Description

EP Energy’s (“EPENEG”) 2022 unsecured notes ($195MM) present a compelling risk / reward proposition, with total annualized return potential of 20 – 25% over the next 24-months (equity-like returns) and significant downside protection (see further below). The 7.75% 2022 notes currently trade in the high 70s, provide a ~10% CY, ~16% YTM and more likely 2-year yield to par of ~22%. The 2022s is a uniquely positioned security (small hurdle for the company to address to extend the runway) and will NOT bring down the house (less than 4% of the $4.9Bln enterprise) and as this is a cycle bet with increasing evidence of cycle strengthening, EPENEG and its stakeholders (Apollo-backed consortium) will continue to lengthen the maturity stack. Moreover, there are multiple options for EPENEG to address the 2022 maturity including using cash / borrowing availability totaling ~700MM + basket availability of ~680MM – evidence of EPENEG extending the “cycle recovery” via exchanges and open market purchases in the past.

Away from the 2022s being a small hurdle (i.e. NOT bringing down the house), the set-up for EPENEG is attractive: 1) well positioned for the enfolding cycle recovery: every $5 move in WTI is ~$120MM of annualized EBITDA and we’ve assumed they simply lock in current strip prices for 2019E resulting in ~$1.1Bln of EBITDAX which might prove out to be conservative as this doesn’t give credit to future oil upside nor productivity improvements ; 2) new management w/ evidence of productivity improvements: new management has shown early evidence of productivity improvements and our 2019E assumptions might prove out to be $100 - 200MM conservative and 3) new management + private equity holders motivated to sell non-producing assets: mgmt has been more vocal in recent months on pursuing non-producing asset sales resulting in a deleveraging and unlocking equity value (our view is that a $500 - $1Bln asset sale could be in store over the next 6 – 12 months which would greatly de-risk the balance sheet and accelerate a par event on our 2022 security). All said, we like the 2022 security given its unique position (relatively s-duration and not large enough to be a stumbling block especially as company is focused on lengthening the runway to the cycle recovery) and also believe the 2024 security (more liquid) and equity offer an interesting set-up given improved operating metrics and increased probability of asset sales (de-leveraging event).

EPENEG (f/k/a El Paso Corp’s E&P division) is an indpt oil and natural gas producer that was purchased in early 2012 by an Apollo-led group for ~$7.2Bln (Apollo, Riverstone, Access Industries and Korea National Oil are all still involved in the equity) and subsequently went public in early 2014. EPENG has ~400 MMBoe of proved reserves, more than 20-years of drilling inventory and >82 Mboe/d of average daily production. Over the last several years, EPENG has high-graded its future drilling inventory by establishing large acreage positions in 1) Eagle Ford, 2) Altamont and 3) Wolfcamp (in our view, portions of this will be monetized). 

Why now on the 2022s:

1)      S-duration stub security that’s “manageable”: in the grander scheme of a ~$4.9Bln enterprise value, the 2022 note (~$195MM security or ~4% of enterprise) is NOT going to take down the entire house. Evidence supports this as Apollo has undergone multiple exchanges over the past several years and the company has more recently been making open market purchases of the 2022 – 2023 unsecured notes

2)      Multiple options to address via liquidity + secured baskets: in addition to ~100MM of cash and ~600MM of additional liquidity, EPE has ~$680MM of baskets ($371MM of 1.25 lien or better and $308MM of 1.5 lien or better) which is more than enough to take care of the remaining unsecured notes (246MM of 2020 + 195MM of 2022 and ~379MM of 2023 = 820MM). As highlighted above, EPENEG has already shown their cards in showing an interest in lengthening the maturity runway - in Dec 2017, EPENEG exchanged $1.1B of the unsecured notes due 2020, 2022, 2023 into a new Secured Note due 2024. As this is a cycle-bet for Apollo and its partners, addressing the 2020 and 2022 unsecureds (less than $450MM in total) is a no-brainer in the context of gaining runway through 2023

3)      New mgmt. team is apt to focus on disposing of non-core assets: In Nov 2017, EPENEG brought in Russell Parker (CEO), Ray Ambrose (SVP of Engineering) and Chad England (SVP of Operations). The new team previously worked together at Phoenix Natural Resources and, with several members, at Hilcorp. Management is being incentivized to deleverage the balance sheet (stated goal is to take down below 3x) and we believe Wolfcamp non-producing acreage will likely be the path to deleveraging

a.      Asset proceeds would likely be used to address the unsecured maturities (2020, 2022, 2023) and effectively provide runway through mid-2024 (i.e. a true cycle bet for an Apollo cyclical asset)

b.      And an asset sale of non-producing assets would unlock value (no impact to profit metrics and very likely a 0.5x – 0.75x reduction in leverage profile)

4)      Recovery in oil market is underway: entire cap structure is viable when WTI is at $60+ … Equity is front and center exciting when WTI is at $70+. We are underwriting WTI at $65 in 2019E to get to our $1Bln estimate versus current spot in mid-70s (and notably, strip has now moved above $70). Every $5 move in WTI is $100MM for EPENEG and we think leverage (before factoring in any asset sales) could get to 3.75 – 4.0x levels in 19E if WTI hangs in at current levels

5)      Additionally, there is a growing disparity between less leveraged North American E&P public equities (trading at 7-8x 18E EBITDAX and 6 – 7x 19E EBITDAX) versus highly leveraged credits like EPENEG (through the unsecureds, EPENEG trades for ~4.5x 18E EBITDA and ~3.8x based on 19E EBITDAX of $1.1Bln – additionally, assuming EPENEG is successful in selling a non-producing asset most likely in Wolfcamp, the creation multiple will likely drop into the mid-3x using 19E EBITDAX); bottom-line is that the EPENEG trade can be hedged via equity shorts if concerned about WTI volatility

a.      Assuming Q2 2017 production stays constant in 2019E (we believe this might end up 10 – 20% overly conservative) and assuming EPENEG hedges at the current strip price, Q2 2017 EBITDA of $215MM should increase by at least $60MM (~$10 of WTI improvement, optionality around NGL and gas prices) = $275MM * 4 = $1.1Bln EBITDAX in 2019E

6)      Downside protection: the 2022 notes trade at recovery values BUT the reality is that the business has a covenant-light capital structure and more-than-adequate liquidity to weather the next 3-4 years (i.e. buy-in high 70s and gather ~31 points of interest = ~46 creation value in the case of a restructuring in 2022)

Over the next 6 – 24 months, we expect the 2022 Unsecured Notes to appreciate significantly (notably, the company repurchased some of the unsecured notes in the Q2 period in an attempt to further lengthen the runway) providing ~22% 2-yr yield-to-par returns (equity-like returns with debt-like creation multiple / ~4.1x on 19E EBITDAX + high probability of being <3.5x upon a non-producing asset sale). 

Capitalization:

EPENEG’s capital structure consists of a ~3.5Bln of Secured debt (inclusive of 1.125, 1.25, 1.5 lien) and approximately $800MM of Unsecured debt (2020 maturity trades close to par, 2022 in high 70s and 2023 in low 70 context). Additionally, there is ~$600MM market cap, 80% of which is still held by the parties who purchased EPENEG in 2012 for $7.2Bln (their equity is “struck” at an implied value of ~$11 / share versus ~$2.40 current).

Margin of Safety:

Given our views that oil recovery is in full swing, we anticipate EPENEG’s entire capital structure will trade up as we gain more clarity on the business showing line of sight >$1Bln of EBITDAX in 2019E. We also believe a non-producing asset sale is highly probable over the next 6 – 12 months as management’s incentives are aligned with much higher equity prices (9 – 12 / share is where they really pick up). Additionally, given the unique nature of the 2022 security, we believe EPENEG will continue to execute on open market purchases and / or might try and proactively exchange the 2020, 2022, 2023 unsecured notes to lengthen the runway through 2024. In either case, cycle recovery and / or lengthening the runway on the maturity stack, the 2022s are well positioned to be addressed over the next 2-years … as a result, we believe the 2-year-to-par returns of >22% (equity-like) while creating the business for ~4.1x EBITDAX on 2019E figures (and more likely mid-3x in the case of a non-producing asset sale) is an attractive creation multiple.

Catalysts:

Exchanges / Open market purchases: Evidence of Apollo “playing the cycle” is evident as they have gone through multiple exchanges and company has recently been making open market purchases of the unsecured notes … in an effort to lengthen the runway

Non-producing asset sales are increasingly probable: We believe the management team is laser-focused on selling some of the Wolfcamp acreage. Our view is that $500 - $1Bln of net proceeds might be realized which would effectively unlock value for the entire capital structure and serve as a 0.5 – 1x deleveraging event

Evidence of production improvements: New management has done a nice job of enhancing productivity in the Eagle Ford and Altamont. More evidence is likely in Q3 – Q4

Cycle bet: Cycle play (less than 2-years) with recent evidence of cycle improvements (debt is well covered in scenario where WTI is at $60 and equity is well covered in scenario where WTI is $70+) in which you’re paid to wait (10%+ CY and ~22% yield-to-2-years)

Leverage / FCF / ample liquidity: Leverage through the unsecured notes is ~4.3x (face) and 4.1x (market) on our 2019E estimates (assumes $65 WTI and productivity improvements). Notably, this estimate might prove out to be conservative as every $5 additional on WTI is $100MM and management might surprise to the upside on productivity improvements. Given $680MM of basket capacity and ~$700MM of liquidity, we believe the 2022 security ($195MM is less than 4% of the enterprise value) will be addressed sooner versus later

Sponsor / management focus: Apollo-backed consortium still owns ~80% of the equity and is focused on maximizing value. Apollo has also contributed >$300MM to a JV drillco and while bears will point out they are taking improved economics, our view is that they would not be throwing good money after bad if they didn’t see the cycle recovery ahead. Additionally, new management is heavily incentivized to see the market cap go from $600MM to >$1.5Bln – the most likely path to unlocking value (as they will point out) is via a non-producing asset sale

Catalyst

Exchanges / Open market purchases: Evidence of Apollo “playing the cycle” is evident as they have gone through multiple exchanges and company has recently been making open market purchases of the unsecured notes … in an effort to lengthen the runway

Non-producing asset sales are increasingly probable: We believe the management team is laser-focused on selling some of the Wolfcamp acreage. Our view is that $500 - $1Bln of net proceeds might be realized which would effectively unlock value for the entire capital structure and serve as a 0.5 – 1x deleveraging event

Evidence of production improvements: New management has done a nice job of enhancing productivity in the Eagle Ford and Altamont. More evidence is likely in Q3 – Q4

Cycle bet: Cycle play (less than 2-years) with recent evidence of cycle improvements (debt is well covered in scenario where WTI is at $60 and equity is well covered in scenario where WTI is $70+) in which you’re paid to wait (10%+ CY and ~22% yield-to-2-years)

Leverage / FCF / ample liquidity: Leverage through the unsecured notes is ~4.3x (face) and 4.1x (market) on our 2019E estimates (assumes $65 WTI and productivity improvements). Notably, this estimate might prove out to be conservative as every $5 additional on WTI is $100MM and management might surprise to the upside on productivity improvements. Given $680MM of basket capacity and ~$700MM of liquidity, we believe the 2022 security ($195MM is less than 4% of the enterprise value) will be addressed sooner versus later

Sponsor / management focus: Apollo-backed consortium still owns ~80% of the equity and is focused on maximizing value. Apollo has also contributed >$300MM to a JV drillco and while bears will point out they are taking improved economics, our view is that they would not be throwing good money after bad if they didn’t see the cycle recovery ahead. Additionally, new management is heavily incentivized to see the market cap go from $600MM to >$1.5Bln – the most likely path to unlocking value (as they will point out) is via a non-producing asset sale