Kayne Anderson Energy Development Company F3Q08 (Qtr End 08/31/08) Earnings Call Transcript

| About: Kayne Anderson (KED)

Kayne Anderson Energy Development Company (NYSE:KED)

F3Q08 Earnings Call

October 9, 2008 10:00 am ET


Monique Vo – Investor Relations

Kevin S. McCarthy – President, Chief Executive Officer, Co-Portfolio Manager and Director

Terry A. Hart – Chief Financial Officer & Treasurer

James C. Baker – Vice President

J.C. Frey – Vice President, Assistant Treasurer, Assistant Secretary and Co-Portfolio Manager

David LaBonte - Senior Managing Director of Kayne Anderson Capital Advisors LP


John Kang - RBC Capital Markets

Alex Paul - Cedar Hill


Welcome to the third quarter 2008 earnings conference call for Kayne Anderson Energy Development Company. (Operator Instructions) At this time, I would like to turn the call over to Monique Vo, Vice President of Investor Relations.

Monique Vo

Before we begin this morning, 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 statements discussion in our annual report on Form 10-K and our quarterly reports on Form 10-Q. 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.

Kevin S. McCarthy

Joining me today in Houston are Terry Hart and Jim Baker and J.C. Frey and David LaBonte in Los Angeles.

First we'd like to review market conditions for the MLP sector both during the quarter and since September 1st, then we'll review KED's operational performance during the quarter ended August 31st, including a discussion regarding the performance of our five largest private investments. Next, Terry will discuss our financial performance and guidance based on our most recent portfolio. Then we'll open the phone lines for our Q&A session.

I probably don't need to remind anyone on the call that the global financial markets have deteriorated substantially since the end of our fiscal quarter. But before I discuss recent events, let me review what happened during the quarter.

The quarter began strong, with MLPs trading at the highest level since the beginning of the year. In June and July MLP prices went down approximately 8% as high commodity prices sparked concern about energy conservation and the Dow fell by almost 10%. After reaching a low point on August 5th, the Citi MLP Index increased by over 5% through the end of the quarter. Most industry participants were anticipating further strength in September and did not foresee the massive downturn the MLP sector was about to endure.

Since quarter end, the broader equity markets have declined significantly as a result of the global credit crisis. Between August 31st and October 8th, the Dow declined 19.7%. During this period the MLP market has been devastated. I hesitate to use such a strong word, but I think it's appropriate. Since the end of the quarter, the Citi MLP Index is down 35.8%. It is down 23% in the last five trading days. To give you a perspective on the magnitude of this decline, the largest quarterly decline for MLPs in the last 15 years was only 14%.

There are many reasons for the comparatively weak performance in the MLPs. What I'd like to highlight is that we believe the reasons are largely technical as the operating performance of the MLPs continues to be very strong. During the quarter, MLPs increased cash distributions by 12% year-over-year. While commodity prices have come down, processing spreads have remained strong, and concerns that high gasoline prices would lower demand have been mitigated.

What are the technical factors at play? Well, MLPs have been indirectly impacted by the credit crisis in several ways. First, the bankruptcy of Lehman had a significant impact on the sector. As one of the top three underwriters in the space, Lehman's retail system was a substantial owner of MLPs. Lehman's proprietary desk had participated in many pipe transactions and owned a significant number of MLPs in their book. Lehman also had a large dedicated fund of MLPs with close to a billion of assets that has become entangled in the Lehman bankruptcy.

Second, we believe that the investment and commercial banks that provide leverage to certain institutional funds, whether through prime brokerage accounts or total return swaps has continued to tighten their credit standards. This forces these hedge funds to either post more collateral or, more likely, sell securities.

Third, there's been some deleveraging among the dedicated MLP closed-end funds, including Kayne Anderson's two closed-end funds, in order to keep within leverage limitations. It's simply not possible to maintain strong credit ratios in light of a 35% decline in assets without reducing leverage.

Finally, we've seen retail investors who are understandably nervous about general market conditions convert some of their MLP holdings to cash.

The biggest question on the minds of all MLP investors is when is this going to turn around, and unfortunately, I don't have the answer to that. Clearly, we need to have a stabilization in the overall capital markets and an easing of the credit crunch. After that, we think that historically low MLP valuations will eventually bring investors back to the sector.

Right now, the simple average yield in the MLP universe is 13.4% whereas over the last 10 years the average yield has ranged between 6% and 10%. Of the 35 midstream MLPs, only four are currently trading at a current yield of less than 10%. The remainder are all trading at double-digit yields. As of yesterday, the spread to 10-year Treasuries for MLPs was over 700 basis points compared to its 10year average of 284 basis points.

We firmly believe that strong operating fundamentals and compelling valuation measures will prevail over time and that MLPs will generate strong risk-adjusted returns for investors over the intermediate and longer term.

I'd like to spend a minute discussing our share price performance during the third quarter. KED's share price declined $1.02 or 4.3%. Between August 31st and October 8th, our share price declined $10.48 or 45.9% to $12.37 per share. We're obviously disappointed in the stock price performance. We're hopeful that the operating results and the net asset value we released yesterday confirm that KED's business prospects remain intact in spite of the turbulent credit and MLP markets.

During the first quarter, KED had a total return of negative 3.8% based on the change in NAV plus dividends paid during the quarter. KED outperformed the Citi Index by 1.9% during this period. The decrease in NAV was principally the result of unrealized losses of $7 million and realized losses of $6.4 million on our portfolio. Of the $6.4 million in realized losses, the majority or $5 million was attributable to the SemGroup bankruptcy that we previously disclosed. Unrealized losses were comprised of losses of $8.2 million on public MLP and affiliates, partially offset by unrealized gains of $700,000 on fixed income securities and $500,000 of gains on private MLPs.

With regard to the private MLPs, we had a decline in the valuation of direct fuels by $7.1 million, offset by a $3.9 million increase in the valuation of Millennium, a $1.8 million increase for VantaCore, and a $1.9 million increase for International Resource Partners.

Last week we announced our quarterly distribution at $0.42 per share. Based on yesterday's close of $12.37, we are now yielding approximately 13.6%.

As of August 31st, our long-term investment portfolio consisted of 87% equity securities and 13% fixed-income securities. Since the beginning of the year, the percentage of fixed-income securities has declined substantially. This shift is consistent with our plans to increase our equity holdings after electing to no longer be treated as a regulated investment company or RIC in February of this year.

Let me now turn to an update of our five largest investments. Despite the difficult quarter, all of our private investments except for direct fuels increased in value or remained flat. One of our largest investments is in Direct Fuels, a specialty refining, storage and distribution company in the Dallas-Fort Worth area. After exceeding budget in every quarter since we made our investment, Direct Fuels had a very difficult quarter operationally.

Most of the weak performance was attributable to its wholesale gasoline and diesel business. In this business, the company purchases products in the Houston market and arranges for the transportation to its storage facilities in the Dallas market and then sells the product to wholesale fuel distributors who ultimately supply the local gas stations. Inventory gain or loss is typically not large in this business as the inventory holding period is typically two to three weeks.

During July and August, Direct Fuels was affected by an unprecedented decline in the price of both diesel and gasoline, which fell more than $0.73 a gallon between mid-July and mid-August. This significantly impacted the profitability of the partnership's wholesale business. The partnership's core business, transmix refining, was not impacted to the same degree because of the significantly higher margins and shorter inventory holding period. Margins have recovered again in September, allowing the partnership to report positive EBITDA for the quarter, but at levels well under budget.

We're actively working with Direct Fuels to reassess the wholesale business model to determine if there are ways to reduce volatility, lower inventory and lower working capital costs. As a result of this process, we have lowered our forecast to reflect more conservative margins, which we believe are sustainable in a variety of pricing environments. As a result, we decreased our per-unit valuation of Direct Fuels by 13% during the third quarter from $24.00 to $20.80.

Another large MLP investment is Millennium Midstream Partners, a natural gas gathering and processing company with operations in Texas, Louisiana and the Gulf of Mexico. On September 11th Millennium entered into a purchase and sale agreement with Eagle Rock Energy Partners for the sale of Millennium for total consideration of approximately $236 million, which consisted of $181 million in cash and 4 million Eagle Rock common units with an implied value of $13.75 per unit.

KED's portion of the sale proceeds consisted of $37.5 million in cash and 1.7 million unregistered Eagle Rock units. A portion of our proceeds, consisting of $227,000 in cash and 687,000 units has been placed in escrow for 18 months. The transaction was closed on October 1st.

We were very happy to close on the Millennium transaction because we believe it validates our strategy of investing in high-quality midstream companies. Based upon the agreed-upon value of the Eagle Rock common units of $13.75, we recognized a pre-tax gain of $17 million upon closing of the transaction. This gain is based on our fair market value of the consideration received, including cash in escrow and the Eagle Rock units received. Based on the expected proceeds from the escrow and the holding period for the Eagle Rock units, we intend to initially assign a fair market value on the Eagle Rock units equal to approximately 92% of fair market value.

Since the transaction price was negotiated in early September, there's been a significant deterioration in the price of Eagle Rock units. Any changes in value of the Eagle Rock units compared to the agreed-upon value will be recognized in future periods as unrealized gains or losses. As of October 8th, our unrealized pre-tax loss was $7.8 million based on the closing price of $8.76 per unit.

I'd like to point out that we believe Eagle Rock's assets and business strategy are sound. Unfortunately, the stock has been disproportionately hurt compared to other MLPs as Lehman Brothers was the largest institutional owner, with over 14% of the units as of June 30th.

Because of the recent volatility in Eagle Rock's closing price, the company is providing a range of internal rates of return on its original investment in Millennium. These return analyses are detailed on our website. I refer you to those pages for details, but to summarize, depending on the prices assumed for the Eagle Rock common units, the IRRs range from 15% to 21%. These figures incorporate the liquidity discount I mentioned before. We're marking the units at 92% of current market value. Assuming no liquidity discount on the Eagle Rock units, the IRRs range from 16% to 23%.

During the quarter we increased our per-unit valuation of Millennium by 5.4% from just over $24.00 to $25.31. This valuation reflected in part the terms of the transaction that was being negotiated with Eagle Rock at that time. Because the value of the transaction decreased slightly during the final negotiations and because the Eagle Rock units have declined in price, the valuation of the cash and units received from Eagle Rock is now currently less than the $25.31 per share.

KED's cash proceeds from Millennium were used to repay indebtedness and to make additional investments. On October 2nd we used proceeds of $37.3 million to pay down our revolving credit facility. Through October 7th, KED has purchased $7.5 million of public MLPs and $9.1 million of fixed-income investments and plans to borrow under the credit facility and use cash on hand to settle these purchases. While the turbulence in the market has negatively impacted our existing portfolio, it did allow us to make these investments at very attractive prices.

Our third-largest investment is International Resource Partners, a coal producer in Central Appalachia. IRP's yearto-date EBITDA results are 74% ahead of budget through August, primarily driven by higher met coal prices and better-than-expected performance in the partnership's coal marketing business. This has more than offset disappointing operating performance at the partnership's surface mines, which have missed production targets due to adverse mining conditions. I point out that the partnership's core business - underground met coal production  continues to hit production targets.

Spot market prices for metallurgical coal, which provides roughly half of IRP's cash flow, are over $200 per ton compared to $85 per ton at the time we invested in IRP. Spot market prices for steam coal are currently $110 per ton compared to roughly $50 per ton at the time we made our investment.

Because a substantial portion of IRP's coal production in 2008 is sold under long-term contracts, the average realized price is substantially below spot market prices. For example, in the third quarter it sold met coal at an average price of $120 per ton and steam coal at an average price of $53 per ton. These contracts begin rolling off in 2009 and we expect that IRP will be able to sign new contracts at higher rates. Consequently, we have increased our estimate of 2009 EBITDA and have raised IRP's valuation from $23 to $24 per unit.

Now I'd like to turn to our fourth-largest investment, ProPetro. We have some encouraging news to report about ProPetro on two fronts.

First, we're happy to report that ProPetro's operating performance has improved substantially over the past several months. In fact, August results were the best of the year. Revenues were approximately 80% higher than the low point, March, of this year. While one month's results are clearly too early to declare a victory, the results are certainly encouraging. These results were driven by a meaningful turnaround since the return of Bill Martin, the former owner of the Utah business, combined with a stronger outlook for drilling activity in Utah. Anadarko Petroleum, ProPetro's largest customer, projects production increases of 10% per year in the Rockies, and we believe they'll increase their activity in the Uinta Basin over the next several years.

ProPetro is also in preliminary discussions to sell certain of its mid-continent assets. While at a very preliminary stage, if such a transaction were completed it would allow ProPetro to repay indebtedness, provide liquidity to fund certain growth opportunities in Utah, and to allow the management team to continue to focus on its core operations in the Rockies. Given the turbulence in the credit markets, the execution of any transaction is far from certain.

Last quarter we reported that we were attempting to convert our loan in ProPetro to a PIC loan at a higher rate. Negotiations between ProPetro and its lending group are progressing at a slower rate than expected due to the demands of certain first lienholders, but we remain optimistic that the first and second lien debt holders will be able to negotiate an amendment with the company.

In spite of these positive developments, we've left our valuation of ProPetro unchanged at $20 million or 57% of par value given the substantial execution risks that remain. We believe there's upside to our current valuation as the turnaround progresses, the balance sheet is restructured, and to the extent that a sale of assets is completed.

Our final significant private investment is VantaCore Partners, a private MLP which operates an aggregate quarry and asphalt business. On August 4th VantaCore acquired Southern Aggregates for approximately $50 million. Southern's assets consist of four sand and gravel operations near Baton Rouge, Louisiana. We believe this was a very attractive acquisition because it diversified the geographic operations of the partnership, it provided opportunities for growth in volumes as competitors' mines are depleted, and it was expected to be immediately accretive to VantaCore's distributable cash flow.

As part of the transaction, KED's ownership of the senior secured term loan with a principal amount of $7.5 million was redeemed at 103% of par. KED used these proceeds, along with $12.3 million of new funds, to purchase $20 million of VantaCore common units. The purchase price of $20 per unit was reduced to $19.50 per unit in lieu of KED receiving a cash distribution with respect to VantaCore's second quarter. As a result of this transaction, KED now owns 1.5 million units of VantaCore and we've raised our valuation of VantaCore by approximately 2.1% from $20.44 to $20.87.

Subsequent to quarter end, the Southern Aggregates operations were negatively impacted by Hurricane Gustav as most of Baton Rouge lost power for several days. While Southern Aggregates operations and its customers are now back online, this event will negatively impact VantaCore's results for the month of September. As a result, we currently expect that the acquisition will be neutral on a DCF per-unit basis for the remainder of the year. We continue to believe that the acquisition will be accretive during 2009.

Let me spend a minute talking about Quest Midstream Partners. This is not a large investment for KED  our original cost basis was $7.5 million - but it's worth a discussion because of the events at the general partner. On August 25th, Quest Resources, Quest Energy Partners, and Quest Midstream, the private MLP, announced that its CEO had resigned due to questionable transfers from the company funds to entities controlled by him. Since that date, the CFO has been terminated and the outside auditing firm has resigned. Not a pleasant situation to say the least, but I'd like to make a few points.

First, please realize that this is a very delicate legal situation, so I have to be restrained in what I can say.

First, we believe that the private partnership will have little direct exposure to the loss of funds, if any.

Second, we believe that the biggest risk to the private partnership is that any financial difficulties at the two public companies  Quest Resources and Quest Energy Partners - may reduce the drilling activity on the oil and gas properties that are behind the midstream assets in the private partnership, thus impacting future volumes transported on our gathering system.

Third, we believe we are adequately protected under the terms of the partnership agreement. The limited partners can force a sale of the assets and are entitled to receive their original investment from the proceeds of the sale before any money gets distributed to the subordinated unit holders.

Finally, we've been asked by many investors what we can do differently to avoid such a situation in the future. I can assure you that we'll continue to conduct in-depth due diligence prior to making any large investments, including going forward a background check regardless of whether a company is public or not.

I would remind people that there are practical limitations to even the best of diligence. If it turns out as alleged that there was fraud involved and that fraud was not detected by the independent auditors, the independent Board and the underwriters of the public offering, there's a chance that we can't uncover what's missed by others, especially when we're not a controlling investor.

Now let's turn to our leverage situation. Against the backdrop of the global credit crisis, I'd like to walk through KED's leverage position and liquidity. As of August 31st, KED's leverage was $77.5 million, which represented 25.3% of total assets. At that time KED's borrowing base was $85.2 million.

During August we started to have discussions with our lenders to modify certain provisions of our credit facility which limited the amount we could borrow against our total holding of private MLPs. Given our shift in strategy, we believe that more flexibility was required. In September we received such an amendment from the banks without any increase in rate. As a result of this amendment, the borrowing base as of August 31st would have been increased by $13 million to $98.2 million.

After the Millennium transaction closed on October 1st, we used $37.3 million of the cash proceeds to pay down our revolving credit facility. As of October 7th, we had $37 million of borrowing with $63 million remaining available under our investment facility at an average interest rate of 3.7%.

With that, I'd like to turn the conference over to Terry Hart, our Chief Financial Officer, who will discuss our financial performance and guidance.

Terry A. Hart

During the third quarter we had a net decrease in net assets resulting from operations of $9 million and our net asset value at the end of the quarter was $224.2 million or $22.19 per share. This compares to a net asset value as of May 31st of $236.8 million or $23.51 per share.

KED had a net investment loss for the third quarter of $600,000, which included $400,000 of deferred income tax benefit.

Interest income earned from KED's fixed-income investments and its short-term investments were the primary components of its $1.9 million in investment income for the period.

KED received $5 million in dividends and distributions, of which $3.8 million was treated as a return of capital resulting in a net contribution to investment income of $1.2 million. During the third quarter we lowered our estimate of return of capital from 97% to 90% based on the 2007 K-1s received from our private MLPs.

Operating expenses for the period were $2.9 million, including $1.3 million of base investment management fees, $1 million of interest expense, and $600,000 for other operating expenses.

During the third quarter KED had net realized losses from its investments of $4 million and net unrealized losses of $4.4 million net of income taxes. Our pre-tax losses of $5 million on the sale of equity and debt securities of SemGroup were the driver of the $6.4 million pre-tax realized loss during the third quarter.

On October 2nd, KED declared a dividend of $0.42 per common share or $4.2 million based on its third quarter results.

As of August 31st, KED had $77.5 million of borrowings, with $22.5 million remaining available under our investment facility at a weighted average interest rate of 3.72%. As of October 7th, we had $37 million of borrowings, with $63 million available, at a weighted average interest rate of 3.74%. We anticipate borrowings of approximately $16 million to fund securities that we have recently purchased.

Now let's turn to our guidance, which we review on a quarterly basis and provide updates as necessary. Let's start with dividends, distributions and interest income that we estimate can be earned from the portfolio.

I'd like to emphasize that the portfolio composition and the average yields are as of October 7th instead of August 31st to provide a more-recent snapshot of the portfolio and to capture the impacts of the Millennium sale, including the reinvestment of a portion of the proceeds made since closing. As always, we report any additional changes to the portfolio as of the end of each quarter.

With that caveat in mind, our portfolio at October 7th consisted of $52.8 million invested in public MLPs and MLP affiliates, with an average yield of 13.9%, $14.1 million invested in Eagle Rock units associated with the Millennium sale, with a yield of 19.8%, $124.8 million invested in private MLPs, with an average yield of 8.4%, $24.7 million invested in fixed-income securities of private companies with an average yield of 11.3%. Both the dollar amount and the yield exclude our investment in ProPetro. And lastly, we had $2.5 million of investments in repurchase agreements with a yield of 1.9%.

Based on this portfolio we estimate dividends, distributions and interest income to be approximately $5.8 million per quarter. Please note that this estimate does not include the impacts of return of capital which will reduce net investment income reported under GAAP. Additionally, this estimate does not include interest income from our ProPetro investment as we do not anticipate receiving a cash interest payment during the fiscal fourth quarter.

Now let's turn to our estimates of interest expense and operating expenses. Based on $37 million borrowed on our revolving credit facility at October 7th and the anticipated borrowings of $16 million to settle purchases of securities over the past several days, we estimate interest expense to be $800,000 for the quarter. We estimate our base management fees to be approximately $1 million per quarter and other operating expenses are estimated to be approximately $600,000 per quarter.

We do not provide guidance on realized gains or incentive management fees but, as mentioned previously, including the pre-tax gain on Millennium of approximately $17 million, we have had approximately $9 million of after-tax realized gains for the year. I'd like to point out that the guidance provided is a run rate estimate and not a projection for the fiscal fourth quarter. Due to the timing of the Millennium sale, we did not receive a distribution during the fourth quarter for Millennium or on the new Eagle Rock units. Effectively, the sale price of Millennium included the values of these foregone distributions.

In addition, please note that the guidance includes a distribution on the VantaCore common units purchased during the fiscal third quarter. KED did not receive a cash distribution on those units during the quarter. Instead KED elected to reduce the purchase price per unit in lieu of such distribution. KED will receive a distribution on the VantaCore units commencing in the fiscal fourth quarter.

I'd like to turn the call back now to Kevin.

Kevin S. McCarthy

That's the conclusion of our prepared remarks. At this time we'd like to begin the question-and-answer portion of the call.

Question-and-Answer Session


(Operator Instructions) Your first question comes from John Kang - RBC Capital Markets.

John Kang - RBC Capital Markets

I guess when you look at the average yields for your private equity investments, would you say, I mean, obviously you're relatively fully invested but, as you look forward, are you seeking to receive higher yields or are you still basing your buying decisions on, I assume, fundamentals of the underlying business more than the yield as you look for good rates of returns on your initial investments.

Kevin S. McCarthy

Yes. I mean, I think certainly the dividend rates on new privates we expect are going to be higher, but we really look and evaluate the whole package. We look at the coverage ratios. We look at comparable M&A values. I don't think we would get many privates done if we went out and said the rate on the privates had to be 19%. We still think we can do private transactions with good coverage ratios at a 9% to 10% current yield which could have very attractive internal rates of return to us.

John Kang - RBC Capital Markets

And then, Kevin, I was wondering if you could just give a just a general overview on how you mark to market the value of your private equity investments? I assume there's probably no real change in your general methodology, but I wonder if part of this current market stress - and that's kind of being kind - does that factor in in any way in the current environment?

Kevin S. McCarthy

Well, realize the valuations and the NAV that we disclosed yesterday are based on our fair market value assessment as of the end of the quarter, August 31st, and it reflected the market conditions at that time.

From a methodology standpoint, we really haven't changed anything in that we look at a variety of factors, including where the public companies are trading, what the coverage ratios are relative to the public companies; also what the M&A values are if we were to turn around and sell that business. So our methodology is the same, but we tend to look at more than just the factors of what the current share price is in the market, which we're obviously forced to do with our public MLP securities, and we take in an entirety. And there's some times where frankly the M&A  there's some markets where the M&A valuation would be lower than public market comparables and there's some times when it could be higher.

John Kang - RBC Capital Markets

And just a last question from me on International, are you able to tell us how much is surface versus underground, how much is met versus steam?

Kevin S. McCarthy

It's probably - on the steam versus met, it's probably best to talk about contribution to cash flow. And as I mentioned in the prepared remarks, it's roughly, based on current year, roughly 50-50. Going forward with substantially higher - you know, met coal has increased disproportionately relative to steam coal, so going forward the company will get more and more of its cash flows from met coal.

Jim, do you recall surface versus steam? It's about the same, right?

James C. Baker

As far production?

Kevin S. McCarthy


James C. Baker

Production is roughly equal, yes.

Kevin S. McCarthy


James C. Baker

A million tons for each order of magnitude.

John Kang - RBC Capital Markets

And then just as a quick follow up to that, with the met coal, approximately how much of that is already committed and priced or is that pretty much still open to current market for '09?

James C. Baker

John, the majority is already priced for 2009. There are pricing bands, so there's a $20 per ton range, but they are in negotiations to set that. The majority, the vast majority, for 2010 is unpriced on the met side, and so the interplay in negotiations would be to reassess the contract and the contract price for 2009 in return for increasing the contracted amount in 2010. Those negotiations are under way.

I'd say as we sit here today the majority is contracted. It's contracted in a range that is similar to the 2008 rates, but we do remain hopeful given the current prices in the market that we will be able to contract what is uncontracted at very attractive rates as well as hopefully reassess already contracted 2009 levels and adjust those price bands that were negotiated a year or two prior.

Kevin S. McCarthy

So we're expecting a substantial increase really just based on the repricing of the open tons from 2008 to 2009, but we're also expecting a substantial increase from 2009 to 2010 as a significantly higher percentage of the production becomes uncontracted in 2010. 2010 is pretty much the full impact of current market.

John Kang - RBC Capital Markets

And is it primarily a few domestic customers or is it - on those contracted tons?

Kevin S. McCarthy

Well, the company has the benefit of this marketing business, LMK, which is the second-oldest coal marketing business in the country, that has extensive both domestic and international customers. So on the met coal side they've got some big contracts with India and continue to look to sell that coal internationally.

John Kang - RBC Capital Markets

So that should give you some flexibility for 2010, then?

Kevin S. McCarthy

And we really see in this year the benefit. If you were a typical Appalachia coal producer with most of your production contracted, you wouldn't see the real benefit of the substantially higher prices. The company's been able to realize some of that through its marketing arm, which is why EBITDA is so high above budget this year.


Your next question comes from Alex Paul - Cedar Hill.

Alex Paul - Cedar Hill

I never thought it would reach this point, but what I'm curious about is with the remaining capacity in KED, does it even make sense to be considering more private investments given where the public stocks are trading and what kind of hurdle rate would you have to expect from an IRR basis to be doing a private deal?

Kevin S. McCarthy

Well I think, certainly, our IRRs, before we had always talked about sort of 18 to 20 base case IRRs when the public securities were in the sort of 12 to 14 range. I think to make a new investment right now, given the opportunities in the public space, you'd certainly be north of 20 in your IRR expectations. I think in this market, Alex, you need to remain flexibility, remain liquid. If we see a good opportunity out there, we have some capacity to act, but we'll be very selective at this point.

Alex Paul - Cedar Hill

Have you guys heard anything more specific about what Lehman has been doing since they've gone into a trustee situation there?

Kevin S. McCarthy

No, and when you talk directly to the individuals at Lehman, they really don't know as well. I mean, it is a very complicated process. Most of it is happening in London. And it's unclear to everyone involved what's happening to the assets that were controlled by the Lehman hedge fund.

Alex Paul - Cedar Hill

As far as their prop book, who is - Barclays own that now? Who owns that part of the business?

Kevin S. McCarthy

Not clear. The prop business probably had a lot more flexibility to sell their securities in the days before and days after the bankruptcy. So I think that no one knows for sure, but there's probably a higher likelihood that those have already been monetized based on some of the blocks we've seen.

Alex Paul - Cedar Hill

Well, J.C., what are your traders hearing as far as who are the major sellers these days?

J.C. Frey

Clearly retail is the largest holder of MLPs and you would suspect that, considering everything that's going on in the market with money market accounts breaking a buck and things like that, that retail investors have sought to reduce leverage, reduce their margin requirements. So they're sellers. You keep hearing about various institutions out there selling. Certainly Lehman had a major impact on the market. It's hard to quantify exactly how much it was.

And what you haven't heard is much in the way of who's buying, and clearly there's somebody on the other side of the trade. And so there are buyers out there; it's just they're waiting for a certain price.

Kevin S. McCarthy

I think, Alex, given the magnitude of the decline we've seen in the last three days, it's impossible to pinpoint one party or group of people that have been causing it. I mean, it's pretty much widespread selling by most of the holders of MLPs.

Alex Paul - Cedar Hill

Have the securities been trading in a fairly liquid manner, though, or has it been you try to sell 100 shares and the bid goes down by another half?

Kevin S. McCarthy


J.C. Frey

Well, I don't think it's, you know, you sell 100 shares and the bid goes down by half as much as, you know, what you saw yesterday was extreme violence that there wasn't that kind of trading. Things just gapped down.

And I suspect there's a - it's a combination of things. You have likely forced sellers so, whether brokerages are causing their clients to, you know, individual accounts to sell is one thing, due to no longer meeting margin requirements. Also retail investors in this time tend to exacerbate some of the trades because they often use stop-loss orders and things like that, and so that creates an overhang due to the stop-losses becoming market orders. There are, I'm sure, hedge funds out there, both dedicated and non-dedicated, who are experiencing difficulties and who may be levered and seeking to reduce leverage.

And of course there's the swap market, where you have, you know, you may have to delever, unwind swaps, to meet margin requirements. Many rumors out there of various parties exiting the space. Goldman Sachs is out there reducing their swap exposure to MLPs.

And so this all has a convergence type effect where it's a perfect storm for selling. And with the broader markets being as weak as they are, there's very little conviction. Yesterday MLPs weren't the only things that were down. The broader markets were quite negative early in the day. You've seen REITs sell off quite dramatically. Most other energy related asset classes like shipping, coal, Canadian trusts, you know, you name it, have all experienced weakness. So MLPs aren't, you know, you can't just sit there and look at MLPs in a vacuum.

Alex Paul - Cedar Hill

No, certainly not. The difference here is, in my mind at least, is what is the impact of the businesses going to be on the MLPs because of this situation, and what do the future growth rates look like if I look out to 2010, 2011?

J.C. Frey

That's a great point, and it's, you know, 2008's likely to go down as one of the biggest growth years on record with some of the largest coverage ratios we've ever seen. Certainly we've cut back our expectations for growth in 2009 on average [from MLPs]. You're looking probably in the 8% or so range. A large portion of that growth is coming from acquisitions and expansion projects that have already been - they already have taken place or are largely  you know, they're already been placed in service or they are pretty far along in terms of development.

And my argument would be that I don't know how much growth you really need when you're yielding 13.5%, 14%. You know, Warren Buffett took back paper at 10% in a company that was on the ropes with the prospects of AIG going bankrupt. So a 13.5% yield today, 14% yield with an 8% growth rate in '09 and you're probably going to see 2%, 2.5% growth this quarter in the next couple weeks. Those are pretty good numbers.

And it's just a matter of time before you have some stability back in the market. You need to get past the elections. You need to get retail - what's the best way to reconcile what has happened to them over the last 12 months with, you know, Bear Stearns, SocGen, Fannie Mae, Freddie Mac, you know, Prime Reserve, you name it. There's been a lot of shocks to the retail system and at some point they're going to get tired of earning 50 basis points on their 90day Treasuries.

Kevin S. McCarthy

Certainly, Alex, we do think that more difficult access to capital will slow growth rates. What the growth rates actually are in 2009 will be both a function of the capital spent as well as the decision by the Boards of the MLPs on how much to increase at what rate given the difficult market conditions. So it's very difficult to tell, but I would reiterate what J.C. said, which is we still think the total return valuation prospects for the MLP sector are very strong in spite of the more difficult capital markets next year.


There are no further calls.

Kevin S. McCarthy

I'd like to thank everybody for their time this morning and continued interest in KED, especially in these difficult financial times. I look forward to having further updates in conference calls in the future. Thanks very much.

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