Description
YDROCARBON INC.: BUY
(Ticker: MWP; Recent Price: $22.46; Market Cap: $268.0 mm)
Would you be interested in owning a company with an 89% interest in a stream of cash flows expected to grow over 100% from 2005 to 2006 and increase four-fold from 2006 to 2010? What if we told you that this interest was being valued at 9x 2006 pre-tax cash flow and 6x 2007 pre-tax cash flow? If this type of company interests you, please read on.
Markwest Hydrocarbon (MWP) owns four distinct assets:
1) 2.5 million subordinated units of Markwest Energy Partners (MWE), a publicly traded master limited partnership that owns midstream oil and gas assets;
2) A natural gas processing and natural gas liquid (NGL) sales and marketing business;
3) Cash on hand; and
4) An 89% general partner (GP) interest in MWE entitled to increasing percentages of limited partner distributions – we’re saving our analysis of the best asset for last.
We value MWP’s four assets at over $43 per share, nearly double the current price of $22.46.
Subordinated Units of Markwest Energy Partners (MWE)
MWE engages in the gathering, processing, and transmission of natural gas, the transportation, fractionation, and storage of NGLs, and the gathering and transportation of crude oil – these operations are generally referred to as midstream. It has large operations in Texas, Oklahoma, Mississippi, Louisiana, New Mexico, Michigan, the Gulf of Mexico, and Appalachia. Recently, MWE has grown through the nearly $400 million acquisition of the Javelina gas processing and fractionation facility in Corpus Christi, Texas in late 2005 and internal system expansion in East Texas. It should be noted that recent earnings have been depressed by hurricane damage to the Starfish Pipeline in which MWE purchased a 50% non-controlling interest in 2005. However, the facility should be returned to full strength by the end of 2006. MWE has plans for further internal projects and acquisitions that are expected to continue growth in distributions to unitholders. According to management, the internal projects have IRR’s of 20-25%. Capital expenditures for 2006 are expected to be some $50 million, but may increase to $100 million, leading to incremental growth on currently anticipated EBITDA of around $130 million.
We like MWE because a large portion (33%) of MWE’s net operating margin is fee-based, which limits exposure to commodity prices and provides a relatively stable stream of cash flows. The remainder of its net operating margin is generated from percentage-of-proceeds, percentage-of index, and keep-whole contracts (each type of contract is outlined in MWE’s most recent 10-K) that make MWE’s results more sensitive to the prices of natural gas and NGLs. Currently, MWE’s operating earnings would increase $1.50-$2.20 million per $0.05/barrel increase in the price of NGLs (recently $0.71/gallon for ethane and $1.11/gallon for propane) and increase $0.85-$1.40 million per $0.50/MMBtu increase in the price of natural gas (recently $6.20/MMBtu). MWE’s commodity price exposure is mitigated by:
(1) Natural hedges occurring because of the variety of activities in which MWE is engaged;
(2) Derivative hedges such as costless collars and swaps; and
(3) MWE’s ability to shut down certain operations if they become unprofitable because of swings in commodity prices.
Currently, MWE trades at a 7.8% dividend yield based on its most recent distribution. This compares to an energy master limited partnership (MLP) average dividend yield of 7.0%. Not only does MWE trade at a higher yield, it also has better growth prospects than many of the other energy MLP’s. According to Street research, its per unit quarterly distribution is expected to grow from $0.87 currently to $1.00 by year-end, a 14.9% increase. Other MLP distributions are expected to increase on average only 6.7% by year-end. Anyhow, MWE units may be cheap, though not as cheap as the GP interest – the value of the GP, which we are saving to discuss last, is the principal focus of this write-up. Analysts at Wachovia present a good analysis of MWE if you’d like further information.
On 4/25/06, MWE filed to sell as many as 3.85 million units to get its debt-to-equity ratio back towards its financing target of a 50-50 debt-to-equity ratio. The offering is expected to be completed later this month. We think the offering may be acting as an overhang on the MWE units although once the MWE offering process starts, we think the MWE story (which we think is underappreciated) may provide support for the stock.
Valuation of MWP’s MWE Units
Total Units 2,469,496
Market Price $44.50
Total Value $109,892,572
Natural Gas Processing and NGL Sales and Marketing Business
MWP processes natural gas into NGLs and markets them wholesale to business customers. The contracts for this business are mostly on a keep-whole basis. These keep-whole contracts state that as MWP processes natural gas into the NGLs that it sells, it must replace the NGLs with the energy-equivalent amount of natural gas. Thus, MWP earns the spread between NGL prices and the price of natural gas needed to replace those NGLs. This spread is called the fractionation spread, or frac spread for short. As frac spreads can be volatile, the profitability of this business has been volatile as well. MWP has focused on renegotiating these contracts to avoid having to operate at a loss at times. In late 2004 MWP renegotiated its contract with Equitable, which represents 25% of its keep-whole volumes, such that it has locked in a floor margin of $0.08/gallon. It is currently working on renegotiating its contract with Chesapeake that covers an even larger percentage of its volumes (30-40%). The Company also engages in a hedging program involving futures, options, swaps, and forward contracts to minimize commodity risk for approximately 40% of its volumes. Between the already renegotiated contract and the hedging program, management estimates it is 60-70% hedged for the next 12 months, much of it at attractive prices.
The market appears to be placing a negative value on this business given its history of burning cash at times. We think this view is wrong. During 2005 frac spreads got increasingly unfavorable to MWP. However, in 2006 frac spreads have begun to recover nicely, and we see this business being profitable for the rest of the year, but especially in the second quarter. Check out the Henry Hub frac spread graph on Bloomberg (FRAC
) to see what we’re talking about. The improved frac spreads should give MWP extra leverage in renegotiating its contract with Chesapeake.
Valuation
With no true comps for this piece of the business and extremely variable results, the conservative way to value it is using book value excluding cash. At 3/31/06, this value was approximately $17 million consisting mostly of working capital. With current frac spreads, this valuation is low.
Cash on Hand
At 3/31/06, MWP had $18.2 million of cash and marketable securities after netting out MWE’s cash that was consolidated.
GP Interest in MWE:
Description
MWP owns an 89% interest in the GP of MWE. The GP is entitled to a 2% general partner interest and incentive distribution rights that give the GP an increasing percentage of MWE’s distributions as they grow. Specifically, incentive distribution rights entitle MWP to receive 13.0% of all cash distributed in a quarter after each unit has received $0.55 for that quarter, 23.0% of all cash distributed after each unit has received $0.625 for that quarter and 48.0% of all cash distributed after each unit has received $0.75 for that quarter.
As MWP has only fairly recently gotten to the point that it receives its maximum incentive distribution percentage, its incentive distributions will continue to grow significantly as MWE’s unit distributions grow. As MWE’s distributions are expected to grow at more than 10% for the next 2 years as it incorporates recent acquisitions and expands gathering and processing capacity in growing areas, the GP distribution will grow at more than 50%. See the table below. (Source: Street research – 2006-2007, internal estimates 2008-2010)
2006 2007 2008 2009 2010
LP Distribution / Unit $3.73 $4.12 $4.45 $4.76 $5.04
Growth % 15% 11% 8% 7% 6%
Total LP Distribution (mm) $55 $69 $74 $80 $84
GP Distribution (mm) $15 $23 $29 $34 $39
Growth % 166% 58% 24% 18% 14%
GP % of Total Distribution 21% 25% 28% 30% 31%
MWE’s recently announced offering will also grow cash distributions to MWP. MWP will only have to contribute 2% of the new money raised to maintain its GP interest and incentive distribution rights, but it will immediately begin receiving approximately 20% of cash flows from MWE. Thus, the GP is leveraged to growth in distributions per MWE unit (both through internal projects and acquisitions) and the number of MWE units outstanding.
The current market price of MWP underestimates the value of its GP interest. The recent announcement of a proposal for a management buyout at Kinder Morgan, Inc. (KMI) highlights the market’s tendency to undervalue GP interests. A central reason for the $100/share proposal vs. an $84.41/share market price was management’s frustration concerning the lack of value attributed to KMI’s GP interest in Kinder Morgan Energy Partners LP (KMP).
Implied Valuation of GP Interest
Units in Markwest Energy (MWE) at Market $109.9 million
Sales and Marketing Operations $ 17.0 million
Cash on Hand $ 18.2 million
Subtotal $145.1 million
Current MWP Market Cap $268.0 million
Implied Value of 89% GP Interest in MWE $122.9 million (9x 2006 GP distribution and
6x 2007 GP distribution)
GP Valuation Based on Comps and DCF
A discounted cash flow analysis based upon Wachovia’s most recent projections for MWE for 2006 and 2007 and a 6-8% increase in distribution thereafter (lower than management’s 10% goal) yields the following valuation for MWP’s GP interest (in $mm):
Discount Rate
9.0% 9.5% 10.0% 10.5% 11.0%
Terminal Growth Rate
3% $328.8 $303.0 $281.0 $261.9 $245.2
4% $385.4 $349.9 $320.3 $295.4 $273.9
5% $470.3 $417.6 $375.4 $341.0 $312.2
6% $611.8 $523.9 $458.0 $406.8 $365.8
7% $894.8 $715.4 $595.7 $510.3 $446.2
A comparable company analysis of other GP interests yields the following valuation (in $mm):
2007 GP Value/
Company Ticker Distribution 2007 Distribution
Inergy Holdings LP NRGP $25.2 22.2x
Crosstex Energy Inc XTXI 32.8 22.9x
Magellan Midstream Holdings LP MGG 70.6 18.0x
Enterprise GP Holdings LP EPE 124.1 25.3x
Min. Multiple 18.0x
MWP Distribution $20.6
(89% of total GP Distribution)
Value $370.0
The management takeover bid for $100/share for KMI implied a 16x multiple of 2007 KMP (a larger, more mature MLP) GP cash flow according to Street research. The stock has traded above that level as the market anticipates an increased bid at some point.
Upside Potential
Taking the average of the valuations from the DCF valuation using a 10% discount rate and 5% terminal growth rate and the comparable company analysis you arrive at the following upside potential for the shares:
Comparable Company Analysis Valuation $370.0
DCF Analysis Valuation 375.4
Average GP Interest Valuation $372.7
Current Implied GP Interest Valuation $122.9
Valuation Upside $249.8
Shares (in mm) 11.9
Upside per Share $20.94
Current Price per Share $22.46
Upside % 93.2%
This analysis gives a price target of over $43 per share assuming that MWE is fairly valued and the MWP natural gas processing and natural gas liquid (NGL) sales and marketing business is worth book (we think it’s worth more).
Issues
• Interest rates. Master limited partnerships and their general partners tend to trade on a dividend yield basis. If interest rates continue to rise, the required yield on these stocks may rise driving down the price.
• Real and perceived commodity price risk. MWE and MWP trade with oil and natural gas prices on a daily basis despite limited exposure to commodities. That being said, large movements in commodity prices could have a material effect on results.
• Management. MWE and MWP’s management team has historically done a poor job of interacting with the investor community. In 2005, they had to file restated financial statements because of an issue with accounting for compensation that not many investors fully understood. The restatements caused delays in filing some of the 2005 10-Q’s. They are making a valiant effort to fix their investor relations and have hired several new professionals. Despite these problems, their oversight of the business itself seems to be adequate.
• Taxes. Several of the comparable publicly-traded GP’s are organized as LP’s which makes a comparison between MWP, which is organized as a corporation, and these other GP’s more difficult.
Indirect LP Ownership
Given the tax issues related to owning LPs for many institutional/offshore investors, a position in MWP, which is a regular C Corporation, is a great way to invest in a high-growth LP as well as an undervalued GP.
Catalysts
• June investor meeting that will bring some attention to the name
• Growth in GP distributions and MWP dividends in coming quarters
• Restructuring of keep-whole contracts that would make sales and marketing business cash flows more stable – this could lead to a sale of the business to MWE
• Flow through of improved frac spreads to MWP results for remainder of the year
Bottom Line
The market has not given MWP full credit for the value its GP interest in MWE and has penalized the share price for a hard-to-predict marketing business and historically poor interactions with Wall Street. GP distribution increases from MWE, MWP dividend increases, restructuring of MWP’s keep-whole contracts and better investor relations should drive the stock price higher.
Catalyst
• June investor meeting that will bring some attention to the name
• Growth in GP distributions and MWP dividends in coming quarters
• Restructuring of keep-whole contracts that would make sales and marketing business cash flows more stable – this could lead to a sale of the business to MWE
• Flow through of improved frac spreads to MWP results for remainder of the year