Legacy Reserves: Putting Its Credit Extension Into Perspective

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About: Legacy Reserves Inc. (LGCY), Includes: MCEP
by: Daniel Jones
Summary

Fears continue to abound regarding Legacy Reserves and the company's ability to extend its credit facility.

While risks do exist, a look at another highly-leveraged firm from last year might provide us with some nice perspective.

The oil and gas E&P firm's leverage is only slightly worse than Mid-Con's when it received an increase on its facility.

This suggests that the picture for Legacy might not be as dour as many fear.

Sometimes one of the best ways to get an idea as to the future of a particular company is to look at what is going on with a business with some characteristics that are similar to it. In this case, one thing investors are worried over concerning Legacy Reserves (LGCY) is whether or not the firm can survive this recent downturn in energy prices.

At this time, Legacy is my largest holding and while things have been painful, a development last year regarding my second-largest holding, Mid-Con Energy Partners (MCEP), suggests that, at the very least, there’s very little for shareholders to worry over when it comes to the upcoming revolving credit facility renewal for Legacy. This does not mean that Legacy is permanently out of the woods, but it does imply that investors probably don’t have too much to worry about at current energy prices until heading into 2020 when some of its Senior Notes and (likely) its Second Lien debt will come due.

A positive development for Mid-Con

Of all the E&P (exploration and production) firms in the oil and gas space, one of the ones I am most surprised at recently has been Mid-Con. Yes, most of the industry has taken a beating by this point, but the drop Mid-Con has seen (a decline of 39.9% since the start of October last year and down 64% from its 52-week high) has been staggering. Yes, the company is among the smallest public players out there and it had more leverage than it probably should, but its capital structure is fairly simple, free cash flow should be generated at current levels, and management has succeeded in growing production materially recently. At the end of the day, the huge drop in share price in it, as well as for many players in this space, can be chalked up to an overreaction in the oil markets.

One great positive development for Mid-Con was announced by management on December 19th when the firm came out to say that its credit facility lenders had agreed to increase its borrowing capacity by $10 million from $125 million to $135 million. Prior to a recent asset sale the firm announced, Mid-Con’s outstanding debt stood at $94 million and management said that they intend to continue using internally-generated cash flow instead of ringing up the firm’s debt further, but the fact that lenders increased its borrowing capacity despite the huge downturn in oil prices we’ve seen since early to middle of last year implies that there’s more appetite, for lenders out there, for oil and gas E&P firms right now.

To put how big of a deal this is into perspective, I decided to create the following table below. In it, you can see a breakdown of two different measures of free cash flow and two different measures of EBITDA and operating cash flow for Mid-Con under an assumption of $3 per Mcf natural gas prices (natural gas makes up around 6% of the firm’s output) and oil ranging between $45 per barrel and $70 per barrel for this year.

The high free cash flow and high EBITDA calculations do not factor in the fact that management must cover $3.2 million worth of preferred distributions per annum, while the low free cash flow and low EBITDA calculations have those figures subtracted from them. To be technically correct, preferred distributions should not be factored into these calculations, but since they are real cash outflows, it’s highly likely that lenders have taken the distributions into consideration.

*Created by Author

Now, in the next table below, you can see the debt/EBITDA ratios I calculated for Mid-Con based on both EBITDA calculations. In general, a ratio of 3 or lower is considered desirable, while a ratio of 2 or lower could be considered quite healthy at this time. 4 or high indicates that the firm is significantly leveraged and needs to focus on debt reduction, but it’s not necessarily a death certificate for the firm. Under the likely version of the ratio that lenders might consider important (with preferred distributions factored in), $45 oil would imply a debt/leverage ratio of 4.35.

If oil had been $50, this improves considerably to 3.83, but that is still quite high. Even so, the fact that management was able to get additional capacity in these uncertain times is a positive. To put this in perspective, the actual price of oil on the day before this announcement was made was $46.12, down from $49.80 a day earlier.

*Created by Author

One caveat some market participants might point to here is that Mid-Con did go on to engage in a significant asset sale that helped to reduce leverage materially and may have had (we’ll have to wait to see) a limited impact on cash flow. That said, this transaction occurred about two months after the credit facility increased, the terms of the credit facility extension did not stipulate such a transaction as being necessary, and it’s unlikely that lenders would have been even aware of a pending sale that far in advance. In short, I believe the deleveraging transaction that happened subsequent to the credit facility increase had no impact on the decision by lenders to increase its facility.

Legacy is not much worse off

Right now, Mid-Con’s capital structure is simple in that it really only has its common equity, preferred equity that can convert to common, and its credit facility. Legacy, meanwhile, has its common equity, convertible senior notes, senior notes (two classes with different interest rates and maturities), a second lien facility, and a revolving credit facility. Total debt, excluding convertible notes, is about $1.20 billion, while with convertible notes it’s $1.33 billion.

Upon a bankruptcy-induced restructuring, there would be different debt holders arguing over the value of the firm’s assets, with those on the lowest tiers pushing for the highest corporate valuation possible, while those on the highest tiers in terms of seniority pushing for a lower valuation. This legal bickering could and would have ramifications for the enterprise, but with credit facility lenders having the highest seniority, it’s extremely likely, especially given Legacy’s PV-10 value, that its credit facility lenders would be made whole.

Because of this, there is some restructuring-related risk with Legacy that Mid-Con doesn’t have nor did it have at the time of its credit facility’s increase, but I would argue that this isn’t great enough to affect the decision of lenders at the highest seniority level. At the end of the day, the decision of whether or not to extend maturities for the firm’s revolving credit facility will be based very largely on fundamentals.

*Created by Author

In the table above, I laid out the EBITDA, operating cash flow, and free cash flow (assuming the same $225 million is spent on capex this year as last year), and its debt/EBITDA ratios both in a world where convertible notes are considered by lenders and where they aren’t. This assumes that production growth this year stands at 0% and the same table below illustrates what happens if production grows at 10% and is achieved uniformly.

What we can see here is that, with higher oil prices, while the company is more leveraged than Mid-Con, its leverage ratios really aren’t that high compared to Mid-Con. It’s only with currently-low prices that we see some elevated amount of debt in relation to EBITDA, and even toward the low end of prices we can see similar leverage if convertible notes are left out as I believe they should be.

*Created by Author

Takeaway

Right now, the fundamental picture between Legacy and Mid-Con is similar. Now that Mid-Con received a bump higher in its borrowing capacity (and especially after its asset transaction), I believe it’s safe to assume the risk of a bankruptcy at current prices is essentially gone. For Legacy, investors still seem to fear the worst, but when you compare their debt levels, you find that there are some striking parallels between the two.

Admittedly, Legacy’s position is less attractive than Mid-Con’s and may require an eventual asset sale on the order of $50 million to $100 million, or a cut to capex, if production growth this year isn’t significant, but the fact that we saw lenders loosen their hold in a way on Mid-Con implies that Legacy could very well see its credit facility extended beyond 2019. If that happens, the firm will have yet another year to work out how to pay down or refinance its other debts, but with the market so volatile, it’s likely we’ll see high enough energy prices between now and then to address that down the road.

Disclosure: I am/we are long LGCY, MCEP. 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.