore common units to help finance the acquisition. As part of this transaction, VantaCore also re-negotiated its credit agreement and received more favorable pricing. VantaCore ability to pay cash distributions continues to be constrained by the cash generates to the limitations in it senior credit facility.
For the distribution, we received in May, 48% of the distribution was paid in cash. A balance was paid in paid-in-kind preferred equity. We expect to continue to receive a significant portion of our VantaCore distribution in the form of paid-in-kind equity for the next several quarters until demand in the construction markets for cohorts.
As a result of the Laurel transaction, we expect the relative portion of cash distribution to be significantly greater than it would have otherwise been. At the end of our -- at the end of the quarter, our VantaCore common unit valuation declined by $0.50 per unit to $0.825 per unit. This decrease was largely the result of the dilutive effect of additional preferred equity that was issued in lieu of cash distribution.
The total value of our VantaCore investment, which includes both common and preferred decreased just slightly 1% for the quarter, as the benefit of the Laurel Mountain acquisition was offset by substantial decline in the values of the publicly traded accountable companies.
In terms of new private investment opportunities, we’ve seen an increase in the opportunities that meet our investment criteria. While no transactions are imminent, we are encouraged by the increase in deal flow and continue to target transitioning our portfolio such that 50% to 75% of our portfolio is in private investment.
More importantly, any new investments must generate appropriate risk adjusted returns for KED. As I mentioned in our last call, we have been over earning our distribution for several quarters. We believe our decision to increase the distribution by $0.02 per share, provides a prudent cushion as we continue to access the potential monetization of some of our private investment.
With that, I’d like to turn the conference call over to Terry Hart, our Chief Financial Officer, who will discuss our financial performance and guidance.
Thank you, Kevin. First, I’d like to discuss our financial performance during the quarter. By quarter end, our net asset value was $22.68 per share, a decrease during the quarter of $1.86 or 7.6%. This decrease was primarily a result of declines in the value of our public MLPs and our investment in ProPetro. For the quarter, KED had a total return of negative 6%, as measured by the change in adjusted NAV, which includes the impact of distributions.
During the quarter, asset level performance was mixed for KED sectors. The total return of the public MLPs in our portfolio was negative 10.2% under performing a loss of 9.2% for the Alerian MLP Index. The total return of the private MLPs in our portfolio was 11.4% mainly driven by an increase in Direct Fuels.
Our debt portfolio excluding ProPetro had a total return of 2.9% outperforming the Bank of America/Merrill Lynch high yield energy index, which had a total return of negative 0.8%. And finally, ProPetro had a disappointing quarter decreasing its value from $31.7 million to $20.3 million for the total return of negative 35.9%.
As Kevin mentioned, our stock price decreased by 1.2% during the quarter but significantly outperformed both the Alerian MLP Index which declined 10.5% and the S&P 500, which declined 4.1%. Since quarter end, our shares have increased by 2.3% as of July 20th, compared to a gain of 9.5% for the Alerian MLP Index and gain of 4% for the S&P 500.
Now, turning to our results of operations for the quarter. We received $4.9 million of cash dividends in distributions of which $3.8 million was treated as return capital during the period. During the quarter, we received $1.5 million of interest income, of which $400,000 was paid-in-kind interest from ProPetro. We also received $600,000 of paid-in-kind dividends, of which $400,000 was from VantaCore. These paid-in-kind dividends are not included in investment income, but are reflected as an unrealized gain.
During the quarter, our operating expenses including management fees and interest expense were $2.4 million and after considering the impacts of income tax, we had $2.9 million in net realized gains and $18.2 million in net unrealized losses.
During the quarter, our net distributable income beat the midpoint of our guidance range by 3%. Our investment income was higher than projected due to higher interest income resulting from increased for the debt holding and rotations into higher yielding securities.
Our expenses were lower than expected as a result of lower management fees due to a decline in our asset values and lower franchise taxes due to a court case that overturned the constitutionality of these taxes in Louisiana.
On June 28, we declared a distribution of $0.41 per share. This distribution was paid on July 20th. On July 19th, we had $80 million borrowed under our credit facility, which represented 67.5% of our quoted borrowing base. The pricing on our borrowings was LIBOR plus 2% as long as our borrowings were less than the borrowing base attributable to quoted securities.
Now, turning to our guidance, we estimate that our portfolio would generate dividends, distributions, and interest income of approximately $6.9 million during the next quarter. This estimate includes cash distributions of $1.5 million per quarter from Direct Fuels and assumes $600,000 per quarter from VantaCore based on the cash distribution of $0.275 per share for the common and preferred A unit.
I should also point out this guidance’s pro forma for partial distribution that we expect to receive related to our $4.8 million incremental investment in VantaCore that closed on June 8th. Our guidance does not reflect any changes in cash distributions made by MLPs or changes in interest rates since May 31st. And our guidance is not a projection of investment income on a GAAP basis since it includes PIK distributions from Kinder Morgan and Buckeye Partners and excludes the impact of return of capital.
Based on projected borrowings of $82.5 million in our credit facility, we estimate cash, interest expense to be approximately $460,000, a similar LIBOR rate of 0.24% and a spread of 2%. We estimate our management fees to be approximately $1.44 million per quarter and other operating expenses to be approximately $400,000 per quarter.
Based on these estimates and assumptions, our net distributable income is projected to be approximately $0.44 to $0.45 per share for the third quarter of fiscal 2012. Our net distributable income in the third quarter is projected to be greater than our current dividend of $0.41 per share but we feel this level of payout is prudent and sustainable under a variety of different scenarios that could occur at our three largest private investments.
We will reassess our dividend guidance as we have more clarity regarding these potential future events.
Now, I’d like to turn the call back over to Kevin.
Thanks, Terry. That’s the end of our prepared remarks. At this time, operator, we’d like to begin the question-and-answer portion of our call.
(Operator Instructions) Your first question comes from the line of Selman Akyol, Stifel Nicolaus.
Good afternoon, Selman.
Selman Akyol – Stifel Nicolaus
Good afternoon, Kevin. A question for you, on the backlog of IPOs, you described them being mostly as non-traditional and I guess, I’m wondering how does that compare to what you’re seeing in terms of increased activity on the privates that you’re looking at investing?
Actually, the privates were looking at all three opportunities, sort of, come to our door step recently, are all sort of traditional mid-stream asset. That’s encouraging.
Selman Akyol – Stifel Nicolaus
And then, I guess, the follow-up there is, how -- what's the competition like with the private equity guys these days?
Very little competition in terms of what we’re trying to do in terms of forming a private MLP. The competition is really a sale process. The M&A market remains quite strong and so the question for these management team is do you sell now at an attractive multiple or do you form a private MLP growth business and then sell it two to three years down to take it public and that’s the math that most of these management teams are going through.
Selman Akyol – Stifel Nicolaus
All right. Thank you very much.
Thank you, Selman.
(Operator Instructions) There are no further questions at this time. I would now like to turn the call back over to Mr. Kevin McCarthy.
Thank you, Operator. With that, I’d like to thank everyone for the time this afternoon and for their continued interest in KED. Please refer to our website at Kaynefunds.com for future updates and we look forward to speaking with you on next quarter’s call. Thanks very much.
This concludes today’s conference call. You may now disconnect.