Description

Opportunity:

Westlake Chemical Partners (WLKP) has recently suffered from IRS confusion, creating an interesting opportunity for investors.   In the next six months, I think investors have an upside opportunity of 50% upside in the best case, 25% upside in a base case, and limited downside risk.

Background:

Westlake Chemical Partners is a limited partnership formed in early 2014 to operate ethylene facilities for Westlake Chemical (WLK).  WLK created the structure assuming that the MLP structure would create value for WLK stock (through IDR and GP interest), provide tax shelter for income, and provide acquisition currency for growth initiatives.  WLKP purchased 10.6% of Westlake Chemical Opco LP in August of 2014 as part of the WLKP IPO. 

WLKP operates 3 facilites, Petro 1, Petro 2, and Calvert City.  Petro 1 has 1.25b lbs of ethane feedstock capacity, Petro 2 has 1.49b lbs of flexible feedstock capacity (ethane, propane, butane, naptha).  Calvert City has 630m lbs of ethane or propane feedstock capacity. 

WLKP and WLK have an operating agreement through 2026 that requires WLK to purchase 95% of the ethylene production of Opco  at cost plus 10 cent per pound rate.  Opco sells the remaining 5% of its production to third parties.  Margins on third party sales are running now ~25 cent per pound, down from near 40 cent per pound, down as ethylene margins have come down with crude. 

WLKP had a long term growth plan driven by organic capacity expansions at existing facilities, drop downs of the remaining 90% of Opco assets, third party acquisitions by WLKP or WLK, and increases in contract margin with WLK (e.g., 10cent to 11cents per pound).  This was intended to drive consistent quarterly increases in distributions and double digit annual growth rates in distributions.

On April 29, 2015, WLKP increased its holdings of Opco to 13.3%.  Also, on April 29^th, WLKP declared a quarterly distribution of $0.2829/unit, up from $0.275/unit in February.  As it traded at $28.80/unit, WLKP was yielding 3.9%.

New IRS Proposal and Selloff:

On May 5, 2015, the IRS issued proposed regulations governing MLPs including interpretations of what activities in the processing and refining of natural resources qualified.  The contradicted a previous private letter ruling provided to WLKP that established ethylene production as qualifying income.

The proposal provided for a 10 year transition period for partnerships like WLKP that previously received private letter rulings.  In addition, a 90-day comment period was provided for industry participants to discuss the proposal before final rules are established.

WLKP sold off substantially since the proposal.  The stock dropped more than 30% from $28.80 to under $20/unit.  WLK dropped more than 10% in the same period, losing more than $1b of value.

Scenarios:

From here, there are 3 scenarios that play out for WLKP, listed in decreasing probability order.

Scenario 1, and most likely outcome in my view, is that the IRS proposal becomes the rule.  In this case, the long-term viability of WLKP is clearly impaired, and WLKP stops being a strategic tool for WLK.  Instead, WLKP becomes an unnecessary complication and share overhang for WLK and there is little likelihood WLKP can be used to help finance future WLK growth.  WLK made comments along these lines recently at a Wells Fargo investor conference (5/6/2015), suggesting that WLK shares never benefited from the MLP structure with WLKP and now are being penalized for it.  The company suggested that if the proposal became the rule, “we’ll look at options to maximize values to both Westlake and its shareholders and the partnership and its unit holders.” 

In this case, WLK would buy in the public WLKP units at a small premium and unwind the structure.  The cost of this option is small to Westlake – as there are 12.94m public units outstanding.  At the current price, the cost to buy the public units is approximately $260m (vs $950m cash on balance sheet at WLK at Q1 2015). 

The question is what price WLK would use to wind down WLKP.  If WLK pays no premium, then WLKP unit holders get distributions during the interim period (90 day comment period + unknown rule finalization period ~ 6-9 months in total) with a current yield of 6%.  This compares highly favorably to current 1 year treasuries at 0.22% yield.  I believe that WLK would actually pay a premium, and I would suggest a premium of about 20% to get to the IPO price of $24/unit for WLKP.  The incentives for WLK to pay a premium are high for several reasons:

1) each $1/unit (5%) premium only costs $13m vs. the $9b market cap of WLK and the ~$1b of cash on balance sheet and the $300-400m of FCF in 2015

2) WLKP unit holders are more likely to sell/less likely to fight if they are made whole (back to IPO price of $24/unit)

3) WLK’s long term incentive is to be seen as shareholder friendly in order to continue to favorably access capital markets for growth,

4) WLK has unusually high management ownership as 70% of WLK stock is owned by trusts controlled by family of the CEO.  They have the incentive to cleanly and quickly unwind the whole structure so that their WLK stock can recover and remove the overhang.

While note directly comparable, WMB/WPZ executed this type of collapse transaction to the benefit of both parties on 5/13/2015.

Scenario 2, is that the IRS allows WLKP to retain its MLP status.  This is less likely than Scenario 1, but not improbable by any means.   There are multiple reasons that the IRS can be persuaded to allow WLKP income to qualify:

1)      Potential long-term tax policy damage as a result of reversal of policy

2)      Potential for litigation against the IRS by any number of impacted parties (including WLKP)

3)      Inconsistency in allowing natural gas refining to qualify in the case of nitrogen (TNH) but not for ethylene

4)      Inconsistency in allowing for refining of natural resources in the case of petrochemical refiners using catalysts for fuel production but not ethylene production

In the case that WLKP retains its favorable tax status, then a return to the original distribution growth story is likely.  Unit holders would have 50% upside in this scenario including 45% capital appreciation and 6% yield, with embedded yield growth in the future.

Scenario 3, is that the WLKP does not get wound down in the near-term and the IRS ruling goes against them.  I believe this is the least likely outcome, but remains a small probability.  In this scenario, it is not likely that WLK allows WLKP units to languish.  Instead, as the recent quote from the Wells Fargo conference suggested, WLK could find ways to maximize value for both WLK and WLKP by utilizing multiple levers to continue to take advantage of the tax free status through the transition period.  More drop downs to WLKP and/or an increase in the contractual margin would increase the distributions at WLKP, allowing WLKP to continue to raise capital and fund future growth opportunities for WLK.  While plausible, this scenario is tough to execute since WLKP will have a hard time raising new equity capital at attractive yields given the 10 year overhang.  WLK would likely find it easier and more cost effective to finance growth through fixed income markets.  It is hard to assess what WLKP unit prices do under this scenario, but the bias is that units go up as WLK would be trying to generate distribution growth and valuation expansion. 

Risks:

The biggest risk is that in the near term as nothing really happens during the IRS comment period and rule finalization, WLKP yield continues to grow.  It is hard to assess the near-term ceiling on WLKP yield, but it is fair that it could approach 10% (as in the case of SXCP).  That would imply that WLKP could trade down to $13-14/share.  This appears to be a very low probability because the probability of IRS reversal is substantially greater than 0, and WLK management continues to provide unit holders comfort about maximizing value.

Catalyst

IRS rule update

Future potential drop-downs to WLKP

Potential for distribution increases at WLKP