A Deep Bullish Dive Into Blueknight Energy Partners

Summary

• Our conviction in Blueknight Energy Partners has increased following the publication of the company's Q3 earnings results.
• We believe that the company is in the beginning innings of a turnaround following a string of poor capital allocation decisions and operational mistakes.
• We are bullish on the name and will present an in-depth bull thesis on the company in this article.

Introduction

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)	1.15
Shares Outstanding	40.71
Share Price (NASDAQ:BKEPP)	5.34
Shares Outstanding	35.13
Market cap	234.41
(+) Debt	258.59
(-) Cash	2.78
Enterprise Value	490.22

Click to enlarge

(Source: CapitalIQ)

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.

Reasons for Share Price Decline

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.

(Source: thinkorswim)

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).

Implications

In our view, these decisions have negatively impacted Blueknight in two ways (above and beyond the financial impact of the impairment charges:

• Investors need to have faith in management's ability to allocate capital wisely and prudently - these errors have eroded the market's faith in BKEP's management to do so and have reduced equity value.
• The failure of these pipeline projects also dim the scope (to some extent) of BKEP's long-term prospects since these pipelines were meant to drive increased crude oil volume to the company's Cushing oil terminals. Successful project completion would have had a two-pronged benefit for BKEP investors (greater transportation and storage revenues).

Why We Are Bullish

Distributions

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 could choose to temporarily suspend distribution payouts in the event of a liquidity or operational crisis - a two-quarter suspension of all distributions would save the company nearly $16 million, which the company could use to pay down its debt or repurchase shares on the open market.
• Blueknight shares are trading at levels that imply that the market considers severe financial distress as a possibility. We are confident in Blueknight's financial position and view true financial distress as a remote possibility given that the company has a valuable lever it can pull to retain cash and meet any financing or liquidity needs (suspending or reducing distributions).
• While such a decision would likely draw short-term ire from the market, it would improve BKEP's ability to engender a long-term financial and operational turnaround.

Asset Valuation

Blueknight owns the following assets which are responsible for generating the bulk of its revenue:

• Cushing oil storage - BKEP owns 6.9 million barrels of crude oil terminaling facilities, the majority of which are located in Cushing, OK (page 7 of 10-K). Cushing has historically served as one of the country's major oil storage and export hubs, although some have argued that its relevance has declined due in part to efforts to build energy infrastructure elsewhere.
• Asphalt storage - BKEP also has 8.8 million barrels of asphalt storage capacity - the company owns 53 asphalt terminals across 26 states as of March 31, 2019 (page 5 of 10-K).

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

We were enthused by Q3 earnings results because they indicate that the BKEP's new CFO (Andrew Woodward) is committed to cost-cutting and improving the company's financial position:

• G&A expense was for the quarter was down to $3.84 million from $4.3 million in the prior-year period, which represents a 12% YoY decline. G&A expense for the nine-month period was down 20%, which (annualized) represents savings of ~$3.4 million. Woodward stated on the earnings call that going forward, G&A expense for 2019 can be extrapolated to 2020.
• Adjusted EBITDA in the quarter was $18 million, up 20% YoY. The company attributed this to improved operational performance and expense reduction.
• Operating margins improved across all of BKEP's business segments, an encouraging sign given that crude prices in Q3 2018 were higher than those in Q3 2019 (higher crude prices generally lead to more volume and greater profitability).
• Distributable cash flow during the period was $11.6 million, up from $9.0 million in Q3 2018. This represents a distribution coverage of 1.43x (distributable cash flow divided by the company's quarterly dividend payout).

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:

(Source: CapitalIQ)

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:

• Loews Corporation (L) announced in April 2018 that it was considering exercising a call option to buy the outstanding common shares of Boardwalk Pipeline Partners (a Houston-based midstream MLP) for $12.06 a share.
• The general partner of Boardwalk Pipeline Partners is Boardwalk GP, LP, which is indirectly controlled by Loews (details can be found on page 2 of the ruling).
• James R. McBride and Bandera Master Fund L.P. (which McBride presumably controls) subsequently filed a lawsuit against Loews and Boardwalk GP, claiming that Loews' buyout offer was unfairly low.

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.

Risks and Caveats

• Blueknight faces commodity price risk because the company's second largest business is crude oil storage and transportation, which exposes the company to fluctuations in crude oil prices (higher prices lead to higher demand for Blueknight's storage and transportation services).
• BKEP currently has long-term financial debt of $259 million and LTM interest expense was $16.9 million. Although we view this scenario as highly unlikely, a significant drop-off in operational performance and/or questionable capital allocation decisions could lead to a liquidity crisis for Blueknight, which has just $2.8 million of cash on its balance sheet (per its most recent 10-Q filing).
• As we described in the past article, the last couple of projects undertaken by the company have been questionable at best and have contributed to shareholder value destruction. There is no certainty that future projects or operational decisions will be sound, although we are hopeful that Woodward (BKEP's new CFO) will work prudently and exercise sound judgment.
• Blueknight is a small-cap company whose share price has been trading at depressed levels for the past twelve months. Investors should prepare themselves for significant share price volatility as a turnaround (if management can execute) will likely be choppy.

Conclusion

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.

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.