October 19th was one heck of a day for shares of Legacy Reserves (NASDAQ:LGCY), with shares climbing by more than 10% as of the time of this writing. However, the real treat was not for those shareholders but was, instead, for shareholders in the company's two classes of preferred shares, (NASDAQ:LGCYO) and (NASDAQ:LGCYP). At one point, these shares were up as much as 26.7% and 24.3%, respectively, while the largest move higher for the common shares was an increase of 13.6%. In what follows, I will dig into why I believe this is, and more importantly, why I believe this trend will continue if Legacy survives.
In the only graph I will show in this article, please be sure to look carefully at the direction of the x-axis. In most cases, the point on the furthest left is the furthest date from the present and the point to the furthest right is the closest date to the present. In my graph, I changed this around. The reason why is because of how the daily data is downloaded from Yahoo! Finance and the fact that I am unable, in my version of Numbers, to change the data unless I do it manually.
Performing this work manually, by copying and pasting 594 days worth of data, day by day, did not seem like a good use of time compared to providing this disclosure. I looked for a while about how to change this around but couldn't find anything that seemed to work. If any of you have an understanding of how to do this on the iPad version of Numbers, please let me know. I'll be eternally indebted to you.
What has been happening with the preferred units?
With the disclosure out of the way, let's get down to the fun stuff. As many of my readers who follow Legacy know, times have been particularly difficult for the company. Despite the fact that oil prices have moved higher (nearly doubling from their multi-year low), shares have languished and even fallen closer to where they were when many market participants, myself included, thought it was only a matter of time before the company might declare bankruptcy. The single largest reason behind this appears to relate to fears surrounding its credit facility redetermination this fall.
Depending on what lenders have to say about Legacy, it is possible that it could be placed in a rather difficult spot. With only $108.6 million (assuming it hasn't engaged in any asset sales over the past few months and that management hasn't been allocating excess cash flow toward reducing the facility) in wiggle room on its credit facility and $520 million currently borrowed under it, there is a chance that the firm could be hit hard. In a worst-case scenario (which I believe to be very unlikely), the company could be forced into bankruptcy but even if it doesn't then it could be pushed into draconian-like terms on repayments, similar to what Mid-Con Energy Partners (NASDAQ:MCEP) endured earlier this year.
As a result, not only common units but also preferred units have tanked from their highs over the past couple of years. For instance, as of the time of this writing, shares of LGCYO and LGCYP are down 77.9% and 78%, respectively, compared to their $25 liquidation preference. Having said that, if you look at their performance since June of 2014 (the last time they issued preferred shares), as pictured below, you'll see that they have materially outperformed the common shares.
*Graph Created by Author
In the graph, which set the price of each security at a unit measure of 100 (so we can get rid of the original price discrepancy between them) and then adjusted for daily changes, we can see that the preferred units have done well, considering the circumstances, compared to the common. Over the same period of time, shares of the common have dropped a tremendous 94.8% to just $1.25 apiece before the run-up in price on October 19th.
The preferred are likely to continue outperforming
The difference between preferred and common shares is significant. The benefit of common shares is that they participate in the upside associated with the company. If, for instance, oil soared to some very high amount or if the company were being acquired for a very high premium or if extreme cost cutting takes place, the holders of those common units will participate in that upside.
The preferred, on the other hand, will not. In fact, given their liquidation preference of $25 apiece, it would be hard for shares to move up much higher than that, irrespective of what happens with the underlying business. On top of that, even though preferred holders would likely get nothing just like common holders in the event of bankruptcy, they are considered senior to common, and as such, are perceived as being "safer."
Given these distinctions, you would think that, while preferred units faced less downside, they would also be subject to less upside if the market turns around. In the long run, in any case where Legacy survives without filing for bankruptcy, I suppose this would be true. However, until we get far out of the clear regarding this tough energy environment, I believe the opposite is true.
Part of this is due to the fact that, while the company is not required to pay out distributions to common shareholders if management suspended said distributions, they are required to accrue and pay out to the preferred holders if the company survives. Or, at least, they must pay these out before they pay out anything to the common holders. Right now, including October's payment, this boils down to $1.67 per preferred unit for each class.
If you assume that you will be paid these distributions without fail (i.e. the company survives without declaring bankruptcy), then if the share price for Legacy's preferred units is $5.53, then you are really only paying $3.86 for them after you get paid the preferred distributions at some point in the future.
If two years go by without a payment being made, you would have $4 built up in the preferred so the actual amount, net of these payments and not factoring in taxes, that you'll have paid for the shares is only $1.53. Of course, you will have to pay taxes on all distributions, even if not received, that have accrued while you hold them (you will not pay taxes on those accrued before you bought them, but the difference will be reflected in the basis of your shares). This, in my opinion, is one reason why preferred will likely continue to outperform common shares for quite a while absent a buyout.
Some of you may point out that distributions on the preferred may never be paid out. That is true, but if so, then you must be expecting that the common units will go to zero (or at least underperform in perpetuity) because the only way that management can avoid paying out these accrued distributions is if either the company declares bankruptcy and wipes the common and preferred holders out or if the company decides to never pay out common distributions again or if management offers up some sort of exchange for the preferred units and you accept the terms of that offer. Besides these scenarios taking place, the preferred distributions must be paid out at some point in the future.
The second reason for my thinking involves taxation. As I already stated, the tax characteristics of the preferred units are odd but the same can be said of the common units. Seeing as how Legacy is an LP, the company's profits flow through to common shareholders, and more importantly, so do gains from buying back debt at a discount. For as long as bond prices for Legacy are trading at a nice discount to par and as long as market participants are worried about debt loads (and assuming the firm's credit facility is not a concern moving forward), there's an incentive for management to buy back debt at a discount.
If, for instance, the firm can buy back $100 million worth of Senior Notes for $0.55 on the dollar, the difference ($0.45 or $45 million here) will be taxable income for the common holders. Until the market and the company's financial situation stabilizes, this weight will continue to weigh over shareholders.
As proof, by the way, that my thesis regarding the preferred distributions will likely end up being true with respect to their performance compared to common, we need only look at how things have fared since the recent bottom we saw in April of this year. Since April 1st, shares of LGCYO have moved up 100% while shares of LGCYP have risen 102.6% (using October 18th as the end date). Over the same time frame, shares of the common have gone up just 47.1%.
Right now, preferred units seem to be, for investors in Legacy who are not investing in their debt, by far the most reasonable prospect when stacked up against the common units. While a significant turnaround for the market will (absent bankruptcy or a buyout) certainly be more bullish for the common units in the long run, the next year or two should be different. As things stand, the upside for the preferred, based solely on their inherent qualities, should be far better than is the case for Legacy's common units.
Disclosure: I am/we are long LGCY.
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: I own LGCYO, not LGCY
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