Description

This is the idea with which I applied for membership to VIC.  Two short-term concerns that I have learned about that I'd mention in addition to what I had previously written.  (1) I believe that the dramatic and sudden drop in crude during Q4 will lead to a shortfall in Q4 asphalt segment given the company's weighted average cost method of accounting for its COGS and its limited volumes in the quarter due to seasonality.  On a positive note, I would also mention that listed asphalt prices right now are about 10% higher than last year despite the crude costs being over 50% lower.  Inventories are lower going into the paving season than they've been in years and most in the industry are expecting prices to rise significantly through the season.  (2) I believe throughput volumes will be weak during Q4 and Q1 due to Valero taking down operating rates at some of its refineries that NS has pipelines connected to in addition to regular maintain that Valero takes during Q4 (which management has guided to).  Netiher of these issues change my conviction or opinion on NS as a very good investment at current prices.

I have updated numbers below.

Company Overview: Nustar Energy makes money in 3 ways: it collects fees for transporting refined oil products through its network of pipelines, it collects fees for providing storage for refined oil products, and makes asphalt. Nustar does not take any direct commodity risk in its transportation or storage businesses. (I understand that VIC dissuades applicants from writing about commodity driven names but as I hope the writeup shows, this is not something that requires commodity-specific expertise that only a specialist can understand.)

Investment Thesis: Investors can get paid a tax-advantaged 9.5% yield that can grow at a 5-7% CAGR over the next few years (also <9x earnings and ~1.0x book) for owning a company whose core business is an economically defensive toll-collector with high barriers to entry that enjoys highly visible, mid-single digit pricing for the next 18 months. At the same time, investors in Nustar will likely benefit from significant structural change in the supply-side of the asphalt market that can potentially increase EBITDA by 50%+ in the next 3 years.  

I would note that NS is comprised of real assets that have very strategic value to their end markets and customers.  Historical private market values in various market environments have been significantly higher than book value and at EBITDA multiples well above where NS is trading.

Variant Perceptions: (1) Asphalt margins will go higher due to increasing supply shortages, (2) NS is not reliant on capital markets until late in 2012 when it does some debt maturing, (3) pipeline and storage business will put up stable and growing results next year.

 Key Considerations:

• Transportation and Storage segments: Very stable and visible businesses with low capital intensity. These are basically very strategic, quasi-regional monopolies that should produce robust cash flows independent of the macro environment.
• Asphalt: Very briefly, asphalt comes from "bottom-of-the-barrel" by-product of the crude oil refining process. Refiners prefer to focus on making gasoline and distillates. As such, many refiners have/are installing very expensive technology (called cokers) to convert this by-product into higher-value and less seasonal products. As these projects come on, the supply of asphalt in North America is set to sharply decline creating a situation where the US is very short asphalt.
• o While the US is already net-short asphalt, many projections call for us to be 10x more net short than we are in 3-5 years from now due to the installation of there projects called cokers. The company has identified about 25 major coker projects (which I have confirmed and continue to track that will be installed over the next 3-4 years. As very few new refiners are built in the US, this is the only way refiners can expand and increase or maintain their place on the cost curve.
• o The operating leverage to higher margins in this segment can produce dramatic EBITDA growth.
• Insider buying: William Greehey is the Chairman, largest single owner (and recently has been very active purchaser of NS and NSH). He is arguably the most respected refining figure as he built Valero into what it is today.
• Recent technical selling in the MLP space: (1) Lehman was largest player in this space and likely held many MLP position in equity swaps for clients. Since the Lehman bankruptcy, GS and others have unwound such swaps for investors given relatively illiquid nature of these stocks. (2) Large retail ownership. (3) MLP-focused funds that operated on leverage have had to unwind given performance in stocks.

 Investment Risks:

• MLPs have grown via acquisition and capex that have been financed with equity/debt offerings in the past few years given that they pay out almost all their cash earnings. As such, the asset class in its current form is capital-markets dependent for its growth-but, for the most part, not its current earnings power. A corollary to this risk is that given the rise in costs of capital, cash flow would take a significant hit we assume today's lending rates.
• o NS can self-fund its operations and a solid level of growth (about $80mm of capex at mid teens returns) without accessing capital market for the next 3 years at which point it will have to refinance some of its debt.)
• o Further, growth at NS is not dependent on capex but rather on structural changes to the supply-side of the asphalt industry (akin to the cement about 15 years ago).
• An economic slowdown may negatively impact energy demand, which would reduce volumes shipped on MLP's pipelines. (Pricing is reset every July and is based on the previous calendar year's PPI so 2009 looks up mid singles.)
• o So from July 1, 2009 until June 30, 2010, pricing will be based on PPI for calendar year 2008 (about 7.5%).
• NS' crude supply asphalt comes from Venezuela creating dangerous single-supplier dependence.
• o Capex projects are under-way to reduce this dependence but this is a risk in the near-term.
• Though it has been minimal so far, we could see a delay in coker projects due to the environment, thus delaying the asphalt thesis. Refiners could also lower utilization of installed cokers if asphalt prices go high enough.
• o We have seen a few delays but the overwhelming majority of coker plans continue to be in place and are important for refiners competitive strategy.

 More on Business Description

• Transportation segment: Nustar owns a network of pipelines that allow it to transport refined oil products and ammonia between refiners, end users, and storage facilities. These pipelines are very strategic assets as they are crucial in transporting things like gasoline between key endpoints. This is a "price per unit x volume" business and has no direct sensitivity to the prices commodities it transports.
• o The pricing is regulated by FERC and is basically set at trailing and lagged PPI + 1.6%. As such, we should have at least mid-single digit price increases for the next 12-24 months.
• o Volumes are driven by demand for refined products. Obviously this is a risk in a tough macro environment but very tough to see volumes down more than pricing is up in this segment.
• Storage segment: Nustar owns storage terminals that are leased on relatively long-term contracts. This business is driven by occupancy and not throughput. Pricing is set by contract and not much more than 10% of the storage capacity turns over per year.
• Asphalt segment: Nustar purchased 2 refiners from Citgo in April of this year for $350mm + $450mm of inventories for a total of $800mm. These refiners take in heavy crude oil from Venezuela and produce asphalt. Therefore the profitability is driven by the cost of heavy crude and the selling price of asphalt. Nustar has well over 50% share of asphalt production in the Northeast, which is structurally short asphalt.

 Capital Structure/Business Structure:

(For investors with less need for trading liquidity, I highly recommend NSH over NS. As I describe below, NSH is the general partner of NS due to the structure of MLPs, general partners give enhanced returns in their distributions from growth at the LP level with no incremental capital needs.  Feel free to contact me with further details).

The assets of Nustar are organized in a Master Limited Partnership (MLP) structure. An MLP is generally a limited partnership interest whose operations are managed by a general partner (GP).  Nustar's GP does trade publically (NSH) and is the preferred vehicle to play the above thesis through but liquidity constraints keep us at NS.  MLPs typically pay out the bulk of their operating cash flow on a quarterly basis in the form of cash distributions to their limited and general partners. The MLP structure is a tax efficient vehicle because they are only taxed only once at the unitholder level, and generally 80-90% of these taxes are deferred.  The elimination of double taxation effectively lowers an MLP's cost of capital, supporting a higher valuation for assets owned in an MLP structure relative to assets owned in a conventional corporate structure.  The structure was born years ago out of a need to stimulate energy and natural resource infrastructure development.

Typically, limited partners have a 98% ownership stake in the partnership while the general partner has a 2% share. Although LP unitholders provide the capital necessary to run the partnership (and in return receive distributions), they are passive investors, with all management decisions made by the general partner.  In addition, typically, general partners receive a growing proportion of incremental increases in cash distributions to LP unitholders. As the distributions to LP unitholders are increased, the effective GP take of the total cash distribution increases.

Asphalt Demand Driver: The predominant use for asphalt is for paving roads and highways and so we need government spending.  Government already talking about big public works bill as most experts believe we need a huge infrastructure spend initiative given the conditions of our infrastructure. 

Other Miscellaneous:

• NS paid $800mm for is asphalt assets in late March of 2008. It earned about $200mm of EBITDA in the balance of 2008.
• Asphalt demand was down about 15% this year but supply was down 30% which led to record pricing. See attached chart.
• 2008 benefitted from a competitor closing a plant and from Venezuela not exporting asphalt (together about 30% of supply in previous years).
• Significant insider buying for a while now.
• Will get a little hurt in 4Q, as they recently announced, by dramatic drop in crude-which hurts their inventory position on COGS (weighted average cost of good sold).
• Pipeline volumes were bad in 3Q due to confluence of one-time issues and Q4 will be down due to Valero refinery outages.
• Storage incremental EBITDA will be 30mm due to new projects in 2009.
• NS has dominant share in Northeast of about 60% for asphalt.

Catalyst

1. New Administrations fiscal stimulus could lead to better than expected asphalt demand.

2. Stronger than expected asphalt results in Q2 and Q3 due to supply constraints that will intensify over next 2-3 years.

3. Increases in distributions paid to LP and GP unit holders.