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Write Up of APL

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By RWRocksOn
March 29, 2005

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ATLAS AMERICAN PIPELINE WRITE UP AND CONFERENCE CALL
 

This writing is posted on the Foolish Collective, the APL board and the Oil Sector board. The writing is not complete � there are several facts and analytical issues on which I would like to have some help, but I had to get this out of the door!

Where did the idea come from?
I first got the idea of looking at APL from emiller8988's write-up on master limited partnerships (MLP) on the Fool, from his 9/17/2004 post on the Foolish Collective Projects Board. I highly recommend reading that post prior to reading this post.

What is the company?
APL is a Delaware limited partnership begat from their general partner, Atlas America, Inc. (ATLS - which owns 2% of APL � which is in turn a subsidiary of Resource America REXI)). APL acquired the natural gas gathering systems of ATLS and began operations in 1/2000. APL has several important relationships with ATLS that shall be described subsequently.

What does APL own and do?
The company now owns a total of 3280 miles of natural gas pipeline, 1380 in Appalachia (App.) and 1900 in Texas and Oklahoma (OK) that transport natural gas to public utility pipelines. They operate a natural gas processing plant in Velma OK. They are completing the purchase of ETC Oklahoma (called the Elk City system).

Generally, how does the company make money?
APL gets paid to transport natural gas, gets paid for processing natural gas, sells products of natural gas processing.

Specifically, how does the company make money?
The company can be considered in three interrelated parts � the App. transport system, the OK transport system and the Velma processing system. There will likely be two more processing plants added in 2005 after completion of the buyout of ETC Oklahoma is completed.

App. transport system is intertwined with ATLS. All of the board members of APL are employees or board members of ATLS and ATLS acted as the general partner. The two companies have an agreement in which APL will transport gas from all ATLS wells that are within 1/2 mile of an APL system. ATLS will also set up the well to pipeline connection. ATLS operate substantially all the wells serviced in App. and is growing this system with the addition of 195, 270 and 335 wells over the past three years for a total of 5200 wells. APL receives 16% of the gross or weighted selling price of the gas it transports (subject to minimal prices) so revenues from this stream are dependent on the price of natural gas. As the price of natural gas had gone up, the payment has increased over the past three years from $0.58/million cubic feet (mcf) to $0.96/mcf. There are 56 compressors, of which 4 are leased.

The OK system was acquired in 7/2004 when Atlas bought Spectrum for $142 million. The name was changed to Mid Continent (Mid). This system includes not only pipeline but also processing and sale of natural gas liquids (NGL). While the App. operations are dominated by ATLS, the OK system has 650 separate contracts, with ChevronTexaco being the largest supplier (236 wells and 10 mcf/day) and Zincke&Trumbo contributing 9 mcf/day from a new line in Duncan, OK. 75% of these contracts are percentage of processing (POP) contracts, which means that APL takes a cut from the originating wells of the proceeds of the end product. This particular type of contract means that APL receives revenues no matter whether the well makes money or not. The other contracts are fixed fee for gathering, compressing, and processing gas. At end of 2004, APL processed an average of 56.4 m cubic ft per day (mcf) and produced 5799 bbls per day of NGL. APL believes that the majority of the wells serviced in OK are long-lived wells. There are 18 compressors of which seven are leased.

The pipelines in App. have an expected life of over 50 years. Cost of operating the App system is a little over $2m/year. This provides APL with the ideal moat � wide and requiring little ongoing expense.

Velma plant has a contract with Koch hydrocarbons under a monthly renewable agreement to sell the NGL products and sells natural gas to a variety of customers. The technical description of the plant is on page 19 of the 10-K.

What diversification does the revenue stream have?
There is geographic diversification with the acquisition of Spectrum and source diversification with the addition of the Velma plant.

What is the potential for growth?
The company states that their strategy is to acquire more gathering systems and to grow their existing systems. APL's acquisitions of Spectrum and Elk City seem to prove that management is serious. There is an estimated $250 billion worth of "MLPable" assets in the US.

ATLS continues to drill new wells in App. and there really isn't much competition.

In 2004, APL made several efforts besides Spectrum to purchase systems and were unsuccessful.

In OK, there is competition for contracts, but APL believes that they have technical advantages using electrical rather than gas compressors as well of efficiency advantages.

In 3/2005, APL agreed to buy ETC Oklahoma Pipeline, LLC, with 315 miles of pipeline in OK and natural gas processing plants in Elk City and Prentiss OK for $190 m in cash. Financing is from Wachovia and Bank of America and described on page 8 of the 10-K. More than 70% of the system's gross profit during 2004 was derived from fixed fee services that are not dependent on commodity prices - representing approximately 50% of the total throughput volume. The balance of the gross profit is represented by percent of proceeds contracts and, to a lesser degree, keep-whole contracts.

The natural gas processing facility in Elk City, Oklahoma has a total capacity of 130 million cubic feet of gas per day ("mmcf/d") and a 100 mmcf/d gas treatment facility in Prentiss, Oklahoma (collectively referred to as the "Elk City system"). Total gas throughput, including approximately 118 mmcf/d processed at the Elk City plant, is currently approximately 262 mmcf/d. Total compression horsepower consists of 21,000 hp at six field stations and 12,000 horsepower within the Elk City facility. The Elk City system gathers and processes gas from more than 300 receipt points representing more than fifty producers and delivers that gas into multiple interstate pipeline systems.

Financing issues
APL has made two large purchases over the past two years � Spectrum and ETC Oklahoma. APL's major financial relationship is with Wachovia Bank.

Spectrum financing: APL borrowed $100 m from Wachovia under the term loan portion of a $135 m senior secured term loan. The senior note means that Wachovia has priority in repayment of the loan from APL over other APL debts. This gave APL a better interest rate on the loan. APL also used $20 m generated by a sale of preferred units to REXI and ATLS and $22.4 m of the net proceeds from a 4/2004 public offering.

Elk City Financing: APL used Wachovia Bank, National Association and Fleet National Bank, a Bank of America company, to fully underwrite a new $270 million loan facility. The facility will be comprised of a $225 million 5-year revolving loan and a $45 million 5-year term loan. The loan proceeds will be used to refinance the existing $54 million outstanding on APL's current $135 million facility and to finance the acquisition of ETC Oklahoma Pipeline

Their loan rates are based on leverage (debt/EBITDA ratios) that is spelled out on page 7 of the 10-K.

Hedging: APL hedges natural gas prices. 47% is not hedged, 43% is with floating for fixed swaps in which Mid sells future production to the counter party at a fixed price and agrees to purchase production from the counter party at a price to be established by reference to a fixed index price and 10% is hedged with collars. A collar is formed by buying a put option and selling a call option. APL does not use hedges to speculate. They have a hedge committee to ensure this. The percent of hedges will change over time. The gain or loss of the hedge is offset by the sale of the physical product. The hedges are spelled out on page 37 10-K. I don't pretend to understand them.

Share dilution: In the summer of 2004, APL completed public offerings of a total of 2,850,000 shares for a net of $93 m. The general partner contributed $2 m to maintain its 2% interest.

Goodwill: the company carries $2.3 m of goodwill from the acquisition of various pipeline assets.

Legal issues: APL settled advantageously litigation regarding purchase of Alaska Pipeline company with SEMCO for $5.5 m. APL did not end up purchasing the Alaska Pipeline company.

The Oklahoma Tax Commission is seeking $5m from APLMC for underpaid taxes. APL plans to defend itself vigorously.

Distributions: required by law of an MLP � a total of $2.88 per share were distributed in 2004

Conference call: 3/2005
Present were CEO Edward E. Cohen, COO Michael Staines and CFO Freddie Kotek.

Cohen:
They discussed record results (not surprising given the purchase of Spectrum), announcing earning of $95.3 m 2004 versus 15.4 m 2003. Net income was $18.3 m or $2.60 per share 2004 versus $9.6 m or $2.17 per share 2003. Distributions were $2.67/share 2004 v. 2003 $2.39. Better results were the result of improvement in volume and transportation fees and Spectrum acquisition. The EBIDTA (non-GAAP measurement useful for comparison to peers) was $24.3 m in 2004 v. $11.7 m 2003.

In addition, they announced the 1Q/2005 dis. of 75 cents/share, the largest ever.

They discussed the two equity offerings in 2004 (2.8 million shares generating proceeds just under 95m) described in the 10-K discussion above) along with the financing of the Spectrum acquisition. (Wachovia and Key Bank)

SEMCO Energy Inc paid $5.5 m to settle the Alaska Pipeline issue.

Recently entered into agreement to acquire Elk City processing plant. They are very excited about the ETC Oklahoma/Elk City acquisition, which they expect to be immediately accretive to APL for $190 m. with 315 miles of gathering system and two processing plants with one at 100 million cubic feet per day that removes carbon dioxide and one with 130 million cubic feet per day capacity in Elk City that remove NGL. This is currently operating at 127 mcf/day. Like the Spectrum acquisition, they expect this to be a transformative acquisition. Given that their current processing capacity is 110 million cubic feet per day the Elk City acq. will triple capacity. "The price was satisfying to us; we paid 9 to 9.9 times current distributable cash flow". Will be immediately accretive. Near Velma plant. The current Mid America executives are familiar with the Elk City system due to competition in years gone by. Great ability to integrate the two companies. Elk City offers complementary pricing. Company emphasizes the downside in considering acquisitions. Elk City had largely fixed fee contracts in comparison to current preponderance of POP. Fixed fee contracts will informally "hedge" fall in gas prices.

Elk City processing volumes have been accelerating from 114 to over 230 mcf/day in 2004. Financing will come from 270 m dollar credit facility to pay off current facility and to close Elk City deal. More permanent financing options may be announced in a few weeks. Believes that total situation makes for a highly positive excellent situation (buying Elk City).

They believe that they will be able to distribute between $3.12 to $3.32 per share in 2005 � projecting $3.15 (conservatively).

Michael Staines COO:
Transported 110 mcf/day in 2004 improving from 52.5 mcf/day 2003 due mostly to Spectrum acquisition. During Q4 2004 App. output was 55.1 mcft/day compared to 50.1 mcft/day 4q2003. 335 wells added in 2004 compared to 270 2003. Expect 2005 production to rise at similar pace.

MidContinent added 81 wells from acq to end of 2004, (17 mcft/day of new gathered gas) most in late 12/2004 not yet reflected in average volumes, exp substantial daily upturn and volume. Comparison from 2003 quarter to 2004 showed increase from 54 m to 57.6 mcft/day. Currently, Velma system transporting 65 mcf/day and App 53 mcf/d reflecting difficult winter operations.

They are working on construction in Fayette County, Pennsylvania that is expected to be completed in 5/2005. At that time will be able to serve the increasing number of wells and volumes with continue growth at similar rate. Atlas America (general partner affiliate) will have 278 wells connected in next few months and will continue to grow in to 2006.

MidContinent: Pipeline and compression capacity increasing at Velma and remote sites in system at $ 6 m cost. Essentially complete, will increase Velma inlet capacity from 60�90 mcf/day. Confident that demand will meet capacity. Trans fee in App. margin was 96c mcf up from 82 cents 2004 copared to 2003 and for last three months 2004 1.08 mcf from 83 mcf end 2003, a 30% increase

They discussed App. the price of natural gas increasing from $5.20/ mcf in 4Q2003 to $6.75 in 4Q2004 and $6.80 in 2005 and higher for end of the year. In MidContinent, average margin 71c mcf end of 2005. 80% are under POP contract remainder is fixed fee, no keep-whole contracts.

Hedging: they noted that in App. APL only transports and therefore does not use hedging for those operations. Atlas America, affiliate of general partner, does conduct forward sales of gas (79% in 1Q2005 was hedge for $6.75/mcf � about $6.90/mcf hedge for remainder of 2005, about 70% of total)

In MidContinent APL does own the gas and does hedge. They hedge the equity gas liquid, which is the portion of ultimate sales proceeds APL retains. 81% of the 1Q/2005 of this is hedged at $6.17, but does not reflect negative basis, hedged at 50 cents per mcf.

CFO Freddie Kotek:
They noted that their income statement now has several new line items due to Spectrum acquisition such as plant operating expenses. They recorded Spectrum for 5 1/2 months. They believe that they are improving their administrative costs.

Reconciliation of EBIDTA and pro forma taking out effect of Alaska Pipeline settlement is in the 10-K, pro-forma EBITDA $24m is considered appropriate to compare to 9m from 2003. Goes through the numbers (see 10-K).

Transportation charge up 21% over 2003 on both volume and increased charges.

Depreciation and amortization is up due to Spectrum acq. Have $77 m remaining credit prior to Elk City acq. 7.7 % interest on term loan. Currently 53% hedged through 2006.

Questions from analysts. Regarding Elk City � APL believes that this will provide tremendous growth (why did the selling company sell it, then?) in a hot area for new drilling.

Adjusting to the new accounting demands is more expensive for smaller firms like APL.

AG Edwards asked about new wells for App. in 2005 � answer � ATLS plans to drill about 700 new wells (my note: production from old wells decreases over time and off set new production from new wells) and APL will perhaps hook up about 500.

Distributions from Elk City will likely come on line in 3Q/2005.

End of conference call.

Discussion:
The objectives of producing the following analysis are 1) to increase my understanding of APL specifically and in general to improve my ability to read and understand 10-K's, 2) to determine whether APL is improving as a company and 3) whether APL is a buy at current stocks prices and, if not, at what stock price?

Industry: APL is involved in the transportation and processing of natural gas and has growth as a company goal. It's profits are driven by the price of natural gas through its POP contracts, its ability to charge for transporting that gas (proportional to public demand for gas and the ability of wells to switch to other transport systems) and the demand for the finished products of its processing plants (NGL). Profits will be maximized by the company's ability to control costs such as maintenance and to produce efficiencies by investment in physical assets that improve operating margins, rising gas prices and continued expansion at reasonable cost of capital.

APL enjoys a substantial moat. Natural gas enjoys an inelastic demand (while the price may vary quite a bit), entry into the business requires a significant expenditure of capital, overcoming regulatory and political barriers and obtaining difficult rights-of-way. In addition, pipelines are cheaper than alternative forms of gas transport such as rail, barge and trucking.

Quality of management:
The relationship of APL with ATLS is extremely important with ATLS wells driving virtually all the App. operations and the ATLS general partner owning 23% of APL outstanding common shares as well as the obligatory 2% subordinated shares.

APL is obviously growing by leaps and bounds through leveraged acquisitions. The two questions that arise then are concerning liquidity (servicing the debt) and the cost to shareholder of expansion. If management's estimate that Elk City was purchased for only 9 x distributable earnings, then the addition will be favorable to preexisting shareholders. I view as favorable their declaration that they tend to be pessimistic about acquisitions and that they examined but did not act upon several other proposals for acquisition in 2004.

Given that the value of APL's stock will depend on further acquisitions, the real value of APL lies in their management's ability to find possible purchases, evaluate whether these purchases will be accretive to current stockholders and then arrange appropriate financing for those purchases that they deem worthy. Their track record so far is good (Spectrum purchase). Elk City remains a question.

Some financial numbers:
Debt payment is summarized in Annex A of the 10-K (way towards the end). I'd love to have someone more knowledgeable than myself comment on the amount and quality of debt APL currently carries and how this affects their prospects for future acquisitions. I would guess that APL's tactic will be to roll over the large amount of principal payment due starting in 2008 into the lowest interest credit they can find (principal payments are $2.3m 2005, $2.3m 2006, $2.3 m 2007, $10.6 m 2008 and $36.9 m 2009, but I believe that these numbers do not reflect financing for the Elk City acq)

Some numbers:

Market cap is $247 million, shares outstanding 5.5 million.


Ratios                  2004
Liquidity                                                   
Current                 1.25
Cashflo Liq.           1.59
Leverage ratio                                         
Debt ratio              2.73
LT deb/tot cap       0.38
Debt/EBITDA        3.1
Times int. earned  10.9         


Very important to note that these numbers do not reflect Elk City acq.

I didn't run historical numbers for APL since the company is so different today than it was in 2003. I'm not even sure what number I would use for the denominator of ROE for 2004 � the equity at the beginning of 2004, the end or some average?

There are 5.5 million shares outstanding at the end of 2004. Attention should be paid to the fact that the number of shares more than doubled due to the public offerings in 2004. The offering raised $95m for 2.8 million shares or about $34 per share. Free cash flow for 2004 was $15.5 m (cash from operations was $25.5 m minus $10 m cap ex) or $2.60 per share (not surprisingly, just about the annual distribution).

Calculated enterprise value is based on market cap of $247m plus total liabilities $79 million minus total assets of $216m = $110.5 million. Free cash flow for 2004 was $25m cash from operating activities minus $10m in cap ex = $15.5 m and therefore an EV/FCF of 7.12 or FCF/EV of 14%. Using management's low-end guidance of $3.12 per share distribution for 2005, the current share price of $45 generates (surprise) a P/expected distribution of 14 or a 6.9% return. Are the analysts doing the same math as I am, or what? What these numbers likely take into account is the uncertain nature of integrating another company into the APL system and the uncertainty of the price of natural gas.

APL has grown revenues impressively over the past 5 years, largely through acquisitions and to a lesser degree due to the increased price of natural gas. Management appears to believe that they have technical and efficiency advantages over competition. In addition, their contracts with ATLS (percent of gross sales) and the fixed fee and POP contracts at Mid America remove them from risks involved in the cost of processing the gas. APL has no "keep-whole" contracts. The revenues streams are dependent on the price of natural gas, which historically has roughly tracked the price of crude oil, although the use of hedging and the addition of fixed fee contracts from Elk City will mitigate drops in gas prices (as well as mitigating profits from increases in gas prices). Last year was thus a banner year historically, but the increasing global demand for gas may make such a year routine. I would expect there to be a substantial relationship between the price of natural gas and the APL stock price in the absence of further acquisitions.

Potential for growth: a mid sized company such as APL is ideally positioned. An AG Edwards report on MLPs estimates there are $250 billion of "MLPable" assets in the US. The key is to pay only for stuff that is accretive to shareholders and to a degree that justifies taking on interest payment or share dilution.

Comments about MLP's (warning � I am hardly an expert on MLP's � do your own due diligence!). MLP's enjoy some tax benefits in that profits are passed directly to unitholders as distributions and taxed only at that level and only upon sale of the shares. The general partner of the MLP normally controls the MLP through a 2% equity interest (as ATLS does with APL) that are subordinated to the common (publicly traded) units early in the MLP's existence. For the GP's shares to convert to common shares, certain financial tests must be met and these tests usually align the GP's interest with unit holders of the MLP (you and me). As cash flow and distributions increase, the GP receives a greater portion of the incremental income. This portion can be as high as 50% (this is called a high split). While this may seem quite a bit for a 2% owner to enjoy, MLP's that are operating in a high split situation have higher distributions and distributions growth.

There are also tax peculiarities about MLP's that tend to encourage owners to not sell the stock during downturns in the stock price, thus providing ballast and tempering stock price volatility.

Do not own MLP's in an IRA or retirement plan due to basis complications.

Macroeconomic issues: always just things to think about. If interest rates rise, the cost of capital will also rise, thus making acquisitions more expensive. In addition, money from income-oriented investors will have more attractive alternatives to MLP's for their dollars. The price of the stock will only drop so far, since the yield will of course also rise (income otherwise being equal) and create a hard floor for the stock price.

Red flag: any sale from the GP to the MLP must be scrutinized.

Unanswered questions (for myself and for the Boards):

Why did the sellers of Spectrum and Oklahoma ETC sell seemingly profitable systems?

What is the status of ATLS and REXI and how does this affect APL?

What is the status of APL's debt structure and how does this affect APL's ability to make more acquisitions on credit?

Did the shareholders of APL stock prior to the issuance of the 2.8 m shares in 2004 receive far value for their share dilution?

http://www.anvilpub.com/energy_pipeline_news.htm

Is it a sell or a buy? If you all ready own, the tax implications of selling strongly weigh in favor of holding onto current shares. If I can get the credit/debt questions answered and these questions are answered in the favor of APL then I think that APL is a buy given its yield, the stock price floor that the yield provides, the ability and discipline of management to make accretive and only accretive acquisitions, the size of the company and its favorable relationship with the much bigger players of ATLS and REXI.

I look forward to criticism and answers to those questions I have posed.


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