The China Factor and Activists on AMID
The S&P 500’s 8.01% January rally reversed December’s 8.80% loss driven by dovish Federal Reserve commentary and improved prospects for a trade dispute resolution between the US and China that calmed global recessionary fears. Tangible positive developments on the US-China trade front should be reported by March 2nd and lead to a complete retracement of the fourth quarter “volatility event.” With a less restrictive Federal Reserve and global trade tensions abating, the global economy should begin firming as the year progresses. With successful US-China trade negotiations, the US economy could continue growing into 2022 and extend this decade old bull market to new record highs.
The chart below shows the S&P 500 is fairly priced with a risk premium of 3.53. The middle panel shows (red line) a modest decline in 2019 S&P 500 earnings and those earnings will need to reverse upward before the S&P 500 index can resume solid growth.
The S&P 500 is trading at a modest multiple of 16.6 times its trailing earning and 15.4 times its forward earnings. Over the last 60 years interest rates on average have been higher which makes these earnings multiples better than average values.
US equity market fears remain, as reflected in the chart below, which shows the volatility index for the S&P 500 at 17. Fears have abated from the 35 level hit on “Mnuchin Monday” when the Dow Jones Industrial Average dropped 653.17 points following the Treasury Secretary’s weekend TWEET, that asserted banks were financially sound, backfired.
For the year, 2018 experienced 23% earnings growth, with no stock price appreciation, and occasional elevated equity market volatility. This US equity market behavior is consistent with the unwinding of the financial stimulus bubble.
To achieve broader equity diversification, we are investing in value away from the US equity markets. With a weaker dollar and firmer commodity prices, we favor gold and gold stocks, particularly if the emerging markets recover. We are adding the Van Eck Gold Miners ETF (GDX) to portfolios. For both high income and a recovery in the emerging markets, we continue to add the Templeton Emerging Market Income Fund (TEI) to portfolios.
Attention Activists and Congressmen:
“On December 27, 2018, American Midstream Partners, L.P., a Delaware limited partnership (the “Partnership”) entered into that certain Second Amendment to Second Amended and Restated Credit Agreement (the “Amendment”) with American Midstream, LLC, a Delaware limited liability company (the “AMID Borrower”), Blackwater Investments, Inc., a Delaware corporation (together with the AMID Borrower, the “Borrowers”), the other Loan Parties party thereto, the Lenders party thereto and Bank of America, N.A., as Administrative Agent, to that Second Amended and Restated Credit Agreement, dated as of March 8, 2017 (as amended, supplemented or otherwise modified from time to time prior to the date of the Amendment, the “Original Credit Agreement”), among the Borrowers, the Partnership, the Lenders party thereto, and the Administrative Agent.”
How many retired AMID unitholders would comprehend this on New Year’s Eve, let alone find it on EDGAR? Basically, the 8K explained that due to the “renegotiation” of a covenant with one of its creditors, AMID was suspending its fourth quarter distribution until its debt to EBITDA levels dropped below 5.0. This announcement led to a 36% drop on nearly ten times normal volume driving AMID units down from $4.33 to $2.75/unit. This seemingly terrible business announcement occurred on the last day of the year when tax-loss selling and window dressing would be most intense.
What most investors might not realize was that: AMID’s Debt to EBITDA was 5.65 on September 30, 2018, AMID had just closed a sale for its Refined Products Terminals for $125 million on December 20th, AMID was actively deleveraging its balance sheet, AMID had announced hundreds of millions in planned sales and that the $125 million sale was the second large asset sale in the last six months. "Further, the Partnership has engaged in a review of additional non-core assets and has identified approximately $350 - $400 million of other high value non-core assets that are geographically peripheral to the Partnership's core footprint or could offer greater strategic value to third parties.” Consequently, the elimination of the fourth quarter distribution was not the operating death knell, such distribution elimination announcements typically herald.
This was not lost by one smart institution, ArcLight Capital, a $21 billion energy private equity firm out of Boston. Its Managing Member and Co-Founder, Daniel Revers recently helped launch the Revers Center for Energy at the Tuck Business School at Dartmouth and has an impressive bio. Beyond his philanthropy, Revers joined Michael Dell as a resident of the Millennium Tower in Boston with a $9 million penthouse purchase.
On January 3rd, 2019, just two business days after this extraordinary distribution cut, ArcLight Energy V bid $4.5 per AMID unit. A nearly identical situation occurred on September 28th, 2018, when ArcLight Energy V bid $6.10 for AMID stock in the wake of the 75% distribution cut on July 27, 2018, before that time AMID Units were trading at $11.16. Unsolicited bids are generally welcome, but since this bid came from ArcLight Energy V and ArcLight Capital owns 80% of American Midstream’s GP, it appears to benefit ArcLight over the unit holders.
Further, AMID announced on July 26th, 2018 its revised asset allocation strategy:
“is intended to significantly reduce leverage, provide capital for strategic growth opportunities, and create long-term value…. the Partnership has identified attractive organic growth projects across all core segments. These opportunities will enable the Partnership to continue building an integrated midstream company with greater scale and density in its core operating areas as well as expanding its reach across growing resource developments. The identified projects will focus on the continued development of infrastructure along the Gulf Coast, which would further the Partnership's ability to participate in the growing export market offshore and to Mexico. The aggregate of non-acquisition related growth opportunities ranges from $200 to $300 million through 2020 at a blended multiple near 5-times expected EBITDA.”
This bid, however, aborts the chance for unit holders to recoup their lost capital via its long-term growth strategy described above. It currently appears, ArcLight will acquire the American Midstream Partners at a significant discount to fair value and cause large losses on individual unitholders. Many investors in AMID units are retirement age and have bought AMID units in the last two years after hearing AMID CEO Lynn Bourdon make statements like “These accomplishments underscore the support that we have had and can expect from our sponsor ArcLight Capital Partners, as we move forward” and “Quite frankly folks, this train is leaving the station. I hope as investors, you are as excited as we are about our future….”
Bloomberg’s Rachel Adams has twice written on this story. On October 8th Adams quoted Recurrent Advisors’ Bradley Olson: “Even by the standards of the MLP sector, where shareholder governance is not as shareholder friendly as it is for a corporation, this deal still stands out for being aggressively quick after a dividend cut and with an aggressively low premium,” Olsen said. “This was a proposal that we think tilted the balance a little too far.”
Again, on January 4, 2019 Bloomberg again quoted Olsen “The initial read of the second bid is it seems to be using a set of circumstances that were created by an ArcLight board and ArcLight-appointed management team as an excuse to lower the bid.”
On January 9th, activist Thomas Craig, wrote that AMID units were worth $9/unit and that “The independent directors are the last line in defense against ArcLight and its tactics as they must approve a transaction. I along with other unitholders are supportive of standing firm. I encourage all unitholders to reach out to Peter, Donald, and Gerald [Mr. Peter A. Fassulo, Mr. Donald R. Kendall Jr., and Mr. Gerald A. Tywoniuk] in writing and encourage them to reject the two bids so that AMID has more time to bring Delta House up to full capacity, sell assets, and resume the distribution.”
The critical valuation distinction and potential for injustice are that hard assets’ fair valuations can deviate widely from standard cash flow multiple valuation-based models when cash flows are interrupted. When a hard asset has a temporary disruption in cash-flows (e.g. it can be remedied by repair) the cash flow multiple method will reflect a sharp drop in value that is more extreme than one which would be determined by a comparable valuation method or an actual auction - where other sophisticated hard asset buyers can fully evaluate the future cash flows to properly value the entity.
In the American Midstream and ArcLight situation, the hard asset property value level should not have changed after the distribution cut on July 26, 2018. From one day to the next, AMID’s asset values did not change and nor did their cash flows. The shares dropped due to the distribution being cut 75% and most investors reflexively sold the Units as they were interested in the distribution. Since volume jumped to 20 times normal levels there was a temporary supply demand imbalance as trading jumped. This was likely compounded by the decision not to have a conference call, which seems extraordinary in-light-of the size of the cut and new asset allocation policy. Certainly, ArcLight and AMID are best positioned to accurately assess their properties’ values and long term growth potential whereas retired or elderly AMID unitholders are at a disadvantage. AMID’s Gulf of Mexico properties are long lived natural gas assets (compared to typical fracked wells), which, in combination with properties owned by ArcLight and Enterprise Products Partners, LP (EPD), could be a major long-term high value natural gas asset like the Permian Basin is for oil.
Please Write the Independent Board Members:
We encourage you to follow Craig Thomas’ suggestion. If direct and indirect shareholders write to the independent directors, and they reject the two ArcLight bids, wait until the Delta House production levels return and reinstate the distribution, AMID unit holders could soon be rewarded with a return of over 100%. More importantly, the prospect that other MLP General Partners might copy the distribution cut and bid for the LP units strategy might not be repeated to the detriment of the sector.
The 1986 Tax Act created MLPs. It streamlined the energy partnership structure, removed abuses in the industry and generated hundreds of billions in capital for the development of the US energy infrastructure. The Act helped make the US energy industry into a top global producer which helped carry the US economy through the Great Recession. Over the last several decades, retirement-minded MLP Unitholders have enjoyed outstanding tax advantaged returns and the US benefited from this win-win legislation.
If a trend of distribution cuts followed by opportunistic bids continues at the expense of elderly or retired MLP investors, Congress should enact legislation to rescind the favorable tax benefits which accrue to private equity funds and hedge funds who execute such strategies. This would help retirees, the deficit, the US energy industry, and prohibit a grotesque abuse of the “top one percent” benefiting from the average Joe.
Tyson Halsey, CFA
Disclosure: I am/we are long AMID EPD TEI GDX KYN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.