Natural Gas Partners (NGP) have proposed a series of transactions with Eagle Rock Energy Partners (EROC). These transactions involve:

1. A rights offering to current holders
2. An equity offering back stopped by NGP
3. Sale of EROC’s Minerals Business to NGP with the opportunity to sell to a higher bidder if one arrives
4. Repurchase by EROC of NGP’s Subordinated units, some General Partner Units and the attached Incentive Distribution Rights (IDRs)
5. An option to repurchase all of the General Partner (GP) Units
6. New Equity Incentives for Management
7. Restructuring of certain terms and conditions in the partnership agreement

Valuation

To analyse the proposed transactions we'll use the EROC Valuation from July this year as the base case. The other starting data we need is the end case of the proposed transactions; they can be divided into:

• Changes to discount rates
• Changes to cash flows
• Changes to shares outstanding

The total debt repaid as a result of the transactions would be around 250M. That greatly improves the debt to equity ratio and reduces the 2010 discount rates from 17.5% to 11.6%. 2011 onwards discount rates move slightly from 12.2% to the revised 11.6%.

There are three impacts on cash flows:

• The loss of the minerals business
• The reduced interest expenses
• The reduced cash losses from purchasing in the money hedges to avoid violating loan covenants

The minerals business produced $2.8M in profit in the six months ending June 30th 2009. Our base case is based on 2009 cash flows so annualizing that to $6M is consistent for comparison. The minerals business earned 31.8M in 2008 and nearly zero in 2007. EROC describes the 2008 results as a phenomenon as they reflect $17M of bonus payments “as a result of the regeneration phenomenon we received an initial royalty payment for 304 new wells”.

Interest expenses in the base case are $29M per year (they are in fact running slightly less than that now). Debt will be reduced by 31% which should lead to a straight line saving of $9M.

As described in the initial valuation of EROC, they manage their loan covenants by purchasing in the money hedges. As prices exceed these in the money hedges, EROC net loses money. This was not effectively modelled in the base case but was an inefficient use of cash and not doing this in the future is a benefit even if it’s not quantified.

The cash flow and discount rate changes look promising. Unfortunately they are offset by changes in shares outstanding.

• The rights offering will add 19.6M shares
• The equity offering will add 33.9M shares
• The repurchase of half of the GP units will retire 400k shares
• The subordinated units will not become active in 2022
• Management will receive 8M shares as incentives

The net effect is about 117M shares from 56M today.

Cash flows are 49% of pre-transactions cash flows on a per share basis. With the reduced discount rate this values each unit based on a dividend discount model at $6.90 from $7.66 in the pre transactions base case.

Rights Offering

That’s not quite the end of the valuation. Current unit holders are offered the right to purchase .35 additional units for each unit they hold. They can purchase additional units for $2.50 and will receive a 2 year $6 warrant for each additional unit purchased.

Valuing the right is easy. It’s 0.35 * (post transaction value - $2.50) = $1.54

Valuing the warrant is more complicated. One model would be .35 * (post transaction value – strike price) = $0.315. Unfortunately the warrant is only good for 2 years and therefore an option pricing model is probably more appropriate. Using the option inputs provided I’d value the warrant at 41c. As you only get .35 per current unit held then the warrant is worth $0.14.

• New post transactions valuation - $6.90
• Rights - $1.54
• Warrant – $0.14
• Total value - $8.58

This assumes:

• EROC does not exercise the option for the other half of the GP units
• The equity offering is conducted at $3.10. Every 10c increase in the price of this offering offers unit holders about the same 10c in unit value
• All rights are exercised
• Other assumptions per the original base case estimate

Other considerations

There are also some intangible benefits of the proposed deal:

• If interest rates increase dramatically over the next year or two, EROC will be much better positioned to manage that
• EROC will be better positioned to renegotiate their loan in 2012
• Yield investors will be attracted back to the units
• There is a short term catalyst for the stock

There are also some disadvantages:

• EROC loses a low risk line of business with upside
• The opportunity to assume the risk and reward of the debt pay down over the next 12-18 months is removed. The analysis presented here is based on values at the end of 2009. There is an extra 60% value to be captured in 2010/2011 if EROC makes it through that time period. That risk/ reward is captured in the discount rate.
• These transactions will not be evaluated strictly on their benefit to unit holders, see conflicts of interest below.

The repurchase of the subordinated units and the IDRs for $35.5M is fair. The subordinated units will receive payouts from 2022 onwards. Discounting that back to today values the subordinated units at $40M. The IDRs appear close to worthless.

Restructuring

The transactions propose that future accruals of the minimum quarterly distribution cease. Current accruals may remain but they are a moot point once the subordinated units are redeemed.

Conflicts of interest

NGP have identified in their offer that these transactions pose a conflict of interests. The conflict will be put to the independent directors. Furthermore the most recent 10k outlines the responsibilities of those directors. While it’s well worth reading in full; you should note:

• “Neither our partnership agreement nor any other agreement requires the NGP Investors to pursue a business strategy that favors us”
• “Our partnership agreement limits our general partner’s fiduciary duties to holders of our common units and subordinated units.”
• “We may issue additional units without limited partner approval, which would dilute ownership interests.”
• “Our general partner is allowed to take into account the interests of parties other than us in resolving conflicts of interest”

Opportunity

It appears, on balance, that this is a fair transaction. It offers NGP a way to convert some long dated opportunities into shorter dated ones. It gives unit holders more short term upside while sacrificing a higher risk/ reward over the next few years. It also creates a catalyst as a result of the rights offering and the resumption of distributions. As valued today, these transactions moderately increase the value of EROC units to current holders.

posted by Neil  # 8:46 PM