Value Investors Club / LEGACY RESERVES INC (LGCY)

Description

EXECUTIVE SUMMARY

Legacy Reserves, Inc. (NASDAQ: LGCY) presents a startlingly asymmetric risk-reward profile with substantial upside (many multiples). Both cyclical and structural inefficiencies are at work to create this remarkable opportunity and to shield it from the market’s watchful eye. Legacy has operated a hated business model (upstream MLP) in a sector that has generally been out of favor for nearly four years.

They have pivoted their business model and have very recently changed their legal structure (MLP to C-corp). This will lead to forced buying from passive index funds in the near term and provides Legacy better access to capital markets. As a yield generating MLP, they were sitting on low-decline (<11%) Proved Developed Producing (PDP) reserves in addition to extensive horizontal drilling locations, which now enable Legacy to deliver explosive EBITDA growth while spending within operating cash flow.

EBITDA is currently at the highest level ever (Q2TTM ~284M); we forecast EBITDA to be ~$500m in 2019, ~$930m in 2020, and ~$1.4B by 2022. We estimate net assets are currently worth >2x the market cap on liquidation value alone, which provides a substantial margin of safety and a very low likelihood of

permanent capital loss.

COMPANY OVERVIEW

Legacy is a Midland, Texas-based independent energy company. It has a unique balance of diversified, stable PDP reserves with significant potential for horizontal drilling in the Permian Basin and East Texas. Q2’18 production was 47.5 MBoepd from 4 regions (Permian, East Texas, Rockies, Mid-Continent) with <11% decline.

This low decline is a very significant and differentiating aspect of Legacy versus other exploration and production (E&P) companies in the Permian Basin. Most E&P companies operating horizontal drilling programs experience extremely high decline rates for their wells (>30%). Horizontal shale wells decline rapidly: that is the nature of horizontal fracturing. As a consequence, companies must out-spend cash-flow for a significant period of time in order to build up a stable base of lower-decline producing wells. These companies must spend heavily just to replace last years’ EBITDA, and even more to be able to grow. Whether or not these companies ever “get ahead of the curve” will be largely dependent on the quality of their acreage, future commodity prices, and their operational execution.

Legacy, on the other hand, has a large diversified base of stable, low-decline (<11%) wells which provides a stable platform from which to rapidly grow its EBITDA: it does not have to spend heavily to replace last year’s EBITDA and the majority of its capital expenditure produces new EBITDA. Said another way, “maintenance” capital expenditure requirements are very low. In addition to this base production, Legacy currently has 939 gross (673 net) operated horizontal Permian and East Texas drilling locations on a large base of acreage all held by production. These identified locations are delineated by offset operators’ activity and can be drilled within operating cash flow - enabling Legacy to deliver explosive EBITDA growth.

COMPANY BACKGROUND

Legacy existed as an upstream Master Limited Partnership (MLP) from 2007 to September 2018. It was built on a strategy of buying producing conventional wells that had passed their initial production peak and were in a long-tail, low-decline production phase. The company would purchase new assets with significant leverage and distribute the majority of its free cash flow to unit holders. This model had certain tax advantages to its unitholders (who also enjoyed significant distributions from the company) but was built on the assumption that its depleting asset base would not decline in value.

Then the oil market crashed. Legacy was forced to take significant impairments on its assets, cut its distributions to zero, and faced the risk of breaching several debt covenants (its leverage ratio climbed to nearly 8x). As an MLP, it had not retained any substantial earnings and, as a result, it faced a severe liquidity crisis as revenues began to fall. A pass-through entity that does not pay a distribution is an asset that few investors seek to own. Consequently, the company lost its investor base, the stock fell by ~95% and the company was priced for bankruptcy. Facing similar circumstances, virtually all of its upstream MLP peers went bankrupt and all analysts stopped following the company.

The crisis Legacy faced was indeed severe. The future was extremely uncertain. However, Legacy had what its peers did not: 1) a unique balance of diversified, stable, low-decline PDP reserves along with significant potential for horizontal drilling in the Permian Basin and East Texas, 2) a smart, capable and shrewd management team, 3) a determined board of directors, and 4) significant ownership among the board, management, and founders. The company has not only weathered the downturn but positioned itself for substantial growth. It is currently an “equity stub” with a market cap of $524m (as of 10/17/18) and Q2 reported net debt of $1,319m.

Management realized that Legacy’s undeveloped horizontal drilling assets in Texas could enable them to become an E&P company. While other E&P companies were flocking to West Texas to purchase acreage for horizontal drilling, it was already holding tens of thousands of prime acres (which were already held by production)! The way to save the company was to manage liquidity in the near term in order to provide time to pivot their business model and transition from an upstream MLP to an E&P company. To that end, management took a number of crucial steps:

In 2015/16 they sold less performing assets to increase liquidity and get covenant relief.
In 2015 they signed a joint development agreement (JDA) with TSSP to fund the cost of starting a horizontal drilling program with existing assets; they turned their focus to improving their leverage ratio by growing EBITDA (as opposed to simply paying down or restructuring debt).
In early 2016 they repurchased $169m of unsecured notes on the open market for $0.13 on the dollar, and exchanged $15m of unsecured notes for 2.7m common units.
In 2016 they signed a second lien (2L) term loan agreement with GSO which increased liquidity by 50%.
In December 2017 they bought back $187m of unsecured notes for $0.7 on the dollar (giving them voting control over their bond indentures and paving the way for the “whiteout” transaction described below).
They had a reasonably strong hedging strategy to support revenue and liquidity needs through 2018.
In September of 2018 they:
- Completed a “whiteout” transaction whereby they converted their preferred unitholders into common and transformed from a Limited Partnership to a C-corporation.
- Exchanged $130m of their unsecured notes (due in 2020 and 2021) into convertible unsecured notes due 2023 (which will mandatorily convert if the share price trades above $6 for 20 of 30 days).

These steps have been critical to the company’s success. Under the terms of the JDA, Legacy paid just 5% of the cost to drill certain Permian well locations and received a 20% working interest (WI) in those wells (increasing to 85% WI after TSSP achieved its 15% investment hurdle rate). This allowed management to prove they could execute a horizontal drilling program and grow EBITDA with existing assets, enabling a pivot in their business model from an operator of mature wells to an E&P company. The JDA program went so well that in Q3’17 Legacy payed TSSP $141m to pull forward the reversion date 3+ years. This increased EBITDA and drove down the leverage ratio.

The 2L term loan provided the near-term liquidity that the company needed in order to make the TSSP reversion payment, fund an increased horizontal development program, and buy back a large block of its unsecured notes at a discount, paving the way for the next crucial step: conversion to a C-corporation (and simultaneous “whiteout” of the preferreds). The company completed this step on September 20, 2018. While the company is still over-levered, its new structure provides access to capital markets that were closed to it as a partnership. This is evidenced by the fact that the $130m of notes to convertible notes only occurred after the company transitioned to a corporation.

Crucially, these steps have enabled the company to prove its ability to operate as an E&P company (indeed, it has been functioning in that capacity for nearly 3 years). It has been investing all operating cash flow into growing EBITDA. By doing so, the company’s leverage ratio has fallen drastically (we estimate the leverage ratio at Q3E’18 to be 3.96x pro forma for the conversion of recently issued 2023 Convertible Notes).

Legacy has converted from an MLP to a C-Corp, pivoted it business model to become an E&P company, and is currently drilling its way to recovery. Even now, the market does not seem to recognize the current value nor its sizeable growth potential. Through extensive modeling of all aspects of the operations, we believe it can now move forward to do the following:

Recapitalize the business (Began the process of deleveraging through the Q3’18 exchange of $130m notes due in ‘20/’21 for convertible notes due in 2023)
Accelerate horizontal drilling within operating cash flow
Grow into their debt
Generate sizable long term free cash flow

We believe value has been shielded from the market for the following reasons:

An MLP legal structure – hated in the upstream energy sector
A complex and over-levered capital structure
A misunderstanding of Legacy’s assets and strategy

OPERATING VALUATION

As previously stated, we believe the key to Legacy’s dramatic EBITDA growth in the coming years (especially 2019 and 2020) will be its ability to allocate significant CapEx to new horizontal drilling programs on existing acreage within operating cash flow and with no additional debt. This is achieved by investing the significant free cash flow generated by its low-decline PDP reserves into its existing de-risked horizontal drilling locations. Specifically, we estimate the company will drill between 12 to 20 net wells per quarter in the Permian, and between 2 and 13 net wells per quarter in East Texas in 2019 and 2020, respectively. From there, it will be able to pay down debt, grow free cash flow, and likely acquire new drillable assets. Below we show historical and forecasted CapEx budgets and resulting annual EBITDA figures:

2017 CapEx: ~$177m –> 2018 EBITDA: ~$226m
2018 CapEx: ~$225m –> 2018 EBITDA: ~$317m
2019 CapEx: ~$400m –> 2019 EBITDA: ~$500m
2020 CapEx: ~$750m –> 2020 EBITDA: ~$930m
2021 CapEx: ~$900m –> 2021 EBITDA: ~$1,200m

The following charts illustrate the impacts of increased CapX on Production, EBITDA, Free Cash Flow, Total Debt, and Leverage:

The chart below describes the key factors contributing to EBITDA growth through 2020. EBITDA growth from new production in both the Permian Basin and East Texas are the largest contributors in both 2019 and 2020 ($160M and $409M) respectively. Note how the small decline rate of historical production allows new horizontal production to have a dramatic impact on EBITDA. They are not replacing EBITDA; they’re adding to it!

Below is a similar bridge showing production growth from 2018 to 2020. Again, note that new Permain and East Texas production are the dominant factors as they build on top of the stable base of conventional production.

We believe that the market has not yet realized the underlying value of Legacy’s assets and the incredible growth potential that its new strategy presents. As the company continues to deliver operationally, this hidden value should begin to be unlocked. Given the dramatic growth forecasted and Legacy’s nature as an equity stub, we think that using a forward EV/EBITDA multiple is the most appropriate metric for approximating fair value. Accordingly, our year-end estimates of fair value are based on a 6x multiple of next year’s EBITDA. (As a reference, the average forward EV/EBITDA multiple for 20 peer E&P companies as of 9/14/18 was 6.3, ranging from 3.7-9.9)

We estimate “fair value” of the operations to be roughly $14 per share by year-end, after giving effect to the conversion of the 2023 Notes (and greater than $50 per share by 2021 if they choose to follow a path similar to the one outlined above). However, we don’t know if or when the market will realize this value. What is the margin of safety? What is the “intrinsic” value?

ASSET VALUATION

The previous section presents a valuation based on the operating potential of the business. It is instructive to also consider the value of the existing operation and assets, regardless of growth opportunities as a downside protection and as an indicator of current intrinsic value. This section presents a net asset value (or liquidation value) of Legacy’s assets.

We conducted extensive research on oil and gas assets, looking at comparable sales of both PDP reserves and undeveloped acreage from 2015-2017. In the Permian we estimated the value of the acreage by county, using actual transactions in the vicinity of Legacy’s current assets. This required some assumption of the geology available in each county both in Legacy’s assets as well as in the comparable sales. These should be very conservative estimates of PDP and acreage value given the oil price environment and overall sentiment in 2015-2017. Current market pricing is likely higher.

Liquidation Value (assuming an orderly liquidation of assets):

Current Production (PDP reserves): $1,416m

De-risked Permian Acreage (56k net acres): $850m

Other Permian Acreage (Est. 194k net acres): $97m

Shelby County Acreage (13k net acres): $32m

Other Assets (pipeline/ infrastructure): $100m

Total Estimated Liquidation Value of all Assets: $2,495m

Net Debt (as of June 30, 2018): $1,319m

Net Asset Value: $1,176m

Net Asset Value per Share (~106.1m shares): ~$11.08/share (i.e. intrinsic value)

Equity Share Price (as of 10/17/18): $4.94/share

Net Asset Value / Market Cap: 2.2x

CATALYSTS TO UNLOCKING VALUE

As discussed previously, Legacy completely lost its investor base. A yield-generating MLP that does not pay a distribution does not have a home in the investment community (it was an orphaned security). All analysts stopped covering it. After transitioning its legal structure from an MLP to a C-corporation, Legacy will now be exposed to a much larger universe of potential buyers, most notably index funds which will be forced to buy. There are numerous indices (e.g. Russell 2000, S&P 600, S&P Total Market Index, Dow Jones Total Market Index, etc.) - and even more funds that track those indices.

As a reference, it is useful to look at the average portion of the float of peer companies that is owned by the 3 largest index fund operators: Blackrock, Vanguard and State Street Corp (none of which own any shares of Legacy). These three own 11-28% of peer E&P companies operating in the Permian Basin. (See the chart below)

There are hundreds of funds beyond these, tracking the myriads of indices. Our research indicates that total index fund holdings of peer companies range from 15% to as high as 60% of floated shares. Legacy currently has almost no passive ownership and 93m floated shares, suggesting 14m - 56m shares of LGCY that must be purchased by index funds just in the next year. These passive owners will be required to purchase shares irrespective of price or value. This structural inefficiency represents a major catalyst that could result in rapid share price appreciation, thereby accelerating the market’s realization of fair value.

However, this thesis is not dependent on market mechanics, but rather on the fundamental value of Legacy’s operation. Below are the remaining steps we believe will be necessary for the market to fully recognize Legacy’s value (i.e. for the share price to approach fair value):

Transition from an MLP structure to a C-corp (Closed on September 20, 2018)
- “Whiteout” transaction: the company formed a new entity that acquired the GP of the former MLP partnership, and had a subsidiary that merged with the LP.
- $237.5m par value in preferred shareholder equity was converted to common stock. Additionally, $47.5m in deferred distributions were eliminated to clear the path for a potential equity raise and/or other measures to recapitalize the business.
- Management has indicated the importance of this transaction to provide “enhance[d] access to, and lower cost of, capital”. It allows them access to a larger field of both lenders and investors.
- As discussed, this transaction is likely to induce forced buying from index funds as well as open up Legacy to a much larger investor base.
Recapitalize the Company (Q3’18 to Q1’19)
- As announced on 9/14/18, Legacy has entered into an agreement with holders of existing unsecured notes due in 2020 and 2021 to exchange a portion of them for convertible notes due in 2023.
- Equity Raise: We believe this is likely to happen through further debt for equity swaps or an offering of newly issued shares (there are other potential options, but we believe they are less likely given current circumstances).
- Asset Sales: Potentially sell non-strategic assets (East Binger, Piceance, other Rockies or non-core assets).
- Refinance and/or receive an extension of the current bank revolver. (OCC compliance rules require leverage ratio below 4X; Estimated Q3’18 pro forma leverage ratio is 3.96)
- Refinance 2L loan and/or unsecured notes. (Most likely requires a leverage ratio of ~3x or lower to refinance, hence the likely equity raise above)
- We strongly believe that when the company is no longer excessively levered the equity value will rise quickly.
Accelerate development programs with existing Permian Basin and East Texas assets (2019 onward)
- Expected to fund entirely within operating cash flow, building on a strong foundation of low-decline PDP.
- This effort is likely to generate extreme EBITDA growth in 2019 (~$500m) and 2020 (~$930m).
- This process could begin when management releases 2019 guidance.

RISKS TO THE THESIS

The company is still over-levered. Below is a summary of Legacy’s current debt profile:

1L Secured Revolver (due Apr 2019): $508m
2L Secured Term Loan (due Aug 2021): $339m
8% Unsecured Notes (due Dec 2020): $212m
6 ⅝% Unsecured Notes (due Dec 2021): $137m
8% Convertible Notes (due Sep 2023): $130m – These notes (issued on 9/20/18) mandatorily convert if the common shares trade above $6 for 20 days out of any 30 day period. Legacy’s common equity has already closed above $6 on 40 of the 120 trading days since the end of Q1’18.

If debt markets tighten and/or the company has any operational difficulty that might slow the reduction of Legacy’s leverage ratio, which could impede efforts to extend or refinance the 1L revolver, 2L term loan and/or unsecured notes prior to their respective debt maturities. However, the company has already weathered an extremely difficult period and has positioned itself specifically to be able to deal with these debt issues. So far, the company has:

Bought back $187m of unsecured notes for $0.7 on the dollar in December 2017.
Completed the transition from an MLP to a C-corp on September 20, 2018, which provides better access to capital markets.
Executed an agreement to exchange $130m of existing notes due in 2020 and 2021 for convertible notes due in 2023 (though they will likely be converted to equity well before maturity).
Reduced TTM Debt/EBITDA leverage ratio from 7.7 to 4.7 in Q2 2018. We estimate the leverage ratio at Q3’18 to be 3.96x (pro forma for the conversion of the 2023 Notes); we expect it to be <3x by Q2’19 and <2x by Q1’20.

There are risks associated with execution/cost of drilling (if drilling costs are higher than expected or wells produce below expectation, EBITDA growth and debt reduction could be lower). We have included these potential inefficiencies in our models. Off-setting this risk are the facts that:

The company has been letting off-set operators prove their acreage before they drill it.
The company proved its assets and its horizontal drilling ability with TSSP’s capital instead of its own.
Production growth and EBITDA are at record highs (47.5MBoe / day and $284m TTM respectively).
29 new wells have been brought on line this year and 76 new wells since the commencement of their horizontal drilling effort.
The company has been and is continuing to use existing acreage as currency to swap for larger contiguous acreage blocks and improve well economics.

Of course, there are risks associated with commodity prices. The company is much more dependent on oil than gas prices. If oil prices were to fall, EBITDA and cash flow would fall. Offsetting this risk:

Oil prices could fall below $45 for up to 2 years and the thesis would remain intact (though with a lower upside).
- Incumbent in this risk is the potential for a prolonged pipeline bottleneck in the Permian Basin. Our forecasts take this into account.
The commodity price is likely to be volatile in the short term, but we believe there is significantly more upward pressure in the medium to long term. Our view is that an extended low price environment is extremely unlikely. If it were to fall for a relatively short period (<2 years), Legacy could slow drilling and take other mediation efforts that would implicitly protect this thesis.

CONCLUSION

Legacy Reserves Inc. is a tremendous investment opportunity with a significant margin of safety. The likelihood of long-term capital impairment is low. Legacy weathered the down turn with very shrewd management, a determined board, and a strong asset base. The company has successfully pivoted their business model from an upstream MLP to an E&P C-corporation and is well positioned to execute on that model in order to:

Recapitalize the business and address near term debt maturities,
Expand their horizontal drilling programs on existing acreage both in the Permian and East Texas, within operating cash flow,
Significantly grow EBITDA, and…
Create significant value for shareholders.

The market priced the company in line with its MLP peers, many of whom went bankrupt, and overlooked it due to its legal structure and complex capital structure. The conversion to a C-corporation should induce forced buying by passive index funds, which could facilitate rapid share price appreciation. Our projected returns range from 3x to 12x in the next 12-48 months relative to Q4’18 prices.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

*Recent transition from an MLP structure to a C-corp (creates forced buying from index funds)

*Recapitalization the Company

*Acceleration of development programs with existing Permian Basin and East Texas assets

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			2018	2019
Price:	4.94	EPS	0	0
Shares Out. (in M):	106	P/E	0	0
Market Cap (in $M):	524	P/FCF	0	0
Net Debt (in $M):	1,319	EBIT	0	0
TEV (in $M):	1,843	TEV/EBIT	0	0