In our last article on Blueknight Energy Partners (NASDAQ:BKEP), we outlined several reasons why we are confident in the company's long-term trajectory. Following the publication of that article, the company reported solid Q3 earnings results that show successful cost reduction measures and improved operating performance in BKEP's Cushing oil storage business.
We would like to use this article to further expound on our long thesis on Blueknight and provide an in-depth analysis about the company and its long-term future.
Financial overview (in millions USD)
Share Price (BKEP)
Share Price (NASDAQ:BKEPP)
There are currently 40.7 million shares outstanding of BKEP common units, which trade on the NASDAQ as "BKEP". There are also 35.13 million shares outstanding of BKEPP, Blueknight's preferred shares.
BKEP shares have endured a sharp downwards spiral for the past three years (the high during this time was $7.55) due in part to a series of poor capital allocation decisions and operational mistakes which have eroded the market's faith in the company and its management. We'll outline these mistakes below as well as other headwinds that have battered the company's share price.
Knight Warrior Pipeline
Blueknight announced plans in August 2014 to develop a 160-mile pipeline to transport crude oil for east Texas producers to the Gulf Coast. CEO Mark Hurley noted that the project would cost ~$300 million; would be the largest project ever undertaken by Blueknight; and that construction may be complete by March 2016.
In November 2015, Reuters reported that Blueknight was delaying the Knight Warrior pipeline for a few months because of "lower oil prices and reduced production". Hurley noted that the company had spent $30 million of the estimated $300 million total to complete the pipeline.
The project was eventually canceled in the second quarter of 2016 (page 7 of 10-Q filing) "due to continued low rig counts in the Eaglebine/Woodbine area coupled with lower production volumes, competing projects and the overall impact of the decreased market price of crude oil." This led the company to take a $22.6 million impairment charge.
Cimarron Express Project
In May 2018, Blueknight announced a joint agreement with Kingfisher Midstream LLC, a wholly-owned subsidiary of Alta Mesa Resources, to develop a 65-mile crude oil pipeline from Kingfisher County, OK, to BKEP's terminals in Cushing, OK.
16 months following this announcement, Alta Mesa Resources filed for Ch. 11 bankruptcy and wrote down the value of its assets by $3.1 billion due to financial reporting failures that prompted an SEC investigation. AMR's bankruptcy coupled with a decline in oil prices in late 2018 effectively halted the Cimarron Express pipeline project and caused Blueknight to incur a $10 million impairment charge in Q4 2018.
While our analysis of the situation may be influenced by hindsight bias, we believe Blueknight management could have exercised more prudence by choosing a more conservative and well-capitalized company to partner with. Alta Mesa was established in 2017 with seed funding from Jim Hackett's Silver Run Acquisition Corp. II and a number of private equity players.
AMR grew quickly (it generated operating revenues of $513.6 million in 2018) by expanding aggressively and taking on debt. The company had no debt at the time of its IPO but $835 million in long-term debt and $322 million in interest expense obligations at the end of 2018 (page 78 of 10-K).
In our view, these decisions have negatively impacted Blueknight in two ways (above and beyond the financial impact of the impairment charges:
BKEP shares currently have a high distribution yield, an attractive feature for dividend-seeking investors. The company pays out annual distributions of $0.715 and $0.16 for preferred and common units, respectively. This equates to $31.6 million in cash distributions every year, or $7.9 million. The company's high dividend yield is one of the reasons why we are bullish on Blueknight because of the following:
Blueknight owns the following assets which are responsible for generating the bulk of its revenue:
Most of these assets are under short and long-term contracts - 5.7 million barrels of crude oil storage are under contract as of March 31, 2019, and lease and terminaling agreements are in place for all of the company's asphalt terminals (23 of these terminals are under contract with Ergon).
In our last article on the company, we came to a rough estimate of $865 million as the value of BKEP's hard assets, which is substantially higher than the company's enterprise value (this valuation implies a market capitalization more than twice as high as current levels).
Excellent Q3 Results
Unfair Acquisition/Takeover Unlikely
BKEP announced in August that Ergon had made a buyout offer for common and preferred unit holders, offering $1.35/share for common units (BKEP) and $5.67/share for preferred shares. Ergon subsequently pulled the offer after it failed to reach an agreement with BKEP's conflicts committee, which consists of three independent directors. The goal of this committee is "to review matters that the directors believe may involve conflicts of interest" (page 68 of 10-K).
The conflicts committee likely rejected Ergon's offer due to inadequate compensation for shareholders or some other reason that has not been made public. Note that the conflicts committee is comprised of three independent directors: Duke R. Ligon, Steven M. Bradshaw, and John A. Shapiro.
These individuals all have holdings in Blueknight (the rightmost column shows the implied value of their holdings at a share price of $3 for illustrative purposes:
The fact that the conflicts committee made the decision to contest Ergon's buyout proposal (and was successful in doing so) is indicative of sound corporate governance and a board that has the best interests of stakeholders in mind.
Delaware Chancery Court - Bandera v. Boardwalk
This 10/8 court ruling in this legal battle between Bandera Master Fund L.P. and Boardwalk Pipeline Partners has significant implications for MLPs, especially in regard to acquisitions and takeover attempts. The facts of the case are as follows:
The court ruled in favor of McBride and Bandera, noting that:
"The factual scenario as-pled thus has two dimensions: (I) intentional harm to one constituency without any apparent benefit to other constituencies or to the business of the entity as a whole, and (II) a causal mechanism by which the harm inflicted on one constituency benefits the party in control of the decision. Taken together, these dimensions support a reasonable inference that it was not “fair and reasonable to the Partnership” for the General Partner to cause the Partnership to issue the Potential-Exercise Disclosure on April 30, 2018. A party in control of an enterprise should not be able to transfer value from a particular constituency to itself, even under a constituency-based regime. Rather than a reasoned exercise of judgment about what is in the best interests of the entity, that type of value expropriation more closely resembles theft."
Ergon made a similar move as Loews as its buyout offer caused "intentional harm to one constituency" (BKEP unit holders who have experienced severe share price deterioration) in order to "benefit the party in control of the decision" (Ergon).
This court decision should serve as another inducement for potential investors since it implies that unfair takeover or acquisition attempts by the general partners of LPs will no longer be viewed as legally acceptable in the eyes of the law, which should discourage future attempts to do so.
For one's investment thesis to work, the market must eventually come to the same conclusions as the investor. We view Blueknight Energy Partners as a compelling investment opportunity but it is certainly possible that our thesis will be invalidated if one or more of the above risks materializes or the market fails to give the company credit for its portfolio of assets, high distributions, and attractive equity valuation. Thank you for reading and we welcome all comments and feedback.
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Disclosure: I am/we are long BKEP. 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.