Description

NGL Energy Partners LP (NGL)

Recommendation

This is the third in my series of busted MLP pitches where excessive debt and suspensions of distributions have orphaned various junior securities in their respective capital structures allowing for what I believe to be attractive entry points for investors willing to wait out the multi-year deleveraging process.  The speed of the deleveraging, and ultimately the rerating of the securities, will depend on the underlying fundamentals in the commodity end markets, which in the case of NGL will be the oil & gas industry.  

Formed in 2010, NGL is an over-levered midstream partnership that provides water solutions, transportation and marketing services to energy producers and end users. As the chart below shows, recent history hasn’t been kind to the Company and while the sector has started to recover, NGL units continue to trade near the lows.  As recently as last year, the Company was paying annualized common distributions of $1.56/unit vs. the current unit price of $2.36.  What happened?  Quite simply, management borrowed way too much money to make acquisitions over the years and got into trouble when cash flows took a hit due to difficult macro conditions as well as a customer bankruptcy. The biggest risk here is management.  They are below average and some would even go as far as to say that they’re the worst in the industry.  That might be the biggest impediment to getting potential investors to look at this name. 

While the unit price chart seems to suggest there might be significant insolvency risk, the Company has made progress – far from perfect execution, however – on its capital structure and now has a multi-year runway to substantially reduce debt.  Baring another macro shock or another collapse in energy prices, a restructuring scenario appears to be completely off the table and the credit markets have already priced this in.  I’ve been a bondholder of the 7.5s (’23 maturity) and the 6.125s for several quarters but as they approach par, I’ve also recently added a position in the common units. The February refinancing of the credit facility and the ongoing recovery in global energy demand (and spot prices) has given me the confidence that NGL can successful pay off the $555mm 7.5s that mature in 2023 but are callable at par starting later this year.  At a $600mm EBITDA threshold, the business generates roughly $250mm in free cash flow annually, not including any distributions to preferred and common unitholders.  FCF should be even higher once you factor in lower interest expenses from the debt paydowns.  I estimate the Company will generate nearly $800mm in FCF over the next three years and all of it will go towards debt reduction.  What gives me the confidence that management won’t go out and destroy more value by spending this cash on acquisitions?  Simple – they can’t even if they wanted to.  Bond and preferred covenants handcuff their ability to do anything with the excess cash other than pay down debt.  

Buy unsecured bonds.  This is not an enthusiastic recommendation given where the paper trades but the juice is not bad given where the rest of HY is.  The valuation coverage is solid as leverage through the unsecureds is ~5.6x and declines by half a turn a year.  The 7.5s of ’23 are a coupon clipper instrument with a very low risk of default – they can be paid off from operating cash flow.  The other unsecured issues are slightly more interesting with a near 10% YTM.  I suspect the paper continues to tighten from here providing a decent total return opportunity.  

Buy common units.  The market cap of NGL is $306mm, or a tiny ~7% of the Company’s total enterprise value.  Ahead of the common are $3.4bn of debt and $984mm of preferred obligations.  At a valuation of ~7.9x EBITDA, the units do not scream ‘dirt cheap’ but what interests me is the potential for where the units could trade in 10 to 12 quarters if NGL continues to delever by at least $250mm annually and gets closer to resuming paying distributions.  Regarding distributions, I don’t expect any to get paid within the next three years.  Assuming $750mm in debt paydowns, the units could theoretically be worth 3x the current levels at an 8.0x multiple on a run rate of $600mm EBITDA.  Is it possible 8.0x is a turn or two too low when the energy sector is in an upswing?  I have no idea but multiples have been higher (even NGL’s) in recent history and many more conventional (i.e. still paying distributions) comps trade closer to 10x even today.  You also get free optionality on higher EBITDA generation (hey, I’m hearing ‘experts’ calling for $100+ oil) and the Company doing something opportunistic to further optimize the balance sheet for the benefit of the common unitholders.  Asset sales would be something that management may consider along with exchange offers for the preferreds that are trading at a large discount.  Given the small discounts now offered by the bonds, targeting the preferred discount seems to be a no-brainer and it’s not clear to me why they haven’t pursued this option yet.  In a nutshell, I like the setup here – downside is pretty straightforward and upside could be many multiples higher.  

I think the preferreds trading at 60% of par are interesting but believe the risk/reward is better with the commons.  With distributions suspended for what I believe at least three years, I just don’t know how much the preferrerds could rerate whereas I believe the common has the potential to catch a bid and rerate substantially.

Business Overview

NGL’s key business lines include the treatment, transportation, and disposal of produced water and solids generated from oil and natural gas production, the transportation or purchase and resale of crude oil, and the supply and marketing of natural gas liquids and refined products. NGL is one of the largest independent providers of produced water disposal services in the U.S.  Is water disposal really midstream in the traditional sense?  I know this bugs a lot of full time energy investors but we can table that concern for the time being since I don’t think its terribly relevant to the thesis.  The Company also owns and operates the Grand Mesa Pipeline, which transports up to 150k bbls/d of crude oil from Platteville, CO to Cushing, OK.  The following chart summarizes the geographic locations of the Company’s asset base:

Over the last several years, management has made major adjustments to the asset portfolio that now has three segments – water solutions, crude oil logistics, and liquids logistics.  They divested the retail propane segment and a substantial portion of the refined products and renewables segment.  With the funds, they purchased natural gas liquids terminals that complement the existing natural gas liquids portfolio, and acquired two water infrastructure assets.  The goal was to reduce the working capital required to run the Company and to increase cash flow predictability by adding long-term contracts under acreage dedications and minimum volume commitments. Going forward, I think all three of the Company’s segments are in a decent position to succeed and generate strong cash flow.  There is plenty of capacity that is currently not being utilized on its asset base and management just needs to execute to fill it up.  NGL is no longer an acquirer of assets and the only transactions they’d consider would be sale of non-core assets.  

Water Solutions

NGL’s water processing facilities are located in some of the more attractive crude oil and natural gas producing regions, including the Delaware Basin, the Midland Basin, the DJ Basin and the Eagle Ford Basin. It has become the largest independent produced water transportation and disposal company in the U.S. with a system that handles nearly 500mm barrels of produced water a year. The Company transports, treats, recycles and disposes of produced and flowback water generated from oil and natural gas production. It will also sell produced water for reuse and brackish non-potable water to E&P customers to be used in their oil exploration and production activities. As part of processing water, NGL aggregates and sells recovered skim oil. It also disposes of solids such as tank bottoms, drilling fluids and drilling muds and performs other ancillary services such as truck and frac tank washouts.  

The Company’s core water solutions asset is a system located in the Northern Delaware Basin, where it owns and operates the largest integrated network of produced water pipelines, recycling facilities and disposal wells. This system spans six counties in New Mexico and Texas that represent one of the largest crude oil producing regions in the country with some of the most economic hydrocarbon resource and lowest break-even economics for producers. This system has over 620 miles of newly-built, in-service large diameter produced water pipelines connected to 58 active saltwater disposal facilities and 119 active disposal wells. Over 325k acres are dedicated to this system providing a multi-decade drilling inventory and significant growth opportunity. These assets are substantially supported by long-term, fixed-fee contracts underpinned by major acreage dedications or minimum volume commitments. 

Customer base is comprised of large E&Ps with diversified acreage positions across multiple leading oil and gas plays. The ten largest customers accounted for 75% of this segment’s revenues.  Customers enter into long-term, fixed fee contracts and acreage dedications requiring the customer to deliver all volumes from the dedicated acreage with NGL, some of which contain minimum volume commitments requiring the customer to deliver a specified minimum volume of produced water over a specified period of time.  NGL is paid on a fee per barrel of produced water received. 

Below is a summary of the segment’s recent EBITDA generation:

Crude Oil Logistics

NGL purchases crude oil from producers and transports it to refineries or for resale at pipeline injection stations, storage terminals, barge loading facilities, rail facilities, refineries, and other trade hubs.  It also provides storage, terminaling and transportation services through its owned assets. The operations are concentrated in and around four large crude oil producing regions – the DJ Basin in Colorado, the Permian Basin in Texas and New Mexico, the Eagle Ford Basin in Texas and the U.S. Gulf Coast.

NGL’s core asset here is the Grand Mesa Pipeline that transports crude from the DJ Basin to NGL’s storage facility in Cushing, Oklahoma. Grand Mesa is a 550 mile, 20” diameter pipeline that can transport up to 150k bpd of crude oil. With origins in Weld County, Colorado, Grand Mesa is well positioned to serve the growing DJ Basin / Niobrara production area.  In the last year, 32.8mm financial barrels of crude were transported on this pipeline. 

The customer base includes crude oil refiners, producers, and marketers. The ten largest customers accounted for 78% of this segment’s revenues. Here also customers enter into long-term, fixed rate contracts that include minimum volume commitments on NGL’s pipelines. 

The Company purchases and sells crude oil at floating prices indexed to published rates in markets. It enters into purchase and sale contracts of similar volumes and employs hedging strategies to manage exposure.  Profitability is impacted by forward crude oil prices. The business benefits when the market is in contango, as increasing prices result in inventory holding gains during the time between when the Company purchases inventory and when it sells it. In addition, NGL can better utilize its storage assets when contango markets justify storing barrels. When markets are in backwardation, falling prices typically have an unfavorable impact on storage tank lease rates.

Below is a summary of the segment’s recent EBITDA generation:

Liquids Logistics

NGL purchases gasoline, diesel, propane, butane and other products from refiners, processing plants, producers and other parties, and sells the products to retailers, wholesalers, refiners and petrochemical plants throughout the U.S. and Canada. These operations are conducted through 28 company-owned terminals, other third party storage and terminal facilities, common carrier pipelines and its extensive fleet of leased railcars. The Company also provides natural gas liquids and refined product terminaling and storage services at its salt dome storage facility joint venture in Utah and marine exports through a facility located in Chesapeake, Virginia.

The wholesale liquids business is a “cost-plus” business that can be affected by both price fluctuations and volume variations. Selling prices are based on a pass-through of product supply, transportation, handling, storage, and capital costs plus an acceptable margin. Also, NGL conducts just-in-time sales for gasoline and diesel at a national network of terminals owned by third parties via rack spot sales that do not involve continuing contractual obligations to purchase or deliver product.

The Company employs contractual and hedging strategies to minimize commodity exposure and maximize earnings stability of this segment. In the last year, the Company sold 3.3bn gallons of natural gas liquids, refined products and renewables products.

Below is a summary of the segment’s recent EBITDA generation:

Summary Financials

After a strong FY20, the combination of covid and a customer bankruptcy caused a significant decline in the profitability of all NGL’s businesses.  Even as the Company had started to recover from the worst of covid, the year ended on a negative note with Winter Storm Uri causing significant shut in of volumes in the Delaware Basin for two weeks. 

For the year, produced water processed declined by 278k barrels per day due primarily to a reduction in the number of producing wells completed in NGL’s area of operations.  In actuality, the results were even worse if you strip out the barrels processed from the two new acquisitions and the recent completion of the Poker Lake pipeline.  Volumes on the Grand Mesa pipeline averaged 94k barrels a day, compared to 131k barrels per day during the previous year.  This decline was primarily due to the bankruptcy filing of Extraction Oil & Gas, a significant shipper on Grand Mesa.  Extraction was successfully able to reject the pipeline contract with NGL forcing the two companies to enter into an entirely new contract that is more favorable to Extraction. The new contract won’t have a MVC but NGL will retain the volumes on Grand Mesa.  While the new contact will provide lower rates, there is a ‘price adder’ feature where NGL would get a share of any increase if crude exceeds $50 per barrel, which it does currently.  Finally, demand for natural gas liquids, primarily butane and refined fuels, were severely impacted by the pandemic and drove a large decrease in the profitability in the liquids logistics business.  

As shown below, NGL invested significantly in the years leading up to the pandemic and the commodity price collapse, financed with debt and preferred stock, but now will be forced to maximize the cash flow potential from this asset base to reduce debt in the coming years.  

With its facilities already upgraded, management has been focusing on reducing maintenance capex, which is now down to $40 – 50mm per year.  Growth capex will be capped at $75mm a year but with the majority of the infrastructure already built out, there really won’t be a large growth capex investment cycle in the near future. Management guidance for the next year includes $35mm in maintenance capex and $75mm for growth capex for a total of $110mm.  Thereafter, growth capex is expected to be ~$50mm annually and maintenance capex between $40 – 50mm.  Of course, all of this will be self-funded from internally generated cash flow.  

Management is guiding FY22 EBITDA to be in the range of $570 – 600mm, a sharp recovery from the difficult conditions of last year.  There could be upside to this guidance considering oil and natural gas prices are significantly higher than what was assumed by management in developing that forecast.  The Delaware Basin oil production increases and completion activity and the associated disposal water volumes will be the largest driver of EBITDA growth going forward.  Higher crude prices mean more DUC completions and ultimately drilling in the Delaware, DJ, and Eagle Ford, which will translate into higher water volumes.  DJ Basin production growth will also be very important to EBITDA growth for Grand Mesa and crude logistics segment.  Extraction has been aggressive on the M&A front having merged with Bonanza Creek and recently acquiring Crestone.  Their go forward drilling plans will obviously critical to NGL’s profitability and it appears that their production numbers are increasing with higher oil prices.  The liquids segment has been impacted by the pandemic related demand shock but should see improved results for refined products and blending feedstocks going forward as demand normalizes.

Capitalization

NGL recently completed a much needed refinancing of its credit facility and while it addressed many solvency concerns, the execution was less than stellar, not atypical for this management team.  Extending the maturity of the credit facility was a top priority for management for several quarters given the 2021 maturity and the significant amount that was outstanding on the facility – $1.7bn plus $140mm in LCs.  Management asked for an extension to 2023 by offering asset sales, minority interest investments in the Company’s assets and other potential structures but was unable to come to terms with the banks.  Ultimately, they went down the path to refinance the entire credit facility but it came at a very expensive price. The $2.0bn secured bond came with a whopping 7.5% coupon, a significant increase from the 2.95% rate on the credit facility.  Essentially, the higher rate will cost the Company an extra $100mm per annum!  Oh, and the refinancing also required a ridiculous $40mm consent payment to the Class D preferred holder. The refi also required a suspension of both common and preferred distributions; these payments can be reinstated once leverage falls below 4.75x, which I don’t expect for at least three years.  

There are several positives to come out of the refi, however. First, there are now no debt maturities till late 2023 allowing the business to recover and grow in a post-covid world with the addition of the new water solutions assets recently acquired.  Second, leverage and interest coverage maintenance covenants were eliminated which reduces the risk to equity holders in the event we get another unexpected macro shock that impacts cash flows.  This also provides the Company with significant flexibility once leverage is reduced to under 4.75x as long as liquidity remains over certain levels and no significant debt maturities are due within 90 days.

The Company now has $2.0bn of debt at the secured level and $3.4bn in total.  Leverage through the secureds is 3.5x EBITDA and 5.7x in total.  There is a $500mm ABL with $345mm of availability on it.  It is secured by a first lien on A/R, inventory, pledged deposit accounts, cash, renewable energy tax credits and related assets and a second priority lien on all other assets.  The senior secured notes are secured by a first lien on all assets other than those pledged to the ABL and a second lien on ABL assets.  The Company also has three unsecured bond issues that mature in 2023, 2025 and 2026.  During the last year, NGL repurchased $52.1mm of its 2023 notes, $7.3mm of its 2025 notes and $111.6mm of its 2026 notes at a cumulative cost of $115.8mm.  The Company will continue to acquire bonds in the open market but may have to go down a tender route if it wants to buy size.  

The Company also has three preferred unit issues with a total principal amount of $984mm. The series B units in the amount of $315mm have a 9.0% interest rate.  The series C units in the amount of $45mm have a 9.625% interest rate.  The series D preferreds in the amount of $624mm are held by EIG Global Partners, a large global energy investor.  The rate on the issue is 9.0% for the first 3 years and then increases to 10.0%.  This issue is effectively pari to the B and C preferreds but do have some creditor-like rights that the other issues don’t enjoy. For example, it has a leverage test that the Company has currently tripped and is therefore accruing an extra 100bps or 10.0% in total.  The Company also needs consent from EIG if it wants to borrow funds, make any acquisitions or dispositions in excess of $50mm, and invest in growth capex in excess of $75mm per year.  EIG also got a board seat and 25.5mm warrants to purchase common units with strike prices in the low to high teens.

Preferred distributions are cumulative so preferred payments will come before common unit distributions can be reinstated.

Valuation Thoughts

I value NGL at $4.0 – 5.0bn, or roughly 7.0 – 8.0x what I believe to be an achievable near-term EBITDA run rate in the neighborhood of $600mm. Using today’s balance sheet, I can understand why the market and sellside analysts think the common units are fairly valued at ~$300mm.  I don’t believe a single analyst has a buy on the name and think two even have it as a sell.  

What I’m betting on is that the market might be underpricing the free cash flow generation of the business over the next 10 – 12 quarters.  By the end of FY24 (March end), I have the business generating in excess of $800mm in cash flow, all of it going towards paying down debt.  As a result, net debt will decline from $3.4bn today to $2.6bn in three years.  Because the distributions will remain suspended, the preferred ‘obligations’ will increase from $1.0bn to $1.3bn to account for the unpaid amounts.  Net net, from the perspective of the common units, the balance sheet will have improved by roughly $500mm in three years before factoring in any value accretive transactions like asset sales or discounted exchange offers.  

Not that I have any idea what the world will look like in three years but if the Company is still worth $4.0 – 5.0bn, then the common units could theoretically be worth $3.00 – 9.00 at that time.  Spreadsheet magic!  Look, I get it – this is all so very academic.  You never know how levered equities will trade – the units could double or triple within a year or could be wiped out or unchanged in three. The crux of the thesis is that there’s a lot of cash flow here and the market cap is a fraction in comparison.  Usually you see that dynamic with companies on the brink of a restructuring but there’s literally no risk of that here at the moment given the facts we know today. 

Below is a comp sheet of valuation multiples for a group of MLPs, both large and small. The larger, more diversified names trade around 10.0x EBITDA whereas the smaller ones are in the 8.0x range.  I don’t have a problem assigning an 8.0x multiple for NGL though realize that it will trade below that level until there’s some visibility into when distributions will be reinstated.

Catalyst

- increase utilization of the asset base

- meet or exceed the guidance to establish credibility after years of mismanagement

- continue to be opportunistic with the balance sheet (tenders, exchanges, sale of assets at high multiples)