Description

We believe that NuStar Energy (“NS”) represents an attractive and timely investment at the current price of $44.  NS owns a large, high quality collection of crude oil and refined pipeline and storage assets and currently trades at a yield of 10% vs. its closest peers at 4-6%.  Since the start of 2011, the stock is down 22% (inclusive of dividends) while the Alerian MLP Index is up 44%.  Historically, NS exhibited greater earnings volatility than its peers due to its ownership of an unpredictable (and loss-making) asphalt business.  Last year, the company sold a stake in the asphalt business allowing it to be deconsolidated from its financials which should lead to greater predictability in the future.   More recently, investors have grown concerned about the near-term impact of weaker storage markets and the sustainability of the NS dividend as a result.   Sentiment has turned so bearish that the NuStar GP units (“NSH”) were written up as a short idea here on VIC in early June. 

However, we view the extreme negativity around NS as an opportunity to invest in high quality assets that are trading at a cheap absolute valuation and at a significant discount to peers.  NS is in the middle of an investment period that should ultimately lead to ~$4.50 in 2015 distributable cash flow per share which puts the stock at less than 10x future distributable cash flow at the current price.  Because of the clear and credible path to fully covering the dividend, management is unlikely to cut the distribution.  Once investors see the path to distribution coverage and then resumption of growth, we believe the shares will trade to a more reasonable 7% yield, resulting in ~60% total return potential over the next 18 months.

Storage Segment

The storage segment includes a large collection of terminal and storage assets around the US as well as some assets in the Caribbean and Europe.  This segment contributes ~50% of pre-corporate EBITDA. 

A backwardated forward curve is putting pressure on storage rates as demand for buying and storing oil for investment and trading purposes wanes.  However, the impact is manageable as most of the company’s assets have a specific industrial purpose, with only a small portion of the portfolio that is purely trading driven.  As the company highlighted on its most recent conference call, refined products terminals and refinery crude terminals are not greatly affected by backwardation.  The pressures are generally being seen in certain local markets, particularly on the east and west coasts and internationally.

Last year the company did $288mm in EBITDA in the segment but Q4 was impacted by charges taken with an expansion project that is no longer moving forward at St. Eustatius (we believe the impact was ~$10mm).  The company is expecting storage EBITDA to be roughly flat in 2013.  Net of the impact of ~$10mm from the Q4 charges, NS is effectively projecting a decrease in EBITDA of ~$10mm for the year.  At the same time, 2013 EBITDA will benefit from a full year of the EOG unit train project completed in 2012, the St. James expansion completed in early 2013 ($4mm annualized), the St. Eustatius 1mm barrel storage expansion completed in Q1 2013 ($10mm annualized), and a partial benefit from the second unit train project at St. James that will be completed in Q4 ($18mm annualized).  Given the incremental EBITDA from these specific projects, we believe the company’s target of flat EBITDA is achievable and allows for the pressure they are experiencing on some storage contract renewals.  Additionally, management guidance for 2013 assumes little additional contribution from the WTI/LLS profit share agreement they currently have in place with EOG (beyond what has already been earned year to date).  2014 EBITDA will be supported by the full-year impact of the above projects, the second phase of the St. James expansion to be completed in Q1 2014 and other internal growth projects.

Pipeline Segment (formerly Transportation Segment)

The company’s pipeline segment is comprised of refined products and crude oil pipelines as well as an ammonia pipeline serving agricultural markets in the Midwest.  The core pipeline systems are critical to a number of refineries and end markets that they serve.  Under FERC regulations, pipeline rates are adjusted annually by a formula that currently equals PPI + 2.65%.  The segment contributes ~45% of pre-corporate EBITDA.

In 2012, the segment generated $211mm in EBITDA and it should grow by $50-70mm in 2013.  The increase in EBITDA is driven by the full year contribution of four growth projects completed in the Eagle Ford during 2012 ($30mm annualized), the acquired TexStar assets ($20mm in 2013), a partial contribution from a project for ConocoPhillips that will start-up in Q4 2013 ($15mm annualized), and increases in the FERC tariff rates (~$7mm per year). 

The company’s acquisition of a crude pipeline system from TexStar will be a large growth driver for the company in the Eagle Ford over the coming years.  In Q2, total Eagle Ford volumes were ~175,000 b/d, which the company expects will increase to 200,000 b/d by the end of the year.  The company’s guidance of $20mm in EBITDA from the TexStar acquisition in 2013 implies exiting the year at a much higher EBITDA run-rate, with TexStar expected to generate EBITDA of ~$55mm in 2014.  Eagle Ford growth is one of the key drivers behind the continued sequential increases in quarterly pipeline EBITDA that the company expects for the rest of 2013.

Further, we believe NuStar’s high quality asset base provides for significant optionality.  In particular, NS is pursuing two projects that could be very accretive to the business.  The first is a recently announced open season for a project to transport Eagle Ford crude from several terminals on the company’s South Texas crude system to its Corpus Christi North Beach terminal.  On the most recent earnings call, the company indicated that the project would be split into two phases, with the first phase coming online in Q3 2014 and the second phase in Q1 2015.  Based on the total capex guidance of $135-170mm at the company’s targeted 4-5x EBITDA multiple for organic growth projects, this project could add ~$30-40mm in EBITDA.  In addition, management expects to launch an open season in August for its Houston line (an unused pipeline between Corpus Christi and Houston) to transport NGLs.

While neither project is in the company’s guidance, we believe these and/or other organic growth projects will provide NS with high return investments over the next couple of years that will help the company earn its way back to distribution coverage and then ultimately distribution growth.

Fuels Marketing 

The third (and much smaller) segment is fuels marketing, which accounts for just 5% of pre-corporate EBITDA and consists of several different business lines.  Within the segment, we believe that NS generates ~$15mm from fuel oil and bunker marketing, ~$5mm in crude oil trading and ~$15mm in butane blending.

For 2013, the company expects to generate $20-40mm in EBITDA for the segment.  However, in the first two quarters of 2013, EBITDA has been weak due to challenges in the bunkering business.  Despite this weakness, we think the second half of the year will have significant tailwinds given the ~$15mm in EBITDA that comes from butane blending, much of which occurs in Q4 (some in Q3).  The company is also in the middle of several cost cutting and profit enhancement programs in the segment to improve profitability (renegotiating supply contracts, sub-leasing barges, etc).  Further, for the ~$15mm in segment EBITDA that comes from fuel oil and bunker marketing, we believe there is a floor value for the business of ~$200mm based on the working capital alone.  If NS believed the weakness in these businesses was more than temporary, the company could instead choose to lease its capacity to a third party, allowing NS to liquidate the working capital supporting those operations for a total value of ~$200mm.  While NS would lose $15mm in EBITDA, the implied EV/EBITDA of the sale would be 13.3x ($200mm/$15mm), which would allow NS to monetize a lower quality business at a multiple higher than the company’s current trading multiple and provides interesting downside protection for the segment.

EBITDA Bridge

Given the ramp in EBITDA projected over the next few years, we thought it would be helpful to provide a bridge.  Our projections from 2012-2015 is based primarily on identified growth projects that the company has already disclosed (though some smaller organic growth projects have not been discussed in detail).  We assume the company can generate $35mm in eventual EBITDA from one of the two open seasons and my 2015 estimates include a relatively small amount of additional EBITDA based on the assumption that NS spends $250mm on growth capex in 2015 at 6x EBITDA.  We have assumed no contribution from the asphalt business, which was sold into a JV with Lindsay Goldberg during 2012 (any losses generated in the JV flow through equity earnings and do not impact NuStar’s distributable cash flow or covenant calculations).

Distribution Concerns 

The market has grown very concerned about the pressures impacting NuStar’s storage business and the sustainability of the distribution.  We believe this is more than discounted in the stock given the significant yield differential compared to peers.  We find the probability of a near-term distribution cut to be low given:

1)      As of 6/30/13, NS debt/EBITDA was 4.3x under its covenants, giving ~$320mm of available borrowing capacity on its revolver

2)      Even if NS were bumping up against its covenants, it can always issue sub notes similar to the $400mm offering the company completed earlier this year (it is excluded from the debt/EBITDA calculation up to 15% of total NS capital).  The original issue was targeted at the preferred market and has traded well, with the 7.625% notes currently trading at a yield to call of 6.4% (NS can issue up to another ~$350mm of these securities)

3)      Given the liquidity and capital structure flexibility above, we believe any distribution cut would be management’s choice (i.e., if they did not see a path to distribution coverage).  Management has been clear that they expect to be close enough to covering the distribution in 2014 that there is no reason to seriously consider cutting the distribution in the near-term

4)      The CEO and CFO each bought shares of NSH on June 13^th.  If a distribution cut were imminent, it is unlikely they would each put $50,000 into the stock.   In addition, the COO and General Counsel also purchased shares of NSH in mid-June, while two directors purchased shares of NS in late June

However, even if management decides to ultimately cut the distribution, we find it challenging to craft a significant downside scenario from the current share price.  For example, let’s assume that management cut the distribution by 20% to $3.50 per share (which would be ~1.2x covered in 2014 on my numbers).  Assuming the stock then traded at an 8% yield on the new distribution (still a much higher yield than peers), total NS value would be $48 per share inclusive of one year’s dividend, for a gain of 11%.

Valuation

Given the distribution concerns described above, NS currently trades at a significant discount to its two closest peers, MMP and BPL.  On any valuation metric (EV/EBITDA, dividend yield or distributable cash flow basis), the discount is roughly 20-30%.

Below is my estimate of the company’s EBITDA and distributable cash flow as the growth projects come online from 2013-2015.  In addition, we have included a valuation matrix based on a range of distributable cash flow yields (between 6% and 9%).  While storage weakness and project execution risks remain, we believe the skew is very favorable at these levels.  Even assuming conservative exit valuations, the risk of significant capital impairment appears l

Conclusion 

We believe NS can trade at a 7% distributable cash flow yield (still a 10-30% discount to the current valuation levels of MMP and BPL).  This would translate to a total NS value of roughly $70 per share in about 18 months (inclusive of dividends) for a total return of ~60% as the market becomes more comfortable with NuStar’s recent restructuring and recognizes the underlying stability of the core business.  It also appears management agrees with our positive view as several insiders have purchased shares of both NS and NSH in recent months.

Catalyst