Eagle Rock Energy Partners (NASDAQ:EROC) committed the cardinal sin for master limited partnerships Tuesday and cut its distribution close to 32%. Whether or not you saw it coming is irrelevant now that it's done; the focus now is on what this means for Eagle Rock going forward. There is a case to be made for Eagle Rock as a buyout target, and that's what we're looking at today.
The case for buyouts in general
Energy Transfer Partners (NYSE:ETP) CEO Kelcy Warren summed it up best at the end of September when he shared the following idea with us: "You're going to see the resumption of some kind of M&A strategy that we deliberately shelved for quite a period now."
Mere days later, the MLP space was alive with the sound of mergers and acquisitions. Regency Energy Partners (NYSE:RGP) bought PVR Partners (NYSE:PVR). Crestwood Midstream closed on its acquisition of Inergy and then announced it was also buying Arrow Midstream Holdings. Devon Energy (NYSE:DVN) bucked the IPO trend to merge its midstream assets with the Crosstex Energy family. All in the span of three weeks!
And this is just the beginning. The CEOs behind these deals have all spoken of one key component in their M&A strategy: achieve an investment grade rating. We're about to see rising interest rates and tightening capital markets collide with an American energy story that still requires significant investment. Only the most fiscally fit MLPs will be left standing. Which brings us to Eagle Rock.
The case for Eagle Rock specifically
Fiscally fit it is not, and my Foolish colleague Matt Dilallo has done a great job covering Eagle Rock's financial woes.
Its biggest problem, however, is that it's really trying to do too much at once. Eagle Rock Energy Partners is both a midstream MLP and an upstream MLP at the same time. Upstream MLPs, also known as exploration and production MLPs, must operate sophisticated hedging strategies to mitigate commodity risk in order to generate the reliable income investors demand. Midstream MLPs, for the most part, utilize fee-based contracts and are immune from the woes of commodity price volatility. That is why the most successful MLPs since the advent of the structure have been midstream companies.
Theoretically, if Eagle Rock had reliable revenue from its midstream unit, it could plow that back into its E&P business and potentially do all right. Unlike a great many of its midstream peers, it does not have that reliable revenue though. In fact, Eagle Rock has a very low percentage of fee-based revenue in its midstream segment, which comprises 43% of its business mix. The partnership expects 59% of its midstream revenue will be tied to commodity prices this year and 55% next year. While that's lower than the 73% it was sporting in 2012, it's still way too high for a midstream outfit that is desperate for reliable income. In other words, Eagle Rock is even getting the right part of its business wrong.
This presents a very compelling buyout thesis for the partnership, however. Theoretically, Eagle Rock could court multiple suitors: E&Ps for its producing assets and pipeline companies for its midstream assets. The biggest weakness in the midstream story is its fee-based revenue, but we've already seen impressive turnarounds in that arena. Consider that PVR Partners -- a recent buyout story itself -- managed to increase its fee-based revenue from 30% to 80% in just three years. It's possible, it just might take someone else to do it.
More buyouts are coming, and though it is impossible to say which MLPs will be the next target or when, it can be a valuable exercise to review an MLPs strengths and weaknesses in an effort to see whether or not it would be a buy and why. In the case of Eagle Rock,
Fool contributor Aimee Duffy has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.