What to Buy: Legacy Reserves LP (NSDQ: LGCY)

Why to Buy Now: Midland, Texas-based Legacy Reserves LP (NSDQ: LGCY) is an energy exploration and production master limited partnership (MLP), with properties primarily situated in the Permian Basin, Mid-Continent and Rocky Mountain regions.

The oil-weighted MLP recently announced a fairly transformative deal that will better diversify its resource base across both gas and liquids, while greatly increasing production and boosting cash flows.

Unlike some acquisitions in the MLP space, the innovative deal structure does not overly dilute unitholders. At the same time, the deal’s terms also provide a significant incentive for Legacy’s new strategic partner to drop down additional accretive assets to the MLP in the near future.

With the cash flow potential from additional dropdowns, Wells Fargo forecasts the distribution to rise by 4 percent annually over the next five years.

The current quarterly distribution of $0.595, or $2.38 annually, offers a forward yield of 8.6 percent.

Buy Legacy Reserves LP below 28.

Khoa: Midland, Texas-based Legacy Reserves LP (NSDQ: LGCY) is an energy exploration and production master limited partnership (MLP). Its oil and natural gas properties are primarily situated in the Permian Basin, Mid-Continent and Rocky Mountain regions.

The MLP is focused on long-lived oil and natural gas properties with stable, low-decline production.

Ari: I’ll be honest with you: I’m not a big fan of upstream MLPs, though I know the risk involved in their operations means they generally offer much higher yields than midstream plays. What attracted you to Legacy?

Khoa: The MLP just a made a deal that greatly increases production, which should generate substantial cash flows to support the current distribution, while also creating the potential for future distribution growth. Though the complexity of the transaction may deter some investors in the near term, a high and rising distribution should lead to further appreciation in the unit price, which has already jumped as much as 15.7 percent since the announcement.

In other words, it’s exactly what we’re looking for from a Big Yield Hunting pick: a fat distribution that’s well supported, with the prospect of future distribution growth as well as moderate price appreciation.

Ari: Sounds good. Let’s get into the nitty-gritty of this deal.

Khoa: When it reported earnings earlier this month, Legacy announced it had formed a strategic alliance with WPX Energy Inc (NYSE: WPX) through a pending acquisition in northwest Colorado’s Piceance Basin for $355 million in cash plus a portion of Legacy’s newly created incentive distribution rights (IDRs).

The acquisition includes 2,730 low-decline natural gas wells, with internally estimated proved reserves of 276 billion cubic feet equivalent (BCFE). All of the wells are proved developed producing (PDP), with a production mix consisting of 83 percent natural gas, 15 percent natural gas liquids (NGLs), and 2 percent oil.

The deal’s innovative structure includes an escalating working interest for Legacy that starts at 29 percent upon closing, increases to 37 percent at the outset of 2015, and then 41 percent at the start of 2016. This structure is intended to artificially lower Legacy’s exposure to declining production, by keeping production flat during the first three years, with a 10 percent annual decline rate thereafter.

WPX will remain the operator, and the aforementioned working interest structure means Legacy will have minimal maintenance capital obligations during the first three years following closing.

In exchange, WPX will receive 10 percent of the IDRs right away and have the ability to vest in up to an additional 20 percent of the IDRs upon future drop-downs to Legacy. The vesting rate is 10,000 IDRs for each $35.5 million worth of future transactions. This approach will help keep unitholders insulated from excessive dilution via IDRs.

Ari: Wow, I only absorbed maybe 10 percent of what you just said. Our poor subscribers!

Khoa: It’s a complicated structure, but the end result is that Legacy’s production and reserves will rise significantly, without overly diluting unitholders. And there’s the possibility to acquire more accretive assets down the road.

According to Legacy, WPX, which primarily operates in the Piceance, Williston, and San Juan basins, has a deep inventory of MLP-friendly assets, so the unconventional use of conferring IDRs to a non-general partner will incentivize future dropdowns. Indeed, analysts with Wells Fargo note that WPX has at least $710 million worth of assets that could be dropped down to Legacy over the next three years.

The remaining 70 percent of the authorized IDRs will remain at Legacy for the benefit of unitholders and for possible use in future deals with other operators.

IDRs will not be eligible to receive distributions until the quarterly distribution per LP unit rises above $0.6785, at which point IDR holders receive 13 percent of the distribution, with their share maxing out at 23 percent once the quarterly distribution rises above $0.7375. However, the IDRs can also be reset once the distribution reaches the high splits for four consecutive quarters.

Ari: Enough already about IDRs. What does this deal mean for distribution growth?

Khoa: The transaction is expected to close by the end of June and will be significantly accretive to unitholders over both the short and long term. With the cash flow potential from additional dropdowns, Wells Fargo forecasts the distribution to rise by 4 percent annually over the next five years.

Ari: I noticed that Legacy is heavily tilted toward oil. But this deal mostly involves natural gas. How will that affect the MLP’s production mix?

Khoa: The deal also helps Legacy diversify its resource base across both gas and liquids, which mitigates risk as prices of various commodities fluctuate. At year-end, liquids, such as oil and NGLs, comprised 70 percent of proved reserves, but this deal will lower that to 54 percent.

Of course, the firm also hedges a significant portion of its production, so that offers additional protection from volatile commodity prices as well as providing stability for future cash flows.

Legacy typically hedges 85 percent of its production over an ensuing 18- to 24-month period. The MLP has already hedged 72 percent of second-half 2014 production and 60 percent of full-year 2015 production.

Equally important, this acquisition will greatly increase Legacy’s production. Management has revised its estimate for full-year 2014 production upward to a range of 25,159 barrels of oil equivalent per day (Boe/d) to 25,778 Boe/d from a former range of 19,250 boe/d to 19,759 boe/d. Based on the midpoint of these respective ranges, that’s a projected increase of 30.6 percent!

Ari: I see Legacy has made 128 acquisitions, totaling more than $1.6 billion, since 2006. Any other deals we should know about?

Khoa: During the first quarter, Legacy also made two bolt-on acquisitions, with separate agreements to purchase oil-weighted properties in Chaves County, N.M., and Sheridan County, Mont., for a combined $112 million.

These properties produce approximately 890 Boe/d, contain estimated proved reserves of roughly 9.0 million barrels of oil equivalent (MMBoe), are about 95 percent oil, and are over 95 percent operated. Legacy plans to fund these transactions with borrowings from its credit revolver. The deals are expected to close by the end of the second quarter and should be immediately accretive to shareholders.

Ari: Given all these deals over the years, how many secondary issuances has Legacy done?

Khoa: Legacy’s initial public offering (IPO) was in January 2007. Since then, the $1.6 billion MLP has made five follow-on offerings, with the last one occurring in late 2012 and involving the sale of 9.2 million units, or $227.4 million.

Ari: Let’s get into the distribution. After all, that’s why we’re here.

Khoa: Legacy has increased its quarterly distribution by a modest increment in each of the past 14 quarters, since the beginning of 2011. For instance, the May payout rose 0.85 percent from the prior quarter, to $0.595, or $2.38 annually, for a forward yield of 8.6 percent.

Prior to that, the distribution hit a plateau of $0.52 per unit from mid-2008 through the end of 2010. Over the trailing three-year period, the distribution has grown by 3.9 percent annually.

For the first quarter, the distribution coverage ratio was 1.0x, but following the deal with WPX, it’s expected to rise to 1.1x for full-year 2014 and 1.2x for 2015.

Ari: What does Wall Street think about Legacy?   

Khoa: Analyst sentiment for the MLP is strongly bullish, at 10 “buys,” two “holds,” and one “sell.”

In fact, sentiment has strengthened following the deal’s announcement. Oppenheimer & Co raised its rating to “outperform,” which is equivalent to a “buy,” from “market perform,” or “hold.” Its 12-month target price is $29.00.

And UBS upped its rating to “buy” from “neutral,” which is equivalent to a “hold.” It also increased its 12-month target price to $31.00 from $27.00.

The consensus 12-month target price is $30.91, which suggests potential appreciation of 12 percent above the current unit price.

For full-year 2014, analysts forecast revenue will rise 14 percent, to $554.5 million, while EBITDA (earnings before interest, taxation, depreciation and amortization) are expected to increase by 12 percent, to $303.8 million.

For full-year 2015, analysts project revenue will climb 16 percent, to $641.4 million, with EBITDA rising 16 percent, to $351.8 million.

Ari: Alright, what can investors expect at tax time?

Khoa: Before proceeding, it should be noted that we’re not tax professionals, and that subscribers should consult their accountant or tax advisor to confirm the treatment of these distributions.

In general, MLPs should be owned in taxable accounts, as a significant percentage (generally around 80 percent) of the distribution is considered a return of capital and is therefore tax-deferred. With each payout, the tax-deferred portion of the distribution reduces an investor’s cost basis by an equivalent amount. Assuming units are held for the long term, this means these distributions will essentially be taxed at the long-term capital gains rate upon sale of the security.

Of course, in the interim, this means contending with a Schedule K-1 at tax time, but the high yield coupled with the ability to shelter income from taxes more than offsets the tedium of dealing with this tax form.

while MLPs can be held in IRAs, there is considerable debate regarding the tax implications of doing so. Either you, or more likely your IRA’s custodian, will receive a Form K-1 to fill out, and there may be some taxes due from the portion of distributions designated as unrelated business taxable income (UBTI).

However, because the first $1,000 of UBTI from all sources in an IRA is exempt from taxation, an investor generally has to hold a large quantity of MLP units to trigger taxation. Still, this adds a degree of tax-reporting complexity that most IRA investors would presumably prefer to avoid.

There is one other tax wrinkle for IRA investors in MLPs that’s potentially far more onerous. When an MLP is finally sold, the portion of the proceeds that would be taxed as ordinary income in a taxable account could be liable for UBTI when held in an IRA. And if an MLP has been held in an IRA for many years, this tax liability could be quite substantial.

Still, it’s possible that the income and gains from investing in MLPs in an IRA still make it worthwhile. But that decision is up to the individual in consultation with their tax advisor, and we make no recommendation in this area.

Ari: Where do Legacy’s units trade pricewise in relation to the recent past?

Khoa: Units of Legacy hit a 52-week closing low of $24.76 on April 30, and have since jumped as much as 15.7 percent, to $28.64.

The MLP recently traded near $27.60, so we’re only buying it after most of its ascent, though at least we’re still able to get in below the near-term high. And Legacy is still down about 17.9 percent from its all-time high back in early 2011.

Though it would have been nice to get into Legacy at that late-April low, I’d rather establish a position in a security that has upward momentum than catch a falling knife.

Buy Legacy Reserves LP below 28.

Portfolio Update

We’re completing our review of calendar first-quarter earnings and expect to issue a lengthy update via email in the next week.