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China Education Alliance gets a grade of "F" (for "Fraud")
In this article, I’m going to examine China Education Alliance and provide evidence that the company is inflating its financial statements. China Education Alliance (“CEU” or the “Company”) is an online distributor of educational material with a website that fails to work and receives minimal online traffic, company facilities that are empty and unused, egregious shareholder dilution for no sensible purpose, SAIC financial statements that don’t match SEC filings, a history of small no-name auditors, and suspiciously unreasonable margins.
This article summarizes key points that I have put together in a longer report available here.
Today, CEU trades at a market capitalization of $150 million and its shares are listed on the New York Stock Exchange. In actuality, the stock is worth little more than the $20 million of cash it raised in its 2009 secondary offering, if indeed that cash still resides in the company’s bank account.
To most clearly illustrate my evidence, I have compiled four videos to (i) demonstrate how the company’s websites do not function properly and are unlikely to be as profitable as the company claims and (ii) provide evidence that the company’s training center, which ostensibly generates more than 30% of the company’s revenue, is actually an empty, unfurnished and unused building.
In this article, I also provide SAIC filings that show that the company reported less than $1 million of revenue to the Chinese government in 2008, the year of the most recent filings available.
In addition, I compare CEU with three other Chinese online education providers: DL, CEDU and CAST. Of these companies, CEU is the only company with non-functioning payment methods on its websites. Of these companies, CEU is the only company with dozens of broken links and html errors on its websites. Of these companies, CEU is the only company without a top 4 auditor. In fact, CEU has had 4 different low quality auditors in the past 6 years. CEU receives less web traffic to its sites than the sites of DL, CEDU and CAST by a large margin. Yet investors are to believe that (i) CEU generates gross and EBIT margins that far outpace these comparable companies and (ii) CEU generates revenue that is greater than DL and within range of CEDU and CAST?
Our Videos
Video - Part 1: Core Website Has Non-Functioning Payment System
Video - Part 2: Further Website Errors and Comparison with a Comparable Website
Video - Part 3: More Broken Links, Irrelevant Content, and a Flaw with CEU’s Business Model
Video - Part 4: Evidence that the Company’s Training Center is Empty, Unfurnished and Unused
Our first video introduces the website and demonstrates that visitors cannot purchase products from the company’s website, despite the fact that CEU is primarily a provider of online education.
Our second video examines the company’s online educational game website www.pk1234567.com and demonstrates that it neither works nor generates revenue through online payment because the payment options for the game are non-functional. The second video also contrasts www.edu-chn.com with the properly functioning websites of China Distance Education Holdings (DL), and shows how visitors can in fact purchase products from DL’s websites, whereas they cannot from CEU’s websites.
Our third video shows numerous broken links and faulty html on the edu-chn.com website, as well as examples of inappropriate, irrelevant and outdated content. It also explores a fundamental flaw with CEU’s business model: free test papers and examination material are readily available on the web, and it is unclear why students would pay for content, if in fact the site’s payment options were to be functional.
Our fourth video shows the results of our investigation into the Company’s training center (Heilongjiang Zhong He Education Training Center), which according to SEC filings provides more than 30% of the company’s revenue. Through video footage and more than 40 pictures, we provide evidence that the company’s training center is in fact an empty, unfurnished and unused building. We’re skeptical that this vacant building contributed $11 million of revenue in the first nine months of 2010 (in presentations, management has claimed that the Heilongjiang training center contributes 60% of total training center segment revenues, but even then, we’re equally skeptical that this empty, unfurnished center contributes $5-$6 million of revenue).
Website Usability
The company’s websites do not work, despite the fact that CEU is an online education provider and its websites are the company’s main revenue-generating assets. The websites have non-functioning payment methods and are full of broken links and HTML errors.
Numerous attempts to purchase products online yielded no success. All payment methods on the company’s websites led to error messages. We had multiple investigators call the phone numbers on the websites to try to purchase products. The numbers either led to recorded messages during business hours or the callers were told that the cards “could only be purchased on site in Heilongjiang”. On several calls, the operators answering the phones were not able to provide any information on where these sites were located, although one operator said that cards are “sold at book stores around schools in Harbin”. The cards could not be purchased over the phone.
Click here for a report from one of our investigators who tried to purchase the company’s products online and over the phone. The investigator is a resident of Harbin.
Seeing that it’s impossible to purchase access to CEU educational materials via the Internet or by phone, we became skeptical that CEU could have a strong enough presence locally in Harbin to generate the revenue reported to the SEC. We hired an investigator to visit bookstores near schools in Harbin to search for these debit cards. Our investigator visited fifteen locations, none of which carried CEU learning cards. Of the fifteen bookstores visited, only two sold learning cards, and neither was for edu-chn.com. One was for a competitor we were not familiar with,www.taiqiedu.com, and the other one was for websites of DL. The other thirteen bookstores did not sell learning cards at all. The addresses and a picture of each visited bookstore can be seen in the PDF linked to below. Our full set of pictures of the bookstores are available at this Flickr account. As a result of our investigation, we do not believe that CEU has a strong enough presence either online or locally in Harbin to generate even a fraction of the revenue reported to the SEC.
Click here for the bookstore addresses and pictures.
To summarize, our investigators could not purchase learning cards on the Internet, over the phone, or in person.
These additional errors were encountered while trying to navigate edu-chn.com:
Website Traffic
A variety of online services monitor visitor traffic to websites and make that information available to the general public. We examined traffic reports from the most popular of these services, Alexa.com, as well as one of the most useful traffic information resources in China, chinarank.org.cn.
Both sites demonstrated low traffic to CEU’s websites. When we compared CEU websites to websites operated by DL and CEDU, we found CEU generates a tiny fraction of its competitors’ traffic, yet reports similar revenue.
We provide screenshots and more detailed analysis in our report, and the data shows the following:
Below is a comparison of edu-chn.com’s traffic data when compared with 5 websites of DL.
Training Facility
The Heilongjiang Zhonghe Education Training Center is located at Building 39, High & New Technology Developing Zone, Sidao Street, Qianshan Road, Nangang District, Harbin, Postcode: 150080. This information can be found inexhibit 10.4 in the 10KSB filed in 2006.
The company has not moved its location since 2006. Here is disclosure from its 2006, 2007, 2008 and 2009 10Ks about the training center. As we can see, the company has described the training center as having “17 modern classrooms that has a capacity for 1,200 students” since its inception, and refers to it by the name “Heilongjiang Zhonghe Education Training Center”. Throughout SEC filings and in MD&A, the company consistently refers to a single training center that began operations in 2006.
According to documents filed with the SEC, in 2009 this 36,600 square foot facility generated $12.1 million of revenue at a 78.8% gross margin. Management, however, has claimed in conferences that this facility is only responsible for approximately 60% of segment revenue, with the other 40% coming from smaller satellite facilities. These claims conflict with disclosures in SEC filings, but even if we assume that only 60% of the segment’s revenue comes from the Heilongjiang Zhonghe Education Training Center, that’s gross income of $156 per square foot. Average rent for Class A office space in Manhattan is $71 per square foot per year. This amazing profitability is something we needed to understand better, so we hired an investigator to visit the school. We found that if CEU is able to generate $156 per square foot, they apparently don’t even need furniture to do it.
Our investigator took more than 45 photos, as well as video footage. What we found was a vacant, unfurnished building, with little sign of use. We have created a video that features our investigator’s photos and video footage, as well as general evidence for why the company’s training center is a façade.
Click here for our video on the training facility
Further details on the training facility are available in our longer report.
Financial Comparison with Competitors
Given the faulty website and the empty training facility, it remains impossible for us to understand how this business generates the same revenue, better margins, and higher earnings than its competitors with functional websites, national scopes, and utilized training facilities. We compared CEU to DL, CEDU, and ChinaCast Education Corporation (CAST). We chose not to look at New Oriental Education & Technology Group (EDU) because we believe it is a fundamentally different business with a larger scale, but we do note that it has much lower margins than CEU. We also include the numbers for the Princeton Review (REVU), a popular US test-prep company with which US investors should be familiar. Its use as a comparison company may be limited, but we will let readers weigh the evidence on their own.
Below are financial figures for comparable companies as of June 30, 2010.
Unlike CEU, the comparable companies have functioning payment methods on their websites. Unlike CEU, the comparable companies have no broken links, faulty html, and outdated content from 5+ years ago. Unlike CEU, the comparable companies have top-4 auditors, whereas CEU has had 4 different low quality auditors in the past 6 years. The comparable companies’ websites receive far more traffic than CEU’s websites.
Despite these facts, CEU generates gross and EBIT margins that far outpace the comparable companies, according to SEC filings. CEU generates higher revenue than DL and within a reasonable range of CEDU’s and CAST’s sales figures, according to SEC filings.
We strongly believe that CEU’s SEC filings are fabricated.
AIC Filings
CEU’s locally filed financial statements in China do not match its SEC financial statements. These local financial statements, which CEU must file with the Harbin branch of the Administration for Industry and Commerce (“AIC”), show that the online business generated revenue of less than $1 million in 2008. This corroborates our belief that CEU is mostly a hoax. 2008 was the most recent year for which we could access filings, as of our last inquiry on November 15.
Below are photocopies of the company’s AIC filings for 2008, 2007 and 2006 for CEU’s main operational subsidiary, Harbin Zhong He Li Da Education Technology, Inc. We provide filings in their original Chinese, as well as English translations of those filings.
AIC Reports:
2008 AIC Filings in Original Chinese
2008 AIC Filings in English Translation
2007 AIC Filings in Original Chinese
2007 AIC Filings in English Translation
2006 AIC Filings in Original Chinese
2006 AIC Filings in English Translation
According to SEC filings, the “Online Education” segment generated $22.2 million at 79.4% gross margins; “Training Center” generated $12.1 million of revenue in 2009 at 78.8% gross margins; and “Advertising Revenue” accounted for $2.6 million at 92.0% gross margins. For 2008, “Online Education” generated $16.7 million at 82.9% gross margins; “Training Center” generated $5.6 million of revenue at 65.4% gross margins; and “Advertising Revenue” accounted for $2.6 million at 93.0% gross margins.
Therefore, we should expect the 2008 AIC filings of Harbin Zhong He Li Da Education Technology, Inc. to show at least $16 million of revenue and $13 million of gross profit.
What we find is quite different. An excel summary is below:
High Auditor Turnover and Low Quality Auditors
Low quality auditors and high auditor turnover are both telltale signs of trouble. Repeated transitions from one low-quality auditor to another should be looked at with suspicion, especially considering all of the other red flags that we’ve identified in this article.
Below is the history of CEU’s auditors:
None of the above auditors are considered top 100 accounting firms, and all are small, non-reputable firms. CEU’s longest auditor relationship lasted 3 years. Why would management need a new accounting firm of subpar quality every few years?
Conclusion
It is difficult to believe that this company is valued at $150 million. It is an even sadder state of affairs that the company is listed on the New York Stock Exchange. There are dozens of red flags, any one of which should scare investors away. To recap, here are glaring issues:
Disclosure: Short CEU
Cheniere Energy Partners, LP
This post will be about Cheniere Energy Partners, LP (CQP), a master limited partnership, or MLP, which operates receiving terminals for liquefied natural gas in Louisiana. The underlying thesis is that CQP is an attractive investment because it yields a 17.5% dividend which I view as stable over the next 20 years. I think a more appropriate dividend yield is around 12% – 15%, which yields a stock price range of $11.33-$14.17. That implies stock appreciation of 16% to 46% based on Friday’s close price of $9.72. While one waits for that capital appreciation to occur, an investor in CQP can clip a fairly large quarterly dividend.
Funds and accounts managed by Kerrisdale currently hold CQP, and we may buy or sell shares at any time. We may not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.
Let me begin the discussion of CQP by saying that this is not a bet on liquefied natural gas prices. CQP, like many MLPs, has long-term take-or-pay contracts with its third party customers under which it receives enough revenue to make its distributions. Regardless of what happens to natural gas prices, its customers must make their contractual quarterly payments, unless in certain unlikely circumstances that we’ll discuss. Fundamentally, this investment is a bet on how bulletproof CQP’s contracts are, and what happens when its parent company goes bankrupt, and should not be impacted by what happens to natural gas prices. The stock price may move around with natural gas prices, but in my opinion, unitholders should clip their dividends regardless.
CEI
The CQP situation is complex and noisy, but I’ll try to lay it out as clearly as I can. The story begins with its parent company, the publicly traded Cheniere Energy, Inc., which trades by the ticker LNG on AMEX. We’ll refer to it as CEI in this email. CEI owns various LNG assets in the United States. Let’s take a moment to briefly discuss liquefied natural gas, or “LNG”. LNG is natural gas that, through a refrigeration process, has been reduced to a liquid state. In this liquid state, the natural gas can be shipped economically from areas of the world where natural gas is abundant and inexpensive, like Qatar, to areas where natural gas demand is high and domestic natural gas production is low, like Korea, Japan or Europe. The United States is currently a very small LNG importer, since the wave of recent U.S. natural gas discoveries has depressed natural gas prices and made LNG relatively unattractive in the United States.
CEI began operations in 1999, when it was among the first companies to secure sites and commence development of new LNG receiving terminals in the United States. Receiving terminals are essentially ports that receive LNG by ship from countries like Qatar, re-gasify the LNG, and then ship the natural gas by pipeline to the broader natural gas pipeline network in the US. CEI has essentially completed construction on only 1 receiving terminal, which is a receiving terminal in western Cameron Parish, Louisiana called the Sabine Pass LNG terminal. This is the terminal owned by CQP. CEI’s claim to the terminal is through its 90% ownership of CQP equity units.
CEI also has two other receiving terminals, for which it has done preliminary site work, but no further construction. These two terminals are in Corpus Christi, Texas and central Cameron Parish, Louisiana. CEI owns a 30% interest in a fourth LNG receiving terminal project near Freeport, Texas. CEI also owns a pipeline that connects the Sabine Pass LNG to various natural gas interconnection points and various other small pipelines that it has either begun construction on or may construct in the future.
To summarize, CEI’s main asset is its ownership in CQP and various contracts it holds with CQP and CQP subsidiaries. As well, the pipeline it owns is essentially an extension of the Sabine Pass terminal, and not worth a tremendous amount. As for the Freeport LNG terminal stake, management has previously said that Freeport LNG distributions are $10mm to $20mm annually. Aside from its ownership stake in CQP, its management / O&M contracts with CQP, and the 2.0 Bcf/d regas capacity under contract with CQP, CEI’s other assets are not worth a whole lot.
To build its terminals and pipelines, CEI has taken on a very large amount of debt. Unlike CQP, CEI’s business model assumes natural gas price risk. With low natural gas prices, CEI may have trouble marketing its LNG capacity to customers at a sufficient profit to meet its debt service obligations. For our purposes, we’ll assume that CEI goes bankrupt, perhaps in 2011 or 2012. CEI’s first maturity is in August 2011. CEI has sufficient liquidity to last until then.
CQP
Moving on to CQP, what precisely is the relationship between CQP and CEI? CEI has been public since 1996. CQP, however, went public in 2007, when CEI decided to monetize part of its ownership in the Sabine Pass LNG terminal in order to raise capital. It contributed the Sabine Pass LNG assets to the newly formed CQP, and offered 15.5mm shares to the public at around $21 a share.
So CQP owns the Sabine Pass LNG terminal, and CEI owns 90% of CQP. 10% is owned by the public. The ownership is structured in the form of common units, subordinated units and general partner units. The public only owns common units. CEI owns some common units. CEI owns all of the subordinated and general partner units. See the below diagram.
The relationship between common units and subordinated units are as follows: the subordinated units cannot get paid their distribution unless the common units have been paid their distribution, and all prior accrued distributions if any prior distributions were not paid.
Sometime after June 30, 2012, the subordinated units, under certain circumstances, may convert to common units. These circumstances include: (1) the common units must have been paid the sum of their full distribution amount over the prior 12 quarters and (2) the company must have generated enough cash from operations to cover the common, subordinated and general partner distributions in each of those prior 12 quarters. Basically, if these conditions are being satisfied in the 2012 / 2013 timeframe, common unit holders should not be too worried about subordinated units being converted to common. To repeat a key point: If the subordinated unit distributions are interrupted between now and Q3 2012, the three-year period starts over.
Ok, now let’s discuss what CQP owns. CQP owns receiving terminals in western Cameron Parish, Louisiana, on the Sabine Pass Channel. This is the Sabine Pass LNG receiving terminal. Here is a picture of it:
These terminals receive LNG from tankers, store the LNG, re-gasify it and ship it along two pipelines to the nation’s natural gas pipeline network. One pipeline is owned by CEI and the other pipeline is owned by Kinder Morgan. The total capacity at Sabine Pass LNG is 4.0 Bcf per day, and 16.8 Bcf storage capacity. Of that, construction on 2.6 Bcf/d sendout and 10.1 Bcf storage is complete. The remaining construction was 96% complete as of April 2009 and should be completed by the end of Q3, or shortly thereafter. CQP has entered into 20-year long-term take-or-pay contracts for 2.0 Bcf/d with 2 customers, Chevron and Total. 1.0 Bcf/d is with Total and 1.0 Bcf/d is with Chevron. The terms of each contract is 20 years, beginning on April 1, 2009 for Total and July 1, 2009 for Chevron. Total must pay $123mm per year. Chevron must pay $128mm per year. Under the contracts, Chevron and Total must pay their obligatory amounts regardless of whether they use Sabine Pass LNG’s terminaling, storage and regasification services. From my reading, the only way they can terminate the 20-year contracts is if the Sabine Pass LNG (a) suffers a force majeure that renders the Sabine Pass LNG receiving terminal not operational for over 18 months or (b) cannot meet certain delivery requirements, including taking delivery of approximately 192 MMBtu in a 12-month period, taking delivery of 15 cargoes over 90 days or unloading 50 cargoes in a 12-month period. It is unlikely that Sabine Pass will be unable to meet these minimum requirements. As long as it meets these requirements, Total and Chevron must make their payments.
Also, we can safely report that Chevron and Total have begun making their contractual payments, and have been receiving LNG cargo at Sabine Pass.
What about the remaining 2.0 Bcf/d of capacity at the terminals? CEI owns rights to that capacity and is trying to find customers for it. When Cheniere negotiated the Chevron and Total agreements, natural gas prices were at healthy and rising levels and the outlook for LNG was bright. When CEI began trying to find customers for the remaining 2.0 Bcf/d, the outlook had darkened, and CEI has been unable to enter into long-term contracts for the remaining LNG on the same attractive terms it struck with Chevron and Total.
CQP has entered into an agreement with CEI whereby CEI must make annual payments to CQP in much the same way that Chevron and Total do. The total amount that CEI must pay is $252mm. As we’ll see later on, however, CEI receives back from CQP an estimated $273mm due to (i) its 90% ownership in CQP and (ii) its $19mm O&M / management agreements with CQP. CEI receives more cash from CQP than it pays to CQP. We’ll return to this point.
Next, CQP, like many MLPs, has debt. The debt is actually not located at CQP, but at its wholly-owned subsidiary, Sabine Pass LNG LP. Sabine Pass LNG LP is a ring-fenced, bankruptcy-remote entity that has an independent director. This subsidiary is where all the operating assets are located. The subsidiary has a total of $2,216mm of senior notes, consisting of $550mm of notes maturing in 2013 and the remainder maturing in 2016. A key point is that these notes have a fixed charge test that must be met before dividends can be distributed from Sabine Pass LNG LP to CQP (these are the distributions that are then used to pay unit holders of CQP).
In terms of operating expenses, it does not cost much to operate the Sabine Pass LNG facilities. Management estimates the cost is $39mm per year. Sabine Pass LNG’s operating expenses are fairly predictable, consisting primarily of labor, insurance and management fees.
OK, before we get to the numbers, let’s summarize key points:
Financial Information
Now for the numbers.
As we can see, CQP generates enough revenue to cover its operating expenses, capex and distribution. It’s not a large cushion, but that’s ok. CQP has substantial cash on hand as of Q209 ($128.8mm of cash + cash equivalents and $13.7mm of restricted cash) that it can dip into if it suffers an operating shortfall and cannot cover its distributions from a given quarter’s cash flow. If operating expenses end up being dramatically higher, as in $70mm instead of management’s estimated $39mm, then we would have a long-term problem, but if the cost overrun is smaller, common unit holders should fare all right. Needless to say, CQP’s operating expenses should be quite predictable, and they shouldn’t be materially higher than management’s estimates. Furthermore, as long as subordinated units have not been converted into common, subordinated unit holders will be the ones to suffer a drop in distributions, not common holders.
Next, if you look closely at the numbers, you’ll notice something interesting. Each year, CEI pays CQP $252mm, which is payment for the 2.0 Bcf/d terminalling capacity that CEI has rights to. But because it owns 90% of the CQP units, it actually receives $255mm in distributions back from CEI. In addition, CEI receives $10mm in management fees, and another $9mm under its O&M agreement. The numbers are pasted below.
This is an extremely important element of the story. Why? Because we are assuming that CEI goes bankrupt. If that happens, equity holders will probably be wiped out, and senior creditors of CEI will own the new equity of CQP. During bankruptcy, CEI will have the opportunity to negate any contracts to which it is party. The central assumption of our investment thesis is that CEI will not negate its contracts with CQP. And that’s because it receives more from CQP annually than it pays to CEI. It has no incentive to stop making its $252mm payment to CQP, since it receives back $273mm annually.
What happens if the CEI contract is negated and CEI stops making its $252mm payment to CQP? Most importantly, does that mean that Chevron and Total can reneg on their contracts? No. Chevron and Total can only reneg on their contracts for performance-related issues at Sabine Pass, which we think are very unlikely to occur in such a way as to allow Chevron and Total to terminate their take-or-pay obligations.
But if CEI stops making its $252mm payment to CQP, then the fixed charge test under the Sabine Pass notes would likely be violated. The fixed charge test is 2.0x, and is essentially an EBITDA to Interest ratio.
If the fixed charge ratio falls under 2.0x, as it would if CEI stopped making its contracted $252mm payments, Sabine Pass LNG LP would be unable to dividend funds to CQP in order to pay CQP unit holders. During any period when Sabine Pass LNG LP is not permitted to make distributions to CQP, CQP’s common unitholders will be entitled to accrue any distribution arrearages owed on their units, which will be distributable to them once the fixed charge coverage ratio test is satisfied and CQP receives cash from Sabine Pass LNG LP. Note that while common unit distributions would accrue during this time, distributions on the subordinated units would not accrue.
CQP would likely halt dividends, and the stock would plummet. It’s actually not the worst thing in the world – Chevron and Total would continue to make their obligated payments, and the cash would simply accrue at Sabine Pass LNG LP instead of being distributed to unit holders. But it’s not something we would want to happen.
Fortunately, I think it’s unlikely that CEI will negate its contract and discontinue making payments to CQP if and when CEI goes bankrupt. I think that during bankruptcy, CEI will continue sending $252mm to CQP because it receives more back in return. No creditor would have an incentive to discontinue the CEI payments to CQP. And if a nuisance creditor is just trying to stir the pot by acting irrationally, it’s likely that the bankruptcy judge would rule in favor of the other creditors who are trying to preserve value at CEI.
That is the main gist of the story. But there is more in this gripping tale of wealth and intrigue in distant Cameron Parish, Louisiana.
GSO Loan and Reserve Account
Thanks to Ryan Greener at Harvest MLP Fund for fleshing out this next point (and if part of it is inaccurate, it’s due to my interpretations of the point, not his). If your head is already spinning, definitely do not get hung up on the following several paragraphs.
In August 2008, CEI closed a $250mm convertible term loan with GSO Capital Partners, L.P. This loan gave Cheniere several years of additional liquidity. CEI pledged various assets as collateral (basically, CEI pledged most of the assets that were not previously pledged to a $400mm loan it entered into in 2007). Specifically, GSO was guaranteed the equity securities of all of Cheniere’s domestic subsidiaries (excluding its subordinated limited-partner and general-partner interests in CQP), its 10.9mm CQP common shares and fees payable under its Sabine management fee agreement ($20mm per year).
A portion of the loan proceeds were used to fund a reserve account for making the contractual annual payments from CEI to CQP. CEI must maintain a minimum of one quarter’s worth of contracted payments (ie. $63mm) in the reserve account. When CQP makes distributions to CEI, the distributions first go to the reserve account to ensure that a minimum amount is available for CEI’s contracted payment. As well, CEI’s contracted payments are paid out of the reserve account, not from CEI. GSO controls this reserve account.
By controlling the reserve account and having a claim on CQP’s common shares, GSO is incentivized to preserve the value of CQP in the case of reorganization.
Note also that CEI’s subordinated units in CQP were pledged as collateral in the $400mm loan issued in 2007. Since subordinated shares are not entitled to receive dividends until common shares are paid in full, creditors of this loan agreement are also incentivized to have CEI continue making its $252mm contractual payment to CQP.
Everyone at CEI, whether it be equity holders or creditors, is incentivized to have CEI continue making its contractual payments to CQP.
Some may wonder if there is refinancing risk at the Sabine Pass LNG LP level. Might Sabine Pass have difficulty refinancing its 2013 notes? I doubt it. As long as Chevron and Total are making their payments to Sabine Pass LNG LP, lenders should be happy to refinance the Sabine Pass notes. The notes currently trade between 85 and 90, and at an 11% yield. That yield is too vanilla for my taste, but I bet the bond prices go higher if the high yield market doesn’t suffer a marketwide decline.
Risks
So what do I personally consider the biggest risk to this investment? I see three risks, none of which I consider too worrisome.
First, inflation. An investment in CQP is a fixed income investment wrapped in a riddle, inside an enigma. But make no mistake: it’s a fixed income investment. Chevron and Total are making annual fixed payments to CQP (there is a small CPI-indexed variable component, but it’s small). CQP is making annual fixed payments to unit holders. If we have material inflation, the fate of CQP units should mirror the fates of other fixed income investments.
Second, if CEI files for Chapter 11, GSO would control the reserve account, and the $65mm+ in that reserve account. As of June 30, 2009, the balance was zero because CEI had just made its contracted quarterly payment to Sabine Pass LNG. Perhaps, there exists a scenario where GSO keeps the cash, allows distributions to end, lets the public equity plummet, and then tenders for the minority public equity at a dramatically lower price. I would think that the creditors who have claim to the subordinated units would sue them, as would everybody else under the sun, and the resulting situation would embroil all parties in a painful and unnecessary legal battle. This sort of legal battle in bankruptcy would be ugly, and bankruptcy judges despise these types of aggressive actions by hedge funds. Also, GSO has a claim on CEI’s common units. So whatever action it does would hurt the implied value of the common units it would receive (which are worth $105mm based on the current market price of the public CQP equity). Intuitively, one would think that GSO’s incentives should be aligned with common unit holders. As a sidenote, GSO actually appointed its own director to CQP’s board of directors following the August 2008 convertible loan financing to CEI. Also, while public common holders are minority owners of CQP, they are majority owners of the total common units. The majority of the equity is in the form of the subordinated units, which are not pledged to the GSO loan. It is possible though that GSO could be buying the other loans to which the subordinated units are pledged.
An overall takeaway with regard to this risk is that CQP is not controlled by the public. It is controlled by CEI, which in turn will fall into the hands of a few distressed hedge funds if it files for bankruptcy. Could they find a way to steal value from public common unit holders of CQP in a way that I have not been able to foresee? It’s possible. Funky machinations by CEI’s creditors in the event of a Chapter 11 could conceivably happen. Personally, I think that creditors of CEI will play ball and CEI will continue making its TUA payments. I just haven’t found a compelling scenario where a CEI creditor would rationally act in such a way that would end CEI’s contracted payments. That is the crux of this investment thesis.
Third, there could be a natural disaster, or other force majeure trigger event. A hurricane seems the likeliest.
Finally, some investors like following insider transactions. With CQP, I’ve seen something I’m not sure I’ll see too often. The CEO of CEI, Charif Souki, is also the CEO of CQP. According to CapitalIQ, he purchased 50k shares of CQP in May. In January, he sold 70k shares of CEI. He also had previously bought 40k shares of CQP in October 2008. So he has been selling CEI and buying CQP. You don’t see that too often.
Disclosure: Per usual, this post does not constitute investment advice or a recommendation of any sorts. I may buy, sell or short any of the stocks mentioned at any time. I may be wrong; it won’t be the first or last time.
Eagle Rock Energy Partners, LP
Eagle Rock Energy Partners, LP trades under the ticker EROC on Nasdaq. EROC is an oil and natural gas MLP.
We are holders of EROC common units. On January 14, 2010, EROC issued a preliminary proxy regarding a recapitalization transaction with its sponsor Natural Gas Partners (“NGP”), and the transaction will likely be voted on by public common holders at some point in the next 6 months. We urge common unit holders to vote NO to the NGP proposal, unless it is substantially modified. This post will explain why we think the current transaction is adverse to common unit holders’ interests, as well as discuss an investment in EROC in general.
We have set up a website at www.fair-eroc.com, where we explain why common holders should vote NO to the current transaction. If you are an EROC unitholder, please distribute the link to other public holders. The site and analysis will be updated as revised proposals or other relevant facts emerge.
Accounts managed by Kerrisdale currently hold EROC, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.
Our excel model, historical financials and various EROC analyses can be downloaded here.
Recapitalization
EROC owns various oil and natural gas assets, of both the midstream and upstream varieties, and it suspended its dividend in early 2009 due to declining commodity prices and a potential debt covenant breach in 2010. The proposed recapitalization aims to reduce leverage to avoid a covenant default.
On www.fair-eroc.com, we explain why we believe EROC unit holders should vote NO to the current proposed recapitalization. On that site, we go through three scenarios:
1) No recapitalization
2) Currently Proposed Recapitalization
3) A Fair and Appropriate Recapitalization
The aptly named “Fair and Appropriate Recapitalization” is our preferred course. It is very similar to the currently proposed recapitalization, but removes a $29mm fee to EROC’s sponsor. If the currently proposed transaction is rejected by unit holders, we believe that the Board of Directors will be compelled to adopt a transaction very similar to our suggested “Fair and Appropriate Recapitalization”. If they don’t, we think they would be potentially breaching their fiduciary duty, and be exposed to lawsuits.
We are not going to rehash in this post our discussion of the recapitalization scenarios that is currently on www.fair-eroc.com. Instead, we’ll discuss EROC’s business and potential stock valuation.
Business Overview:
Eagle Rock Energy Partners, LP is a master limited partnership engaged in three businesses:
(i) gathering, compressing, treating, processing and transporting natural gas; fractionating and transporting natural gas liquids (“NGLs”); and marketing natural gas, condensate and NGLs, which we will call its “Midstream Business”;
(ii) acquiring, developing and producing interests in oil and natural gas properties, which we call its “Upstream Business”; and
(iii) acquiring and managing fee mineral, overriding royalty and royalty interests, either through direct ownership or through investment in other partnerships, which we call its “Minerals Business”
Excluding hedges, the midstream, upstream and minerals businesses accounted for 59%, 32% and 9% of 2008 EBITDA, respectively.
The Midstream Business owns assets in five natural gas producing regions: (i) the Texas Panhandle; (ii) East Texas/Louisiana; (iii) South Texas; (iv) West Texas; and (v) the Gulf of Mexico. These five regions are productive, mature, natural gas producing basins that have historically experienced significant drilling activity. As of 12/31/08, Eagle Rock’s natural gas gathering systems within these regions represent approximately 5,200 miles of natural gas gathering pipelines with approximately 2,600 well connections, 18 natural gas processing plants with approximately 801 MMcf/d of plant processing capacity and 207,100 horsepower of compression. The Midstream Business averaged 450.8 MMcf/d of gathered volumes and 322.1 MMcf/d of processed volumes during 2008.
The Upstream Business has long-lived, high working interest properties located in four natural gas producing regions: (i) Southern Alabama; (ii) East Texas; (iii) South Texas; and (iv) West Texas. As of 12/31/08, these working interest properties included 321 operated productive wells and 142 non-operated wells with net production of approximately 5,600 Boe/d and proved reserves of approximately 40 Bcf of natural gas, 7.2 MMBbls of crude oil, and 5.6 MMBbls of natural gas liquids, of which 85% are proved developed producing.
The Minerals business is likely to be sold, so we are not going to focus on it. We will however say that it is a valuable asset comprised of a portfolio of royalty interests in various productive wells in 17 states. The segment will generate $14mm to $15mm of EBITDA in 2009, and keep in mind that 2009 suffered from what could very well be trough energy prices. As well, 2009 figures don’t include any lease bonuses, rentals or other one-time bonus payments, whereas 2008 benefited from $17mm of such “recurring non-recurring” bonus payments. The minerals business has minimal capex / working capital uses. At 12x trough cash flow, we think that Black Stone is getting an excellent deal, and they’ve aggressively pursued this asset ever since EROC first indicated it might sell the minerals division. In the originally proposed restructuring, NGP had arranged to purchase this business for $135mm, an extremely low price, but Black Stone’s persistence and unsolicited proposal shortly after the initial recapitalization announcement prompted the board to recommend selling it to Black Stone.
EROC was essentially created in 2006 when Natural Gas Partners, a $7bn energy-focused private equity firm formed the partnership as a monetization vehicle. NGP and management own the publicly traded partnership’s general partner, all subordinated units, and about 26% of the common units. The general partner is entitled to an increasing share of cash flow as specific dividend benchmarks are met, and these are captured through what are called “Incentive Distribution Rights”.
After going public in 2006, EROC completed more than half a dozen acquisitions totaling over $800 million, including multiple deals involving oil and natural gas production assets and fee mineral and royalty interests. As a result, EROC has become a hybrid MLP with midstream natural gas assets, upstream oil & gas assets, and fee minerals / royalty interests. The margins generated under some of EROC’s gathering and processing contracts, particularly its keep-whole and percentage-of-proceeds contracts, fluctuate based on the price of natural gas and NGLs and, in some cases, the relationship between the price of natural gas and NGLs. Its upstream assets are directly levered to energy prices. EROC attempts to hedge its commodity price exposure through the use of various financial instruments.
In the second half of 2008, the rapid decline of commodity prices had adverse impacts that ultimately led to a rise in forecasted leverage and a cut in the Company’s unit holder distribution. Cash was redirected towards reducing debt.
Per its partnership agreement, when EROC suspends its common distribution, all quarterly distributions under $0.3625 per share are accumulated as arrearages. The Company must repay these arrearages to common holders before subordinated holders get any distributions. Because the Company suspended its distribution in early 2009, $1.01 of arrearages have accumulated through to September 30, 2009. Unless commodity prices surge, subordinated holders are unlikely to receive any distributions over the next several years, which explains NGP’s eagerness to do a deal that replaces their subordinated units with newly issued common units.
Financials
We have attached our quarterly excel model of EROC here. Please note that this is our internal model at Kerrisdale Capital, using publicly available information and our own internal assumptions. Most notably, our projections do not match the Company’s projections. Our EBITDA comes out higher than the Company’s base standalone model, as can be seen by the following comparison:
The differences are due to numerous reasons. We don’t have any reason to believe that our model is more accurate than the Company’s. And really, we build models to better understand the business drivers of our portfolio companies, and are fully aware that our assumptions and profit forecasts may be wrong. We don’t have access to the same detailed information as the Company does, nor have we spent as much time analyzing EROC’s underlying trends as its CFO has.
At the end of the day, our EBITDA forecasts are not terribly different from the Company’s. In our valuation analyses below, we use the Company’s projections.
Valuation
MLPs trade on dividend yields, to a large degree. Based on the Company’s projections, EROC would have $82mm of distributable cash flow in 2010 and $89mm in 2011, in a standalone base case. If the transaction is approved, 2010 and 2011 DCF would be $76mm and $104mm. The dramatic difference in 2011 is due to higher interest costs in the standalone case following a 4Q 2010 covenant breach, based on the Company’s assumption that interest rates would rise 250bps.
The Company’s new distribution policy will establish a conservative baseline distribution that will be expected to be lower as a percentage of total distributable cash flow than many other MLPs. The rationale for this is that EROC’s underlying assets are exposed to more commodity price risk than other MLPs.
The Company has projected a $0.40 – $0.60 annualized distribution if the current transaction is approved. In our analysis, we assume that distributions begin at $0.60, rising to $0.75 in 1Q11 and rising to approximately $0.85 – $0.95 in 4Q11. These amounts are less than 75% of distributable cash flow in each relevant period. In 4Q11, we assume a distribution equal to 70% of distributable cash flow. These are fairly conservative payout ratios.
If the recapitalization transaction is rejected and no modified recapitalization occurs, we estimate a 60% cumulative 2-year gain by purchasing EROC at Monday’s closing price of $6.31, IF management decides to re-instate a regular distribution at the approximate 4x leverage that the Company would have at the end of 2011.
If the current recapitalization transaction is approved, we estimate a 81% 2-year total return.
If the currently proposed recapitalization is rejected, and management chooses to do a modified recapitalization where they sell the Minerals business and do a rights offering, but don’t pay the unwarranted $29mm fee to NGP, we estimate an 87% 2-year total return for common unit holders.
Commodity Price Risk
EROC is a commodity business. Both the upstream and midstream businesses have exposure to energy prices, and, specifically, EROC is highly levered to natural gas liquids prices. NGLs refer to ethane, propane, iso butane, normal butane, ethane and pentane, and the pricing of these products drive the company’s earnings.
Arguing that EROC should generate attractive returns as long as NGL prices stay constant is a bit like arguing that EROC should generate attractive returns as long as the coin I flip lands on heads. Forecasting the direction of the NGL price deck is tough. Unlike other commodities (natural gas and crude oil) that have a somewhat transparent relationship between supply and demand (at least when compared to NGLs), fundamentals for natural gas liquids are driven by a complicated interplay of a host of hard-to-predict factors. NGL supply, demand, and prices are driven by markets that function independently of NGL fundamentals.
On the supply side, NGL supply is largely a function of the quality and level of natural gas production, rather than being responsive to NGL demand. This is because NGLs must be extracted from natural gas in order to meet pipeline specifications. In contrast, domestic demand for NGLs can fluctuate based on a number of drivers, including the overall demand by petrochemical companies, which is driven by economic activity; NGL exports, which are driven by ethylene production levels abroad and global demand for ethylene derivative products; and the economics of using a light (NGL-based) versus a heavy (crude oil based) feedstock in petrochemical steam crackers to produce ethylene and other products.
All of this said, NGL prices have historically been driven by crude oil prices moreso than the overall supply / demand dynamics of the NGL market. According to a Wachovia report in April 2009 (“Cracking the Code on Natural Gas Liquids”), NGL prices exhibit a higher correlation to crude oil prices than to NGL supply and demand imbalances. Wachovia tracked benchmark ethane and WTI prices since 2001, and noticed a 0.93 correlation between the price of ethane and crude oil. The reason is that light-feed NGL components compete with crude oil feedstocks (naphtha and gas oil) in the petrochemical industry, which is the primary end market for NGLs. If oil prices increase 50%, other crude refinery byproducts like naphtha and gas oil will follow directionally, and as those byproducts become more expensive relative to NGLs, ethylene producers will opt for a higher percentage of NGLs in their feedstock mix and NGL prices will rise. And vice versa.
EROC’s upstream business is also tilted towards oil vs natural gas, with more than 60% of 2008 upstream gross profit coming from oil and NGLs. On the natural gas side, EROC’s natural gas short position is generally offset by its gross profit from the natural gas production in its upstream business.
So it’s really oil / NGL pricing that drives EROC’s earnings. The question of whether crude trades at $60 vs. $80 vs $100+ a barrel in 2011 will probably have a bigger impact on EROC’s stock performance than how investors vote on the current recapitalization. In its crudest form (pardon the pun), an investment in EROC is just one of many ways to invest in oil.
Conclusion
Common unit holders should vote NO to the current recapitalization proposal outlined in the January 14, 2010 proxy.
LEGAL:
THIS COMMUNICATION IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND SHALL NOT BE CONSTRUED TO CONSTITUTE INVESTMENT ADVICE. NOTHING CONTAINED HEREIN SHALL CONSTITUTE A SOLICITATION, RECOMMENDATION OR ENDORSEMENT TO BUY OR SELL ANY SECURITY OR OTHER FINANCIAL INSTRUMENT OR TO BUY ANY INTERESTS IN ANY INVESTMENT FUNDS OR OTHER ACCOUNTS. THE AUTHOR HAS NO OBLIGATION TO UPDATE THE INFORMATION CONTAINED HEREIN AND MAY MAKE INVESTMENT DECISIONS THAT ARE INCONSISTENT WITH THE VIEWS EXPRESSED IN THIS COMMUNICATION. THE AUTHOR MAKES NO REPRESENTATIONS OR WARRANTIES AS TO THE ACCURACY, COMPLETENESS OR TIMELINESS OF THE INFORMATION, TEXT, GRAPHICS OR OTHER ITEMS CONTAINED IN THIS COMMUNICATION. KERRISDALE CAPITAL MANAGEMENT, LLC OR AFFILIATED ENTITIES MAY OWN OR OTHERWISE HAVE AN INVESTMENT RELATED TO ANY COMPANIES MENTIONED IN THIS COMMUNICATION. THE SENDER EXPRESSLY DISCLAIMS ALL LIABILITY FOR ERRORS OR OMISSIONS IN, OR THE MISUSE OR MISINTERPRETATION OF, ANY INFORMATION CONTAINED IN THIS COMMUNICATION.