|Shares Out. (in M):||125||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,044||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||2,700||EBIT||0||0|
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Short LNG (Cheniere Energy, Inc) - $8.38
Long CQP (Cheniere Energy Partners ) - $17.21
LNG was written up a little over a year ago. Since then, there have been several significant developments and, with LNG now sporting a market cap north of $1B, I believe now is an opportune time to put on a position of short LNG and long CQP.
Cheniere’s primary asset is the Sabine Pass LNG terminal in Cameron Parish, Louisiana, which can receive, regassify, and store 4 Bcf/d of imported LNG. In 2004, Cheniere secured two Terminal User Agreements (TUAs) with Chevron and Total to provide 1 Bcf/d capacity on a renewable 20-year term for $125m each ($250m total). Based on these commitments, Cheniere was able to raise capital to fund construction, with the terminals completed and first revenue hitting from the contracts in April and July of 2009.
The original business strategy was to import LNG to feed the US’s growing energy needs. 50% of capacity was contracted on a long-term basis with the idea that $250m would be sufficient to cover overhead and debt service. The remaining 50% was contracted to another division, Cheniere Marketing, via an agreement called the Variable Capacity Rights Agreement (VCRA) that would capitalize on increasing demand for LNG by selling its capacity on a spot basis.
Fast forward from 2004 to today and innovations in shale drilling have made importing LNG into the US akin to selling ice to Eskimos.
Cheniere’s stock fell off a cliff as it became apparent that their only revenue would be from the Total and Chevron contracts, leaving no opportunity for growth and negative cash flow on a consolidated basis.
Cheniere could either restructure or seek growth through other avenues. In May 2010 they revealed a plan to do the latter by building a new facility that will enable Sabine Pass to liquefy natural gas and export it to arbitrage low domestic prices with higher overseas prices.
Cheniere has a complex structure and I suggest you take a look at an IR presentation as a visual can be helpful: http://phx.corporate-ir.net/phoenix.zhtml?c=101667&p=irol-presentations
In the current state, revenue is generated by the Sabine Pass facility which is 100% owned by Cheniere Energy Partners LP, a publicly traded MLP (ticker: CQP). CQP has a three-tier share structure: Common Units are first in line for distributions up to $0.425 / quarter. Once the Common are satisfied, Subordinated Units receive distributions up to $0.425. General Partner Units receive all distributions along with the other classes and will receive an increasing proportion of distributions on a tiered schedule if distributions increase above $0.489 per share.
Cheniere Energy Inc, the holding company (ticker: LNG), owns ~40% (12m) of the Common Units, with the balance owned by the public (19m). The Subordinated Units (135m) and General Partner Units (3.4m) are 100% owned by LNG.
LNG receives funds via distributions from its holdings of Common and GP Units. Current cash flow is insufficient to provide any distributions to the Subordinated Units. LNG also has some minor assets that add ~11m (i.e. a Management Services Agreement through which funds flow directly from Sabine to the holding company without going through the MLP structure).
Below is an illustrative cash waterfall:
*Note that LNG just raised $330m in equity, likely to pay down $298m outstanding on the 2007 Term Loan maturing in May 2012. The same may be done for the $204m Convertible Note due August 2012. Run rate interest cost would be reduced accordingly.
Present course should result in a worthless LNG as it would have negative cash flow each year and liabilities in excess of its assets. As a result, management is pursuing the above-mentioned Liquefaction project.
The Liquefaction plan is similar to the original construction of the Sabine Terminal: secure long-term fixed contracts with sound counterparties and use these as the basis to raise capital to fund construction. The goal is to build four liquefaction trains with construction staggered for two at a time (two trains provide 8mtpa capacity), with the first set completed in late 2015.
Capacity for the initial phase has already been contracted out. Cheniere has signed Sale and Purchase Agreements (SPAs) with BG and Gas Natural Fenosa for 3.5 mtpa each on a 20 year basis. Cheniere also signed an SPA with GAIL India on similar terms for one of the second phase terminals, while also providing for 0.2 mtpa from the first two terminals until the second phase is completed.
The economics for the first phase look like this: BG and Fenosa are contracted for 182,500,000 MMBtus each. BG’s capacity charge is $2.25 / MMBtu and Fenosa’s is $2.49, providing revenue of $865m. Including the smaller portion contracted to GAIL at a $3.00 charge adds $31m to for a total of $896m.
Construction costs are estimated to range from $4.5B to $5B. Management has indicated they will finance this with 60% debt raised at the Liquefaction facility level and 40% equity raised at the CQP level.
Importantly, management has indicated that they will issue a new class of shares at the CQP level. The reason for this is that they cannot issue additional CQP shares and maintain the current distribution. CQP’s current annual distribution of $52.7m takes up all available free cash. Diluting CQP would do severe harm to CQP as well as to LNG, which relies on its distributions. Likewise, issuing new Subordinated Units isn’t palatable as the old units would unfairly share the economics of the Liquefaction facility with the new units.
I speculate the new share class will be akin to existing CQP common units: they will be paid a distribution that meets a target return with some type of provision that waterfalls excess cash to current Common and Subordinated Units. If a 12% return is targeted, a $2b equity outlay in 2012 would require annual distributions of $375m from 2016 through 2035.
Phase 1 Liquefaction Cash Waterfall
*From proxy: “The Long-Term Commercial Bonus Pool will equal 11% of Margins generated from any contract entered into by the Company with a term of four years or more.”
This remaining $116m would flow through the earlier waterfall, providing a ~100% contribution to LNG since it would flow solely through the Subordinated Units, leaving no leakage to the publicly held CQP shares.
However, you can see that adding $115m in 2015 to the current cash flow deficit does not exactly support a current market cap in excess of $1b.
Second Phase & Excess Capacity
The current share price is clearly not based on the economics of the existing facility and initial phase of the liquefaction project. Shareholders must be hoping that two other sources of revenue work out. First, there’s the second phase of the Liquefaction facility. If they sign another contract on similar terms as the GAIL contract ($3.00 capacity charge), the second phase would yield $1,095m in revenue. However, even this doesn’t lead to an amazing IRR to LNG at current prices, especially when considering the successful completion of the second phase is anything but a sure thing (financing for the first phase hasn’t even been received yet!)
The second source of revenue is to sell excess capacity on a spot basis (e.g. the first phase is 80% contracted. Cheniere could conceivably contract out an additional 10% on a spot basis). On Cramer, the CEO quoted this potential at $700-800m given today’s prices. The true potential revenue is totally unknowable as it depends on the spread between domestic and foreign natural gas prices in 2016 and beyond. Could the same thing happen that occurred to the Sabine Receiving Terminal as shale developments in Europe and Asia bring down prices and make the long-distance transportation of LNG uneconomical? Who knows? What type of discount rate would you apply to this?
Short LNG / Long CQP
These concerns about future revenue bring me to why I favor a position of Short LNG / Long CQP. Although I believe LNG is overvalued on its own right, I’m concerned that management’s skill at raising capital and promoting their story of unquantifiable future revenues in a hot sector could make this a long and frustrating short. Take a step back and consider what they have built to date: they have turned $250m of recurring revenue and a story into a structure that supports over $3b in debt and over $1b in equity market cap!
There are two key events on the horizon: 1) successfully raising capital for the Liquefaction project and 2) successfully refinancing $550m of the Sabine senior secured due Nov 2013. If they trip on either of these hurdles, a short LNG position would work wonderfully. However, I believe there is a significant chance they get through both of these hurdles and the story drags on for an uncomfortably long time.
If you are short LNG / long CQP, you get paid to wait by collecting the 10% CQP distribution that feeds LNG’s value. I see potential scenarios playing out as follows:
The liquefaction project is successfully financed. The promise of future cash flow via the VCRA enables the 2013 Sabine maturity to be refinanced. LNG steadily loses value due to equity issuance to fund its annual deficits until 2016 as well as the August 2012 maturity. Any construction cost or time overruns accrue in your favor by hurting LNG’s value while CQP’s distributions remain tied to the Total and Chevron contracts which are unaffected.
Cheniere fails to successfully finance the Liquefaction project. The 2013 Sabine maturity is not refinanced as revenue from the existing contracts is insufficient. LNG and CQP are both zeros, but you collect the distribution until default is triggered in late 2013. You may even be able to get out of CQP at an inflated price as it is primarily retail-owned, a group not known for seeing the impending end of long-running distributions.
You receive a negative return as LNG steadily outperforms CQP up to 2016 and all the promises about significant revenue from excess capacity prove true.
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