Description

The Pitch

Atlas Resource Partners (ARP) is an E&P MLP which is attractive from both an absolute and relative perspective.  Currently yielding 11.6% on management’s 2014 distribution guidance, I believe that ARP will trade to a 9% yield on 2014 distributions sometime over the next four quarters. While the timing of the revaluation is uncertain, I believe that ARP offers a return potential of ~40% over the next year (~30% from appreciation and +10% from distributions). More importantly, I believe that the chance of loss is low. Looking a year out, the break even share price would have ARP yielding +13%. I think it is highly unlikely that the yield would reach those (or higher) levels.

Below is a very sophisticated sensitivity table demonstrating total return based on holding period and exit yield.  

Why the Opportunity Exists

On June 10^th, ARP announced that it was acquiring existing gas producing assets from EP Energy for $733MM. Though the acquisition adds 10% accretion to ARP’s distribution, the stock sold off 5%. The sell off wasn’t surprising. ARP issued 14MM units to finance the equity component of the purchase, increasing the unit count by 32%. Over the past fifteen months, ARP has increased its unit count +125%. I believe the recent weakness in E&P MLPs, compounded by the market absorbing such a large issuance, has created a buying opportunity for ARP. Of note, ARP is currently 6% above its 52 week low and 21% below its high; in spite of the fact that it will have posted +40% yoy distribution growth.

Background

We spend a lot of our time in the MLP space. Generally, we prefer fast growing GP’s with dominant asset footprints. Occasionally, we invest in LP’s that fall into a “special situation” bucket; where the LP has growing distributions and is priced at an unreasonably high yield. ARP is, of course, in this second group. We view these situations as low-risk singles/doubles.

ARP is the E&P LP of Atlas Energy (ATLS). ATLS retains a GP interest in ARP (with IDRs), as well as 34% of the LP units currently outstanding. ARP was spun out from ATLS in March 2012 with the intention of ARP growing rapidly by acquiring existing oil and gas production at accretive prices. That’s just what has happened. Over the past fifteen months, ARP has deployed +$1.4B, growing the unit count from 26MM to 59MM, and increasing the annualized distribution from $1.60 at the time of the spin, to $2.35 in 2013 and +$2.60 in 2014. I will assume that most readers understand the IDR structure, so I won’t take time describing why ATLS was motivated to grow both the unit count and distributions per unit, but I am happy to discuss in the Q&A. Suffice to say, ATLS blew through their IDR waterfall and now have reached the 50/50 splits. While acquisitions will continue to be accretive and the ARP distribution will grow in the future, it is likely that the growth rate will moderate to something in the single digits, versus the +25% rate exhibited to date. Nonetheless, an 11.6% yield growing at mid-single digits is nothing to balk at.

The Business

Following the recently announced acquisition, ARP’s producing assets are comprised of ~230,000 Mcf/d, 98% gas weighted, 11% decline production. ARP also has a very interesting drilling partnership business which raises money through retail channels and deploys it into drilling programs in well-understood plays. It’s a great business and I am happy to discuss, but in the interest of brevity, I’ll just focus now on the fact that they should raise $150-200MM of retail funds, which will result in ~$20MM of one-time fee income, plus around $22MM in gross margin associated with recurring fees charged on previously drilled partnership wells.

Following is a simplified breakdown of pro forma distributable cash flow. Since ARP will continue to make acquisitions and drill its liquids-focused inventory, this will change. I include it just to demonstrate that the announced 2014 $2.60 distribution is covered by the cash flows of existing assets at near-market commodity prices (unlike most E&P MLPs).

Hedge Book and Realized Prices

Prior to the acquisition, 87% of ARP’s 2013 production was hedged at an average price of $3.98. Unlike some of ARP’s peers (namely, Linn Energy), they do not use equity proceeds to finance deep in the money puts and call it a hedge. Gas production in 2014 is hedged at an average price of $4.35. Around 85% of ARP’s hedges are swaps, 10% are costless collars and 5% are at the money puts. ARP has said they will hedge 80-100% of the EP Energy production for the next three years and 40-60% thereafter. The hedges will likely be constructed in a very similar manner to the existing hedge book. Using today’s curve, that would put the gas production at $3.94 for year one and $4.15 for year two. The blending the current hedges and factoring in a few pennies of uplift for NGL and oil production, $4.20

Production Expenses

Production costs in 2012 were $1.19/Mcf. The acquired assets should have production costs around $1.60. If you add in a few extra pennies for higher ad valorem taxes on last year’s production, $1.50 seems reasonable for average production costs. 

G&A Expenses

Cash G&A in Q1 was $9.6MM. For the full year 2012 it was $36MM. I doubt that this acquisition will add that much in G&A. I think $50MM is pretty conservative.

Production Decline and Maintenance Cap Ex

You can look at offsetting production declines a number of ways. One is to consider the cost to replace cash flows. Another is to look at the cost to replace reserves.

For a full pro forma year after acquisition, ARP’s existing production will generate around $231MM in production gross margin. An 11% decline would imply something in the range of $25-27MM in gross margin needing to be replaced. I think that a levered equity return of something in the ballpark of 18% is achievable considering their inventory of +50% IRR to-be-drilled wells and ability to do accretive acquisitions. By that reasoning, ~$23MM should be sufficient maintenance capex.

From a reserve replacement perspective, ARP will need to replace 9.2Bcf of reserves each year. The EP Energy transaction was done at $1.69/producing Mcf. At this price, replacing depleted reserves would cost $16MM.

Since ultimately this is about cash flow, I’ll take the first approach and round up to $25MM.

IDRs

The $0.51/unit is based on running through ATLS’ IDR waterfall. It is worth noting that ATLS hits the 50/50 splits at a $2.40 ARP distribution level.

Relative Valuation

ARP’s valuation should be considered in comparison to other E&P MLPs, as well as gas-oriented E&P C-Corps. The most comparable MLPs are LINE, VNR, BBEP and EVEP. Generally these are trading anywhere from an 8.5-10.5% yield, having expanded +100bps over the past few months in response to (much deserved) negative press around LINE and the rising interest rate headline. I’m happy to discuss the positive and negative attributes for each comparable, but considering the positives of ARP (hedge book, lower production declines, high IRR drilling inventory which reduces reliance on acquisitions and partnership business) and negatives (50% IDR burden) it should trade at the lower end of this range.

Comparing ARP to non-MLP E&P companies isn’t necessarily constructive to discern what it should be worth, but rather is helpful to just rule out the idea that its MLP structure has caused it to be fundamentally overvalued. ARP is priced at roughly $1.51/proved Mcf of reserves and $9k/flowing Mcf/d of production. This is right in line with gas-focused E&P names like UPL, SWN and XCO. By comparison, LINE is priced at $2.43/proved Mcf reserve and $16,500/flowing Mcf/d of production.

Risks

ARP is now in the 50/50 splits with its GP, ATLS. Completing accretive acquisitions will be more challenging going forward. Also, as an LP, there will be continued unit issuances. However, at this price I think it is very unlikely that ATLS would elect to issue more units.

Catalyst