Description

Thesis

QEPM is recently orphaned MLP stub equity that should be imminently acquired at a premium in the second step of a two part acquisition, the first of which closed yesterday. This is a low downside, arbitrage opportunity.

Background

QEPM is a collection of primarily natural gas and some oil gathering and transportation assets that were owned by QEP Resources (QEP). In August 2013, QEP listed the assets as a public MLP. The IPO price was $21/unit. QEP retained 58% economic ownership of the vehicle, including the GP.

Outside of the assets owned by QEPM, the sponsor, QEP, had additional complementary midstream assets generating ~$125m of EBITDA that were expected to be dropped into the MLP over time. This entire midstream business called QEP Field Services (QEPFS) was slated to be spun off by QEP under pressure by Jana Partners. The Form 10 filing for QEPFS:

http://www.sec.gov/Archives/edgar/data/1583813/000119312514251350/d731083dex991.htm

 Given the significant drop-down pipeline and QEPM’s relatively stable, fee-based business, the MLP traded at a sub 5% yield prior to October, reaching as high as $26/unit.

On October 20, QEP announced the sale of QEPFS to Tesoro Logistics (TLLP), the MLP of Tesoro Corp (TSO). In effect, QEPM was left completely stranded. The growth prospects for QEPM disappeared as TSO and TLLP holders would become the beneficiaries of those assets. Furthermore, QEP’s 58% ownership of QEPM was acquired in the transaction, including the GP. The resulting structure for TSO is a bizarre one: its own listed LP stake now owns the GP and majority interest of yet another LP. QEPM stock reacted accordingly and is now trading below $15.50, closer to a 7.75% yield.

While QEPM LP unitholders don’t have legal recourse against the GP given light GP-LP governance standards, this transaction has left a lot of bitter unitholders that bought into the IPO with the promise of distribution growth. And, while this isn’t necessarily TLLP’s breach-of-trust-problem to repair, for the reasons detailed below it behooves TLLP to make a reasonable offer to QEPM untiholders as it moves to consolidate the stub.

Reasons stub acquisition should move forward shortly:

-Stated intention by TLLP to takeout public stub: TLLP had to file a form 425 after addressing QEPM acquisition in its 3Q14 release: “TLLP intends to pursue an offer to merge QEPM through an exchange of TLLP units for the outstanding public QEPM units. This process is expected to commence shortly following closing.”

-1^st of 2 steps in acquiring all of QEPFS completed: the transaction between QEP and TLLP closed on December 2, 2014.

- Remaining stub is a small portion of the total transaction size. TLLP purchased QEPFS for $2.5 billion. The float of QEPM that TLLP does not yet own is only 23m units, or $357m at Dec 3 closing price. By comparison, the TLLP market capitalization is ~$4.5bn.

- TLLP now owns a majority of QEPM and will thus have to fully consolidate QEPM’s financials for accounting purposes. However, it will still have to conduct duplicative public calls and file financials for QEPM. This is an administratively cumbersome structure and is not cost effective for TLLP. There is no benefit to having an LP with its own listed stub LP.

Reasons for TLLP should make an offer for QEPM stub at a premium:

- Winning over new TLLP unitholders: TLLP will acquire QEPM in a unit for unit transaction. TLLP management is very aware that QEPM unitholders have already been burned and will want complacent new holders that will be amenable to secondaries. Note TLLP has identified up to $600 of growth projects over next three years, requiring repeated returns to the capital markets.

- Not much incentive to play hardball: TLLP and TSO ownership is widely distributed without a significant controlling individual holder. Institutional management and board should be concerned with reputation/ ease of future equity issuances.

- Cross holdings: TLLP and QEPM share 6 of top 16 holders by size, further favoring deal dynamics for QEPM. While one could argue that adjusted for size, a unitholder in both entities would be indifferent to the particular allocation of the benefit, the egregious position- specific loss at QEPM should preference joint holders to be made whole on that side.

- The transaction is accretive to TLLP. Similar payout ratios at both entities with a 3% yield differential (TLLP 4.5% vs QEPM at 7.75%)

- Offer by TLLP must pass muster of conflicts committee at QEPM. QEP has wronged unitholders. Significant holders have written letters to QEPM board expressing an unwillingness to accept any offer below the $21 IPO price. Now that the GP has been assumed by TLLP, the fiduciary duty of the conflicts committee has transitioned to protecting the LP holders.

- Reference prices: IPO in August of 2013 at $21/unit. Unit price of $20.78 two days before transaction announced. QEPFS price of $19.87 one day before transaction announcement. At the 12x EBITDA multiple that QEPFS was acquired at, the implied QEPM price is ~$19.25/unit. To be made whole, taking into account all dividends earned life to date, QEPM unitholders would need to be taken out at $19.76.

- Precedent transaction in November: Enterprise Products Partners is acquiring the LP stub of Oiltanking at a 10.4% premium to prior day price. Greg King, the chairman of the conflicts committee at QEPM, is also on the board of OILT.

Risks

-QEPM unitholders do not have perfect negotiating leverage other than an outright rejection of the deal by the conflicts committee and lobbing lawsuits by unitholders to obstruct an unfavorable transaction. For its part, TLLP may view this as an opportunistic acquisition and offer no premium as the breach was between the QEP mgmt and unitholders at QEPM. Downside is mitigated by a healthy dividend yield at these levels for generally stable assets. I believe reasonable downside is a 5-10% premium to screen price on day of announcement.

Catalyst

Arbitrage opportunity: should be imminently acquired at a premium in the second step of a two part acquisition, the first of which closed Dec 2.