I think the current implied stub price is probably not very far removed from intrinsic value. Unfortunately my gains on this trade are limited because the merger spread between APL and NGLS increased. Making money on a merger arb while the spread increases is not bad though.
No positions anymore
After my post on the Atlas Energy merger arb/spin off a lot has changed in just a few days because the carnage in the MLP land has continued unabated. This also has had big effect on the implied new Atlas Energy Group stub price that has tumbled from $4.21/share to $0.42/share. This is however a bit of a deceptive figure since it does not account for the merger risk inherent in buying the stub. We can estimate the merger risk by looking at the NPL/NGLS deal that is codependent on the ATLS/TRGP deal, and the deal spread has grown together with the carnage in the sector. If we adjust for the merger risk we get the following price:
The estimate of the merger risk is of course just that, an estimate, because while both deals have the same probability of completion the downside risk might not be identical when the deal fails. I don’t think this difference is material though, although the ATLS deal might have a bit more risk since a larger percentage of the price is paid in cash. But we also get paid a whole lot more than the 7.13% of the APL/NGLS deal. If we only look at the value of the ARP LP units that the new Atlas Energy Group owns we already get a value of $2.26/share:
In addition to this we also get:
I honestly don’t know exactly how to value all these various interests, but when you get a bunch of potentially valuable assets basically for free I think this almost has to be a good bet with a positive expectation. So I have initiated a small position yesterday. Anything else than a small position is probably not wise/doable though since you need to tie up a lot of capital, and you get a lot of deal risk as well. You could theoretically hedge the deal risk to some extent by shorting APL and buying NGLS, but that would require even more capital.
Long ATLS, Short TRGP. No (direct) position in ARP, ARCX, APL or NGLS.
Someone on Twitter posted a slide from the latest investor presentation from Atlas Energy that piqued my interest. The majority of the company is being acquired by Targa Resources, but before the transaction is closed a small part of the company is being spun off to existing shareholders. Management seems to believe that the implied price of the new Atlas Energy Group is substantially below intrinsic value:
While this sounds great we have to realize that at least a part of the possible undervaluation represents a merger risk premium. The size of the risk premium should however be small since:
The only negative is perhaps the fact that the termination fee is ‘just’ $53.4 million, or approximately 3.6% of the current deal value. If Targa Resources would really want to get out from the agreement they could do so. Since both stocks have moved in aggregate a limited about since the deal was announced in October, and with a very high correlation, I doubt that anything has changed so far that would lead to the acquiring party wanting to cancel the deal.
Since we are receiving one security with an uncertain value it is impossible to calculate what the potential return of the merger arbitrage is, but this might exactly be the reason why there is an opportunity here. People who ordinarily would play the merger arbitrage game might not enter because they don’t want a large exposure to the new Atlas Energy Group that cannot be hedged. At the same time the people who would want to buy just the new Atlas Energy might not be interested in the merger arbitrage game since you need a lot of gross exposure to ATLS and TRGP to buy a small new Atlas Energy position.
What the potential return is of the combined merger arbitrage/spin off depends of course critically on the intrinsic value of the new Atlast Energy. The management team seems to think that the disconnect between price and value is pretty huge:
Some of these numbers are already outdated and a bit lower while other are potentially too optimistic, but if it’s roughly right you still get a great deal. The stub is currently trading for $4.21, so if it’s worth $13 you would be looking at more than 200% upside! That should give you some wiggle room to adjust certain items downwards.
Almost all value is related to Atlas Resource Partners. The company owns 100% of the General Partner (GP) Interest, 100% of the Incentive Distribution Rights (IDRs) and a 27.7% Limited Partner (LP) Interest. The limited partnership units are easy to value since they are traded on the NYSE under the ARP ticker. The general partnership units are also relative straightforward since they are entitled to 2% of ARP’s cash distributions. With ARP currently trading at a >19% yield I think we have to conclude that the current distributions are not sustainable, and that makes sense since oil prices have dropped a lot. Perhaps a bit crude, but if the current price is right a fair yield is probably roughly half the current yield. This would mean that the company would distribute approximately $100 million per year to LPs, and as a result the GP would be entitled to ~$2 million/year. This would also imply that the IDRs would be far out the money since they only start to generate cash flow at distributions of more than $0.47/quarter. This represent a yield of more than 15% at the current market price.
So I have a huge discrepancy between the fair value estimate from management and my own estimate. A $17 million revenue stream at a 20x multiple (pretty high) is worth $6.50/share. A $2 million revenue stream at a 15x multiple is worth just $0.60/share and would eliminate almost all upside even if we take all other estimates at face value (I think some need to be adjusted downwards, but not by a whole lot).
So I’m I being too pessimistic here? Is the market too pessimistic about ARP? The management team seems to think so if we believe the Q&A from the latest conference call (emphasis mine):
Thanks Lee. Well of course I think our latest acquisition demonstrated how we can actually grow, we expect profitably without issuing additional equity at these ridiculously low prices. Although one should note that the entire sector wrongly in my opinion is creating yields that are in double-digits. So that part is really foolish, but you will know more about the market than I do. But I do know that with the imagination as we’ve demonstrated one can do deals even where common wisdom would say you can’t do great deals. And I think our counter cyclical approach has proven to be very useful in the past and we’re just watching as the panic in the oil patch increases, we’re in a position now to diversify nicely.
Or are they perhaps right and is there here indeed a great opportunity? And if they are right wouldn’t it make more sense to buy ARP directly? What do you think?
No position in ATLS, TRGP or ARP at the time of writing.