Correction: The previous version of this note incorrectly stated that we compared 3Q13 production to 2Q12 production. That was a typo. We are comparing 2Q13 reported production to 2Q12 reported production (year-over-year). It's a crucial point, and we want to make sure that it is clear. - Kevin Kaiser
BreitBurn Energy Partners (BBEP) remains a top short idea for us. DCF is generated primarily via understated maintenance capex, as evidenced by the fact that the Company posted no organic production growth over the last twelve months, while total capex exceeded maintenance capex by ~$130MM. This is BBEP’s most material distortion of its economic reality, and the reason why the equity is so overpriced. We also take issue with the BBEP’s capital efficiency, leverage, calculation of non-GAAP measures, valuation, and corporate governance.
Understated Maintenance Capex
We believe that BBEP’s “maintenance capex” is significantly understated, and is responsible for nearly all of the Company’s “DCF,” despite management’s qualitative, unsubstantiated comments on the conference call yesterday (8/6/13) that suggest otherwise:
Analyst: “With respect to maintenance capex, what assurances can you give us that your maintenance capex is sufficient to maintain production, and can you provide us with some granularity or transparency about how you go about calculating that number?”
BBEP COO Mark Pease: “I think that everybody on the call knows that we define maintenance capital as the amount of investment that it takes to hold production flat, and we look at it regularly, and what we use for the basis for those calculations is our year-end reserve report . . . And we look at multiple years on that reserve report. So, we don’t cherry pick a year and we don’t try to put the properties or projects that are more capital efficient . . . We take our exit rate for the latest year in that reserve report and then we look at the reserve report and see how our rate varies out in the future . . . And for instance, if our base decline is 10%, and we look at the time period that production covers and it goes up 5% . . . two-thirds of the money that we spend is needed to cover that 10% base decline. So that’s the details behind it and it’s all backed up by what we have in the reserve report . . . ”
Analyst: “And historically speaking, when you’ve done that exercise, how have your projections about the production from the dollars spent, how have those borne out versus your estimates when you’re making that maintenance capex budget.”
BBEP COO Mark Pease: “I think on the whole, they’ve been very good. And that’s one of the things about having a bigger portfolio of projects, some projects come in better than forecast, some come in under forecast, but as a whole, the program has matched closely.”
But, according to BBEP’s actual production results, over the TTM (2Q12 – 2Q13), BBEP’s organic production growth was negative 0.3%, with total capex exceeding maintenance capex by ~$130MM. The consequence is that, over the TTM, understated maintenance capex generated ~80% of DCF. Management says one thing; the numbers say something entirely different. This is BBEP’s most significant issue, and the primary reason why we believe the equity is so overpriced.
Timing of Equity Raise in Focus
With the amended leverage covenants referencing pro forma TTM adjusted EBITDAX (i.e. BBEP gets the Postle Field adjusted EBITDAX in full for the TTM), BBEP does not have to reduce debt as quickly as we had thought previously. BBEP stated that it will be at 4.0x total debt/TTM pro forma adjusted EBITDAX at the end of 3Q13, implying that the Postle Field TTM adjusted EBITDAX was ~$40MM per Q. BBEP’s leverage will continue to tick higher QoQ with calls on cash (capex + distributions) consistently exceeding cash flow by $40 - $50MM per Q (depending on go-forward capex). The timing of the deleveraging was a popular topic on the conference call, and though management gave little hint as to what it’s thinking, perhaps the “Triggering Event” described in the Ninth Ammendment to the Second Amended and Restated Credit Agreement gives us some idea:
“’Triggering Event’ means Parent’s receipt, at any time after Ninth Amendment Closing Date, of net cash proceeds from the issuance of common units (“Equity Proceeds”), as follows: (a) the first Triggering Event means receipt of Equity Proceeds in a cumulative amount of at least $175 million, and (b) the second Triggering Event means receipt of additional Equity Proceeds such that the cumulative amount received after Ninth Amendment Closing Date equals at least $350 million. By way of example, if the Parent receives Equity Proceeds in the amount of $200 million on August 20, 2013, Equity Proceeds in the amount of $100 million on November 20, 2013 and Equity Proceeds in the amount of $50 million on February 20, 2014, the first Triggering Event will have occurred on August 20, 2013 and the second Triggering Event will have occurred on February 20, 2014.”
$350MM of equity at $18.50/unit would amount to 19MM new shares, approximately 20% dilution to existing unitholders.
Changes to Derivatives Accounting, Adjusted EBITDAX, and Disclosure
We note several changes QoQ in BBEP’s derivatives accounting methodology, calculation of adjusted EBITDAX, average realized sales price, and the associated disclosures in the press release and 10-Q:
- BBEP no longer has realized and unrealized gains/losses on commodity derivatives, but total gains/losses, cash settlements, and premiums paid. This is an improvement in disclosure, however, the Company still only counts cash settlements in adjusted EBITDAX/DCF; adjusted EBITDAX/DCF is still, in our opinion, overstated by the cost basis of the derivatives that settled in the period, which amounted to 3.7% of DCF in 2Q13 and 2.5% in 1Q13. There is another ~$28MM in future overstatement coming, as the Company paid $30MM for premiums in 2012. Further, BBEP also paid ~$40MM cash for WLL’s in-the-money swaps, which will overstated future period adjusted EBITDAX/DCF just as paying a counterparty an option premium does.
- BBEP no longer adds “net operating cash flow from acquisitions, effective date through closing date” to adjusted EBITDAX, and it “conformed” 2Q12 adjusted EBITDAX to exclude $1.6MM for this adjustment. For all of 2012, the adjustment generated $19.9MM (12%) of DCF. BBEP will likely “conform” 3Q12 adjusted EBITDA lower by $13.2MM and 4Q12 adjusted EBITDAX by $5.1MM.
- “Average realized sales price” now “excludes the effect of commodity derivative settlements,” whereas last quarter it included them.
Disclosure has improved, but the non-GAAP measures of adjusted EBITDAX and DCF remain inflated measures of profitably due to the fact that BBEP excludes the cost basis of derivatives (both premiums paid and acquired hedges), unit based compensation, non-cash interest expense, and cash taxes from their calculation.
Why so Cryptic on the Postle Field?
BBEP’s management is reluctant to dig into the cash flows from the recently-acquired Postle Field:
Analyst: “Can you share what the cash flow just from [the Postle Field] might be versus the capital that would be needed to keep [production] flat?”
Phenomenal question. We wanted to ask that as well. And here’s management’s response:
COO Mark Pease: “I don’t know if we’ve disclosed that.”
CFO Jim Jackson: “We just haven’t – we have not given that level of detail on [the Postle Field] to date.”
Analyst: “Okay, thank you.”
Why not disclose that answer? Surely they know it, and it’s a crucial information . . . We want (need) to know how much of this new capital is going into the maintenance capex and growth capex buckets. The fact that they don’t want to speak to this issue suggests to us that a significant portion of it will be considered growth capex, which is inappropriate, in our view. This is likely a significant driver of the increase in future DCF coverage.
Guidance Cut or Sandbag?
Despite closing the Postle Field acquisition 15 days early, BBEP did not adjust 2H13 production guidance. That’s an incremental 110,000 bbls of oil production for 2H13 that was not in the prior numbers. Management noted on the call that it was not material enough to adjust guidance, but we think that it is. It’s an extra 1,200 bbls/d in 3Q13 and 600 bbls/d in 2H13.
After spending ~$600MM on acquisitions (before Postle) and another ~$200MM of capital expenditures over the TTM, adjusted net income per unit came in at $0.13 in 2Q13, down from $0.15 in 2Q12, and discretionary cash flow (CFFO before change in WC) per unit was $0.56 in 2Q13 vs. $0.72 in 2Q12. Free cash flow (discretionary CF minus capex) this quarter was negative $5MM (-$0.05/unit) vs. +$28.2MM (+$0.39/unit) in 2Q12. How ‘bout that for profitable growth?