Kerrisdale Capi...'s  Instablog

Kerrisdale Capital Management
Send Message
Kerrisdale Capital is a private investment manager that focuses on value and special situations investments. We manage investment partnerships and separately managed accounts.
My company:
Kerrisdale Capital Management
My blog:
Kerrisdale Capital Blog
  • Cheniere Energy Partners, LP 2 comments
    Jan 25, 2010 8:10 PM | about stocks: CQP
    9.29.09
    • This post indicates a bullish view on Cheniere Energy Partners, LP (CQP on AMEX)
    • CQP has a high 17.5% dividend yield and I believe that the dividend is not in danger of being discontinued
    • CQP has long-term take-or-pay contracts with two large customers that help ensure continued payment of the dividend. While CQP’s parent may go bankrupt, the parent’s creditors are incentivized to continue facilitating CQP’s dividend while the parent is in bankruptcy

    This post will be about Cheniere Energy Partners, LP (NYSEMKT: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.

    CQP Ownership

    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:

    CQP - Sabine Pass Aerial View

    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:

    1. CQP owns and operates the Sabine Pass LNG terminal, which receives, stores and re-gasifies liquefied natural gas.
    2. CEI owns 90% of CQP and the public owns 10%. Of that 90% CEI ownership, 82% is through subordinated units that will not convert into common any earlier than 3Q 2012, if they convert at all. CEI has a relatively high probability of going bankrupt. CEI’s main asset is its ownership stake in CQP. It also has a $19mm annual O&M / management agreement with CQP and rights to 2.0 Bcf/d of capacity at the Sabine Pass LNG terminal.
    3. CEI receives more cash annually from CQP than it pays to it. We’ll see this better when we go through the numbers.
    4. CQP has two long-term take-or-pay contracts with Chevron and Total, obligating them to make annual payments of $128mm and $123mm, respectively, to CQP.
    5. CQP has $2,216mm of debt, located at a wholly-owned subsidiary that owns the Sabine Pass terminals. This debt has a fixed charge test that must be passed before funds can be dividended to CQP, which are then used to fund the distributions to unit holders.

    Financial Information

    Now for the numbers.

    CQP Payments Summary

    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.

    CQP Payment Loop

    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.

    CQP Sabine Pass Debt

    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.
    Stocks: CQP
Back To Kerrisdale Capital Management's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (2)
Track new comments
  • rdtuck02
    , contributor
    Comments (567) | Send Message
     
    Excellent explanation of a complicated situation
    16 May 2011, 11:58 AM Reply Like
  • Flubadub
    , contributor
    Comments (6) | Send Message
     
    Here it is 2013 and no bankruptcy to date. More indebtedness in the construction of a bi-directional LNG terminal but the future output is 86% contractually sold. So an enhanced flow of income starting around 2015. What to make of it all????????? I'll stick with my investment in CQP. Great annual income. No compelling reason to believe share price will precipitously drop.
    20 Feb 2013, 12:27 AM Reply Like
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.