Description

Natural gas pipelines function like mini-monopolies, once a pipe is laid there is no incentive for a competitor to replicate it and because Crosstex charges a fixed fee on volumes transported, it is immune to the fluctuations in gas prices. Crosstex has built a large network of pipelines and treating plants through out the Barnett Shale in Texas, one of the richest shale plays in the US. Crosstex Energy LP’s current asset network generates about $130m in equity free cash flow each year. 83% of this is from fixed fee operations that are completely immune to direct competition and commodity price fluctuations. (The other 17% of cash flow is generated by processing gas and does carry some exposure to commodity prices.)

Valuation:

Crosstex Energy Inc.(XTXI) is the General Partner of the Crosstex Energy LP (XTEX). XTXI owns 16.4m or 34% of the XTEX units and 100% of the incentive distribution rights.  Since the VIC community is familiar with the MLP structure I will refrain from explaining how the IDRs work.

At the current stock prices and distribution level, the LP units are yielding 45% and the IDR’s have a 95% yield. XTEX IDR’s receive 50% of cash distributed above $0.375 per quarter meaning at the current $0.50 XTEX quarterly distribution, the IDRs are still receiving a significant distribution. Historically, the LP units have had a yield of around 7% while the IDR’s have been valued to yield 3 – 4%. It is unreasonable for both these yields to be so high.

XTEX has guided to $250 - $300m in EBITDA for 2009. To maintain its $2.00 annualized distribution, XTEX will need to earn $244m in EBITDA, which means even at the low end of its guidance, XTEX will be able to maintain its current distribution. To be overly conservative, assume the downside is $200m, 20% below the low end of guidance. XTEX will distribute $1.55 per share and XTXI will distribute $0.68 per share, a 30% yield at today’s price of $2.28 for XTXI.  

Assets:

Because XTXI derives all its cash flow from XTEX it is important to understand XTEX’s assets and cash flow. XTEX owns a variety of pipeline assets and processing plants in the Barnett Shale area of Texas and parts of Louisiana and Mississippi. 

Gathering and Transmission assets are comprised of over 5,000 miles of natural gas pipelines and generate about 61% of EBITDA. Customers pay a fixed fee, based on volume, to transport gas through the pipes, making cash flow from these assets very easy to predict. The Treating segment has 225 amine treating plants and 55 dew point control plants that contributed 13% of EBITDA. Fees for treating are based on volumes making them highly predictable and constant. 

The Processing segment has 12 processing and 4 fractioning plants and currently contributed about 26% of EBITDA. XTEX has a variety of different contract structures for processing including fixed fee, percentage of liquids and keep whole. The percentage of liquids (POL) and keep whole (KW) contracts are exposed to fluctuations in the frac spread, NGL prices and natural gas prices. For 2008 it is estimated that about 17% of EBITDA will be from POL and KW contracts. This means that 83% of Crosstex’s EBITDA is fixed fee and volume driven, making it immune to fluctuations in price.   The variation of commodity prices accounts for the difference between the high end and low end of company guidance. 

The Barnett Shale region of Texas has been one of the leading natural gas shale plays for the past few years. New horizontal drilling technology has made this play very economical to drill. In the current environment E&P companies have been cutting back drilling throughout the US, but maintaining their or even increasing activity it in the Barnett because of the low cost to extract that gas. Crosstex is still seeing a ramp up in volumes in its existing pipelines. Devon Energy, one of Crosstex’s largest customers, recently said that they are seeing excellent results from drilling in the Barnett and continue to increase volumes. 

Current Situation:

This year’s hurricanes damaged some of Crosstex’s processing and treating plants in Texas and the assets of some XTEX customers. The decrease in volumes from the hurricanes negatively impacted Q3 08 EBITDA by $14m (20%) and Q4 08 EBITDA by $11m (14%). This one time incident had a dramatic impact on 2008 cash flow. As the assets recover and come back on line in 2009 EBITDA will pick up. 

At the same time the hurricanes hit, the credit markets froze up. As an MLP, Crosstex relies on external capital to fund its growth projects. Unable to raise debt or issue equity at a reasonable price, Crosstex has been forced to shelf most expansion plans for 2009. The liquidity crisis has certainly impacted near term growth prospects for Crosstex, but it has no impact on current operations. The company can still cover its interest obligations by 2.1x if it only earns $200m in EBITDA and does not need to raise any capital to sustain the existing business. XTXI is not in violation of any covenants and is not a distressed company.

In the longer term, Crosstex is well positioned to capitalize on the development in the Haynesville shale play. They already have some initial pipe laid and have strong relationships with the E&P producers in the region. At current prices you are not only getting a great deal on existing assets, but a free option on any growth. 

Catalyst