Description

The central thesis of Crosstex Energy Inc. (XTXI) is the same as Kaneb Services LLC, which was submitted to VIC in November, 2001. That idea worked out very well, which is what inspired me to take a very close look at Crosstex. Readers may want to review the Kaneb write-up along for a historical perspective of the GP/MLP structure. Basically, income-seeking investors tend to buy MLPs, which have attractive distribution yields, while the GPs are a different beast altogether.

Crosstex Energy Inc. owns the 2% general partner interest and 10 million L.P. units of Crosstex Energy L.P., a publicly traded master limited partnership that owns and operates mid-stream energy assets in Texas and Louisiana. Assets include natural gas pipelines, processing plants, and treating plants.

As the general partner, Crosstex Energy Inc. receives incentive distribution rights (IDRs) from the LP such that an increasing share of incremental cash flow generated by the LP goes to the general partner. At the current distribution level, the split is 50/50. This means that for every $1 of incremental cash flow generated by the L.P., $500k will go to the general partner (And you thought your fee structure was good). Crosstex Energy Inc. in turn pays out its after tax cash flow to shareholders in the form of dividends, which will be increasing extremely rapidly due to the nature of the incentive distribution rights and the growth projects, both external and organic, undertaken at the L.P. level.

Based on projects on the books now, dividends for Crosstex Inc. should reach $5/share by YE 2008, which would equal a 7.5% yield based on today’s price. The G.P. group (I am using KMI, EPE, NRGY, and XTXI) is currently priced to trade at a 3% yield (The G.P. part of the MLP/GP structure should always trade at a premium due to the leverage of the IDRs and the resulting increased growth profile). If Crosstex Inc. trades at a 5% yield at YE 2008 the share price would be approximately $100, producing a 49% return not including dividends. If the current 3% pricing for the G.P. group prevails at YE 2008 the share price would be over $150, producing a 124% return not including dividends. In addition to the aforementioned appreciation, you should receive in the neighborhood of $10 in dividends thru YE 2008, depending on how the dividends ratchet up. The dividend adjusted returns are approximately 64% or 139%, respectively. If you are concerned about rising interest rates or the valuation of the G.P. group, you could use some of the dividend income to hedge. I have not done so but it’s a possibility.

My estimates are based on pipeline construction/expansion projects and acquisitions that have been announced and discussed on company conference calls. Crosstex’s management team appears to be excellent – disciplined, conservative when communicating with shareholders/analysts, competent, and very driven. I would argue that between today and YE 2008 there will be more internal growth projects announced, and possibly more acquisition activity, which could serve to make my estimates low.

Projects that have been announced so far are the Barnett Shale/North Texas Pipeline, the North LIG extension, the South LIG expansion, and the El Paso acquisition which was completed within the past few weeks. The financing for these projects/deals is typically 50/50 debt and equity, funded by the L.P. That is, the L.P. issues units and assumes debt to fund any activity, while the capital structure of Crosstex Inc. does not change for the most part.

Rather than lay out each individual project I will go thru the Barnett Shale/North Texas pipeline as a template for how to do the math on the others. Each project involves plugging in cost and cash flow assumptions to get to the project’s effect on Crosstex Energy Inc.’s dividend.

The Barnett Shale/North Texas Pipeline is a 122 mile 24 inch transmission pipeline and 11 miles of 24 inch gathering pipeline from Barnett Shale into Midwest and Eastern markets. The pipeline should be operational in Q1 2006. The base case assumption is for initial capacity of 250 MMcf/d. Cost is estimated at $98m with a 50/50 debt/equity ratio, and estimated cash flow of $17.4m or $15.4m after capex that runs around 2% or 1.96m. Debt service at the L.P. level is 6% on $49m or $2.94m. The incremental cash flow to the L.P. is therefore $12.5m and the IDR calculation is 6.25m. The net cash available for distribution after the distribution coverage ratio of 1.1x is $5.62m. Current units on issue for the L.P. are 20.97m (including 2.85m units placed for the El Paso acquisition that convert on November 14, 2005) so with the extra units placed for North Texas of 1.44m there will be 22.41m units outstanding. Net cash available for distribution per unit will be $0.25. Crosstex Inc. also gets the benefit of increased distributions on its L.P. units, which amounts to $2.5m. The tax rate for Crosstex Inc. is 0% due to a net loss carry forward. Even thought the company will not pay taxes in 2005 or 2006 they set the dividend as though taxes are being paid. The effective tax rate is estimated at 35%. Adding up the pieces, the IDR is $6.25m, the income from Crosstex Inc.’s L.P. units is $2.5m, and the implied taxes are $3.06m, so the net contribution from this pipeline to Crosstex Energy Inc. available for dividends is $5.68m or $0.44/share (with 12.74m shares outstanding).

Like all of Crosstex’s projects to date, the Barnett Shale/NT pipeline project has an upside scenario. In the case of this pipeline, the addition of a compressor would increase capacity to 375MMcf/d and add an estimated $17.5m in cash flow at a cost of only $15m. This expansion would probably be financed with debt b/c it is a small amount and it is so much cheaper than equity. Debt service would then be $3.84m and the incremental net cash flow to the L.P. would total $26.96m with the compressor. For Crosstex Energy Inc., the IDR calculation would be $13.48m. The cash left over for the L.P. after distribution coverage of 1.1x would be $12.13m or $0.54/L.P. unit. The cash flow to Crosstex Energy Inc. would thus be $13.48m from the IDR, $5.4m from the increased distribution on the L.P. units and $6.6m set aside for taxes, or a net $12.27m or $0.96/share contribution from the pipeline with the compressor attached. Management thinks this scenario may play out in the 2007 time frame.

If you work through the same mental gymnastics for the El Paso acquisition and the North and South LIG expansions, including the “expansion on the expansion” projections, you arrive at a dividend for Crosstex Energy Inc. of approximately $3 for 2006, $4 for 2007, and $5 for 2008. In terms of unannounced deals and projects in the future, management has said that the acquisition market is very competitive at present and has favored internal growth projects like the Barnett Shale/NT pipeline outlined above. However, the recently completed El Paso deal may turn out to be very significant for Crosstex. Management has indicated that there will be attractive follow-on opportunities from the El Paso assets, which are located in Southern Louisiana and are proximate to Crosstex’s existing LIG system. The nice thing about Crosstex is that a $100m or $200m project or deal can have a large impact due to the company’s small size relative to the likes of Kinder or Enterprise GP Holdings.

Disclaimer: I own Crosstex and may buy or sell without disclosure or providing updates.

Catalyst

Quickly growing dividends due to Incentive Distribution Rights under GP/MLP structure.