In my last article Modeling Trumps Intuition: Scenario Analysis Of Legacy Bonds, I applied a quantitative framework to the possible outcomes an investor in the unsecured debt faces. This article will be a similar exercise but applied to the preferred shares of Legacy Reserves (NASDAQ:LGCY), which carry the tickers LGCYO and LGCYP. Like Vanguard Natural Resources (NYSE:VNR), Atlas Resources (now deceased), and Breitburn Energy Partners (OTCPK:BBEPQ) (also now bankrupt), Legacy decided to use preferred shares as part of their capital structure. Given just about every upstream master limited partnership ("MLP") that made this decision is bankrupt or very close to it, for Legacy's sake let's hope "this time is different." I consider Legacy to be among the stronger MLPs which include Memorial Production Partners (NASDAQ:MEMP) and EV Energy Partners (NASDAQ:EVEP). I have a position in Legacy's preferred shares and own debt in both MEMP and EVEP.
Preferreds are higher in the capital structure than common equity but lower than debt. For Legacy, the firm's credit facility is paid off first then its unsecured bonds. If there is still any cash left over, it goes the preferred share holders and finally to common unit holders. In reality, it is extremely likely that all equity, including preferred, is wiped out in the event of a restructuring and the model reflects that. Let's go through the first iteration.
Conservative (33% the firm survives)
Using the current market price of $4.63, a 67% chance the firm has to go through a restructuring, and the payment of $2 in deferred distributions being made, which represents a one year hold period, results in a probability weighted return of 56.8%. If you were to run a simulation with these various characteristics an infinite amount of times, on average you'd receive that return. In the event the firm is able to meet the requirements of its borrowing base and maintains enough cash flow to avoid bankruptcy, there are two options within this decision tree. The first assumes the preferred only reaches $18 per share while the other has a more favorable $22 per share target. Theoretically, given current interest rates, LGCYO and LGCYP should trade fairly close to the par of $25 per share if the markets considered the firm truly out of the woods. This run of the model, however, is labeled Conservative for a reason. Keep in mind that despite the favorable returns on average, there is still a sizable 67% chance that you lose all your invested capital.
Neutral (50% chance the firm survives without a reorg)
This run has a few modifications. First, it is now 50/50 as to whether the firm makes it in its current form. Secondly, the preferred shares rise to $20 and $22.50 per share which is up slightly compared to the Conservative model. The average returns change, however, is not the least bit slight: it has tripled to 151.1% on average. As someone who communicates a lot with readers about Legacy, I'd say the average person on Seeking Alpha believes the firm has a 50/50 shot. A suggestion considerably lower or higher tends to result in people vehemently attaching each other. My personal opinion is fairly simple: I do not know. It's going to be a close call as to if the borrowing base takes a material hit. Despite a fairly reliable estimate of at least $60 million in cash flow for 2017, we do not know how difficult it will be for Legacy to deal with any shortfall. We will know fairly soon, however, as results will be published in the coming months. To summarize the results of this run of the model, returns, on average, are very high if you believe the firm has a 50/50 shot of making it through the downturn. Unlike the debt, which has the additional complexity of determining recovery rates and associated probabilities, things are straightforward for the preferreds as they will be wiped out in event of a Chapter 11 (or 7) filing and they will return to approximately par if the firm survives.
Favorable (67% the firm survives)
While still pricing in over a one in three chance of the firm going bankrupt, the expected average return manages to jump to 259.9%. The expected end price of the preferreds were moved higher as well but are still below par value. For high risk investors that are not concerned about the still significant 1/3 chance of losing all their invested capital, this is a substantial average return.
The above solves for market expectations to reach the current market price. To obtain the market price of $4.63 share price for LGCYO, you'd have to price in a 78.95% of a restructuring and the preferreds becoming worthless. To any extent you believe the firm has a better chance of surviving, the preferred shares are a good value at today's levels.
The primary reason I performed this exercise was to gauge if it would be wise to exit the preferred shares I already own and buy the firm's bonds. The additional upside in the preferreds warrants taking the risk relative to the bonds now that they are trading at 50 to 55 cents on the dollar. Back when I purchased my positions in EVEP and MEMP, their debt traded at 20 while Legacy's was printing 15. At that time the debt had the most compelling risk versus reward and by a large margin. Things are different now that the debt has recovered and the preferred remains at a small fraction of par. I am maintaining my position in the preferreds but may establish a new position in the debt if I can purchase it below 50 cents on the dollar.
Disclosure: I am/we are long GST-A, VTR, HCP, HTA, OHI, DOC, WFM, MAIN, BXMT, BNS, LGCYO, CF, EPD, MMP, CF, EVEP, MEMP, TD, RY, HMC, OAS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: WER has positions in EVEP and MEMP debt only - not the common units. The author may enter into long or short positions in any part of the capital structure of any of the firms mentioned in this article. Readers should always conduct their own independent due diligence and not rely upon information or opinions provided by the author.
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