Description

SEMG is a fee based, toll road like business recently emerged from bankruptcy and likely to convert to an MLP in 2011.  If it converts to an MLP, it will be one of the cheapest in the MLP sector both on an FCF yield and EBITDA multiple and has less than 1.5 turns of leverage today vs. a peer group average of 3-5x.  It is possible to get 30-35% upside under conservative assumptions at industry multiples and ~100% with intelligent capital allocation and a more levered balance sheet.  In addition, SEMG could be a very accretive take over target by someone like PAA and the industry has been ripe with consolidation. 

2012 gross distributable FCF (CFO - maint cap ex) could be 130m, or a 10% yield as a base case, but could be notably higher given option value in their asset base and a sky rocketing oil price, discussed further below.  It is unclear how much of gross FCF mgmt would pay out as a distribution under the MLP structure, most MLPs pay out upwards of 95%, but an 80% payout ratio would imply 30-35% upside assuming the equity gets a 6% yield with no discount, and a 95% payout ratio would imply 60% upside under the same math.  Share buy backs using leverage followed by large capital deployment and levering up could take upside over 100%.

Their assets are largely located near high quality "blue chip" energy production regions or new, growth regions such as Niobrara, Duvernay Shale, Montney Shale, & the Mississippi Lime formation, which are each experiencing significant new E&P investment that should drive increased volumes to SEMG infrastructure and provide ample growth cap ex projects.  Management has hinted that they see plenty of growth opportunities and are willing to drive shareholder value through increased leverage and buy backs, but it is too early to know just how proactive they will be in this regard.                                

Business description:

SEMG is a 75% fixed fee, toll road like energy infrastructure (storage, pipelines, processing) business.  Another 15% comes from propane marketing and 10% from variable fees earned on natural gas processing plants etc.  ~40% of the EBITDA is under 3-5 yr contracts, 20% under 2 yr, and another 15% 1 yr contracts.  The company takes almost no commodity price risk, but a collapsing oil / gas market could curtail customer production and therefore, energy infrastructure demand.  ~50% of 12' EBITDA should be oil related, 25% gas processing, and 15% propane. 

SEMG key assets are:

1. White Cliff's; an oil pipeline serving the DJ Basin / Wattenberg and Niobrara Shale. 
2. Cushing, Oklahoma liquids terminal storage. 
3. Natural gas gathering lines in the Bakken Shale. 
4. Natural Gas processing plants in Edson, Canada near the Montney Shale.
5. Liquids tank storage terminal in Milford, Haven UK. With deep water sea access. 
6. Propane terminals & marketing assets
7. Asphalt mixing terminals in Mexico

Semgroup recently emerged from bankruptcy and listed its shares on Nov 10'.  Prior to bankruptcy, SEMG was a private.  While high quality businesses don't usually go bankrupt, in Semgroup's case, the former CEO acted like a hedge fund and made a huge bet against oil in 08 that quickly put the company in bankruptcy when it went against him.  The company no longer operates in a manner where commodity hedging could significantly hurt them and built a new risk system this yr.  The entire senior mgmt team has been replaced. 

The bankruptcy hurt a lot of SEMG customers who had extended letters of credit and physical energy products they were unable to collect - many were mom-and pops.  The company is still trying to win back customers they lost during bankruptcy, particularly in propane marketing, which offers potential upside that is hard to quantify. 

Misperception:

• o No analyst coverage.
• o Complex financials with limited historic data
• o Just listed on exchange in Nov 10'

• o 75% fee based, toll road like business with multi-yr contracts and growth opportunities in high quality regions
• o White Cliffs Pipeline is a gem of an asset and has potential to ramp quickly, creating a high quality growth story
• o Likely to convert into an MLP. Peers in space trade at 14x TTM EBITDA vs. SEMG 8.5x 12'
• o Most unlevered balance sheet in space. > 1.5x today vs. peers 3-5x. Could lever up intelligently, or be acquired
• o Mgmt team seems honest / capable and recently awarded significant performance shares / equity incentives

• o If oil forward curve goes negative it will impact demand for storage
• o If gas prices fall materially if could reduce production in fields they serve with processing
• o Propane spread between spring and winter months
• o Interest rates spike could hurt stock price and ability to refinance / take on leverage at cheap costs of capital

Under conservative assumptions with limited cap ex we think SEMG can grow EBITDA 15% * a yr for the next few years, which would put them towards the top of their peer group (* adding back White Cliff's stake sold end Q310 into 2011).  More than half of their assets are well below full utilization.  We feel almost every asset SEMG owns is currently growing, but the biggest individual driver that is visible today will be White Cliff's.

Primer on each business division:

The financials are complex, with difficult y/y comparisons due to fresh start accounting. asset sales, only one 10Q filed, little history, and limited disclosure on operating metrics like volume and price for most of their assets.  However, our research and calls to management have suggested good growth opportunity.   

10' YTD to FY 2010 EBITDA Bridge:

Start with the roadshow presentation and the YTD adjusted EBITDA for each business line.  Figure out which business has seasonality (Semstream), which business is cyclical (SemMexico) and which businesses are more stable and recurring (the rest).  Our estimates suggest 2010 9 months YTD produced 118m of EBITDA before unallocated items (which are a few million of additional EBITDA gains).  It is important to adjust for an ~8-9m charge in Q210 for Semstream that does not appear to be included in the 9 months adjusted EBITDA figure due to accounting in that division that prevents it from being added back back until Q4, which is typically a larger quarter for this business.  Factoring in some growth for Cushing & the 49% stake of white cliff's sold at end of Q3 gets one to ~160m of EBITDA for 2010.  Absent a collapse in propane spreads, we think 2011 will come out around 160m (growth negatively affected by the white cliff's sale y/y) and 2012 will come out ~185m, or 15% growth.  As discussed earlier, there is plenty of room for EBITDA to be better and this figure is with minimal growth cap ex and winning back business lost in BK.   

Please note: the figures below for Semcrude breakout are our estimates / FERC filings:

SemCRUDE.  White Cliff's; an oil pipeline serving the DJ Basin / Wattenberg and Niobrara Shale

• Only pipeline connecting DJ Basin to Cushing, OK.
• 5 yr take or pay contract on most of existing volume
• 51% owned by SEMG. Volume / day of 27k barrels in Q3 probably end Q4 close to 30k.
• Can go to 50k barrels a day with 1m cap ex and 70k w/ 3 new pumps, moderate to low cap ex.
• Additional 10-20% volume upside from 70k with use of special lubricants, if needed
• 49% was sold during to Plains All American, Anadarko, and Noble Petroleum to help pay down debt.
• I.e looks like ebitda will decline in 2011 over 2010, but it is actually growing quickly.
• Strategically, these partners are incented to use White Cliffs as much as possible.
• Plains is also building a connector pipeline half way between DJ Basin and Cushing to offload some capacity.
• Financials available online at FERC. Fee is set by FERC and fixed with 2% inflation escalators.

White cliff is a gem of an asset oil pipeline connecting the DJ Basin to Cushing, Oklahoma storage and energy trading exchange.  The key reason White Cliffs is a gem is b/c it is a monopoly, very high incremental margins, and only 40% utilization.  There are reasons to believe White Cliffs could ramp to full capacity within 2-3 yrs.  White Cliff is currently producing 5-6m of EBITDA per quarter to SEMG (51% interest), but that could ramp to 12-15m to SEMG within 2-3 yrs.  Most of the volume today comes from Watterburg Shale - a stable "blue chip" oil/gas field.  Wattenburg is adjacent to the Niobrara Shale, a high quality emerging gas/oil shale that has potential to quickly ramp.  While it is a new play and not many wells have been drilled, those that have been drilled are very good and are breakeven at $50-60 WTI Oil.  Anadarko has spoken very positively in their conference calls about this field and is spending a lot of money here over the next 12 months.  2011 will be a big year for this region.  Our calls suggest if the current success rate of drilling is maintained it will ramp very quickly.

It should be noted while this asset only accounts for 40~m of ~185m in 2012E EBITDA, the capital intensity post expansion is quite low due to the nature of pipeline assets and fact that it is only 2 years old.  The contribution to SEMG's free cash flow will be significantly higher than % of ebitda due to the low maint cap ex nature of the asset

SemCRUDE.  Cushing, Oklahoma crude oil storage terminal:

• Company is adding capacity this yr and next.
• Oil storage tanks in one of the best regions in Country and near good production regions
• 100% utilized, 3-5 yr contracts, currently there is a customer waiting list
• Cushing physical delivery gets price premium due to Nymex
• SEMG believed to price at a noticeable discount to peers

Cushing is a critical Hub for oil storage / Nymex Delivery and gets the highest oil prices in the region so transportation into Cushing is sought after.  Cushing has seen very strong demand over the years and in the near term that is expected to continue.  As a testament to this dynamic, SEMG is currently adding capacity and they have a waiting list for additional storage.  They could double storage here next year, but they want to be prudent about growth 

While the business here is 95% leased to 3^rd parties with 3-5 yr contracts, which would lead one to believe this is quite a high quality asset, there are three other large participants in the market, including Plains All American, that are adding capacity.  It is not hard to add capacity, with ~6 months of build / permitting.  One day this market could face overbuilding if demand for storage were to fall significantly, but it does not seem like a near term phenomenon.  Capacity is only built with long term contracts in place and this is true for all 4 noteworthy players in the market, who are rational MLP players.  In addition, during the next 1-3 year Cushing's role in the US oil industry is set to expand into oil logistics / liquid mixing, as a number of new pipelines into and out of the region are under construction to connect Cushing to important Canadian oil sands and import/export through the Gulf of Mexico. 

A "contango" market is important for this business - which means that the forward curve for oil is upward sloping and physical storage with future delivery has a positive carry.  Management has not released a breakdown of customer by type - including financial traders vs. strategic / refining; the latter being more stable.  There is a chance the government increases regulation on commodity trading, which could impact storage demand, but consultants SEMG has hired believe if anything the regulation would require more physical storage where derivatives are currently used. 

SemGAS.  Natural gas gathering lines in the Kansas, Texas, Oklahoma

• 60% utilized - should grow nicely in 2011 as an idle plant is brought back online
• 800 miles of gas gathering lines and 3 processing plants
• Gathering is fee based with LT contracts.
• Processing is % of profits based using an index and shorter term.

SemCAMS.  Natural Gas processing plants in Edson, Canada near the Montney Shale.

• Operates 2 sweet and 2 sour natural gas processing plants
• 600 miles of SEMG gathering pipelines that connect to two 3^rd party major long haul pipelines
• 80% utilization. Opex cost plus contracts earned on natural gas processing
• Room to grow utilization substantially over the next 2 yrs
• Gas processing plants in Canada are generally considered a declining industry, but SemCAMS in growth region
• New emerging play in area - Montney Shale - a low cost shale gas discovery
• Montney Shale is considered one of lowest gas cost discoveries.
• Lots of excitement around this asset
• Land sales in the Alberta region were second highest on record last yr - leading indicator for drilling
• Potential for other infrastructure projects here as Montney shale develops.
• Keyera is a comp to this business in Canada. Income trust structure. Gets a 5-6% dividend yield.

SemLOGISTICS.  Bulk liquids tank storage terminal in Milford, Haven UK with deep water jetty sea access

• 100% utilized. 2 yr contracts. Rates are drifting up for storage in this market
• 20% oil storage, 80% distillates
• Largest independent oil storage terminal in UK. Only true deep water access port.
• Older assets, but mgmt has put in 30m of a 45m cap ex reinvestment program
• Refurbishment is increasing exposure to higher margin products
• Management seems excited about opportunity here, but hasn't given any specifics

Milford, Haven SemLogistics is the largest independent tank storage site in the UK, located in Wales.  It is primarily used as a break-bulk market for deep water tankers, where product is delivered and stored until it can be broken down and put on smaller ships.  It also serves as a strategic reserve location for the country's reserve fuels.  There are financial players that use this site for trading, but it is unclear how the customer volumes breaks down.  In addition, two major refiners with 16.5 of 95m in UK refining capacity are located in this region.

Milford, Haven is considered a secondary storage site for product that does not need to go to the main logistics site in the country, Rotterdam, or ARA.  While the notion "secondary" is not often synonymous with good assets - Milford storage is rumored to be half the price of ARA, as ARA is mostly captive customer/supplier demand for in-land distribution and customers who can afford to pay the fee. 

It is important to understand that this asset has had numerous owners over the last decade and many operators feel it has never had a vision, or adequate investment.  SEMG is the first owner in over a decade to put capital back into the business.  The individual running SemLOGISTICS is Nigel and is rumored to be a good operator.  He has worked with the assets for 8 yrs and came from the previous owner.  Management has hinted of an upward pressure in rates for this asset. 

Longer term, there could be significant opportunity to drive growth and demand for storage in this market.  In particular, a pipeline that feeds in-land UK has been dramatically underutilized for years due to high pricing by Chevron, the current owner.  The bankruptcy docs for SEMG state they plan to use it to transport jet fuel to Heathrow Airport, but there is possibility SEMG could try to bid on the whole pipeline themselves.  Other opportunities include LNG imports from Dragon and South Hook, which just built new facilities at Milford, Haven, and a secular shift toward imports of refined products.

 Imported refined product could end up being a big tail wind.   For domestic UK refining capacity the cost of environmental and regulatory compliance is often too high relative to peers in the Middle East / China.  If refining capacity shifts to other countries like it has in the US - the SemGroup facility is the only real deep water port in the UK and could be a beneficiary of a lift in imports that are unable to unload at other shallow water facilities, like ARA.  It is our understanding that the current refining capacity located near Milford Haven (Chevron & Murco) are not heavy users of SemLogistics storage. 

Those familiar with the Bayonne, NJ facility owned by Macquarie Infrastructure (MIC) will note that shuttered US refining capacity over the years has created a large need to import refined fuels into the MIC owned NJ storage terminals and has allowed MIC considerable pricing power (10-15% per yr) as storage demand has outstripped capacity, which is difficult to add.  Currently, two refineries in the Milford, Haven area (Murco & Chevron) are for sale and if they are sold to foreign operators it could begin this process. Management thinks sale of these assets would be a net positive for their volumes.

SemSTREAM. Propane storage terminals and propane marketing:

• 66% of GM is marketing with the rest being 1 yr propane storage contracts to customers near their tanks
• SEMG buys propane in spring / summer and sells in fall winter hoping to capture summer/winter spread
• Geographic advantages. Low cost provider due to proximity to pipeline.
• Well underutilized propane storage capacity but not disclosed
• Few other large players in area near pipeline and near customers for delivery.

The most important factor for this business is the Propane spread between summer purchase and winter delivery defined by the Montbelvieu curve.  The curve has been positive over the season for the last 8 yrs they have been in the business, but it has varied between 4 cents and 40 cents.  Currently, it is in the mid 30s.  This does imply that a period of lower spreads SemSTREAM's ebitda would suffer, but it is not entirely a 1 to 1 ratio as there are times throughout the year that Semgroup has the ability to sell at high margins due to supply shortages. 

SemStream lost a lot of business in bankruptcy in this division.  It is also the division that put them out of business as the CEO was making large un-hedged, directional bets on oil.  The business today takes limited to no commodity price risk, other than capturing the spread between summer and winter months - which they hedge and lock in at time of purchase using propane where possible and oil when not possible.  Propane delivery is critical to the customer's operations and many were left without propane when SEMG swiftly closed their doors. 

It is unclear how much they can win back but the bankruptcy filings suggested an incremental 40-50m of gross margin benefit if they served as many customers with propane marketing as they used too, most of which would fall to the bottom line.  For instance, the majority of propane contracting / delivery is now being conducted by 3^rd party aggregators who are buying from SEMG to deliver to the customer and are capturing some of the margin for their service.  SEMG used to do this on their own and it represents another opportunity for growth should SEMG want to re-claim more of the value chain.  It should be noted, SemSTREAMs activity in propane marketing has been limited by a high cost of capital over the last 2 years, and management has acknowledged they will pursue more business in this division after a refinancing.

Asphalt mixing terminals in Mexico

• 13 Asphalt storage / mixing terminals across Mexico
• 100% fee based, contractual arrangement
• Purchases and sales are matched - limited commodity exposure

SEMG owns 13 terminals in Mexico where asphalt is temporarily stored and mixed with special chemicals that enhance product quality and transportation before road building.  They have the largest market share, which has been growing, in the country and have been working recently to bring in product from 3^rd parties to improve COGS.  While they seem to be the dominant player in the market, the business can be very volatile as funding for road construction is set each year by the Mexican Government and 2010 has been a very weak year at 2.2m YTD in EBITDA vs. normal periods of 10-12m and high periods of 15m.  Management believes the road conditions in Mexico are in desperate need of improvement and they will not be able to put off the investment for long, but it is unclear when spending will return. 

Likely to convert into an MLP:

During their roadshow mgmt made it clear they are exploring an MLP conversion and if they follow through will target conversion sometime over the next 6-9 months.  We think the odds are very high mgmt will pursue the MLP structure.  Management understands the cost of capital advantages are essential to competing with their peers and for creating the most shareholder value.  All of the assets are MLP eligible and could fit into the entity, but the UK Logistics and Mexican Asphalt terminals would suffer tax leakage (pay 30% UK and 30% Mexico corporate tax rate).  While there are 90m net operating loss to shield income from these assets in the near term, it will not last long.  The business was not an MLP prior to bankruptcy because the previous holders were not allowed to investment in MLP structures.

Peers in space trade at 14x EBITDA

If SEMG converted into an MLP it would be one of the cheapest names in the space on nearly every metric.  We note - the best comp to SEMG is Plains All American (PAA), which has a mixture of pipeline assets, Cushing storage, and derives ~ 1/3^rd of their EBITDA from NGL marketing, similar to SEMG Propane marketing.  Plains is getting a 14x EBITDA multiple and a 6% dividend yield.  Numerous comparables have similar dividend yields.  It is likely that SEMG has a superior EBITDA growth profile given their asset base and low levels of leverage.    

Least levered balance sheet in space > 1.5x today vs. peers 3-5x.

SEMG is one of the least levered energy infrastructure business in the sector at 1.5x.  Management has not disclosed any plans to increase leverage at this time, as they are trying to renegotiate existing facilities, but they seem willing to increase leverage in due time. 

The first priority remains refinancing existing debt facilities.  To put their current interest burden in perspective, they have paid 66m for the 9 months to date in interest costs with 354m of debt outstanding.  While 150m of debt has been paid down this yr, they are paying 8-10% on their debt on average and have a 48m fixed fee on their term loan of 308m.  It is expected they will be able to get their cost of debt more inline with peers over the next few months, which should serve as a positive catalyst. 

Mgmt team seems aligned with shareholders, honest, capable, and willing to drive shareholder value

Our diligence on the CEO has come back favorable.  Norm was previously the CEO of colonial pipeline before retiring.  Former co-workers we spoke with had positive things to say including intelligent capital allocation and the type of individual you'd want to run your business; he came out of retirement to join Semgroup.  While the mgmt team does not own a lot of stock currently they do have a generous compensation package consisting of performance share grants.  The hurdles for the share awards are tied to market cap appreciation and hitting ROIC targets.  They seem highly aligned with shareholders.

Payout ratio:

MLPs typically pay out 95% of their gross distributable cash flow, defined as CFO - Maint cap ex and leverage is used for growth cap ex.  Under a conservative scenario we could see mgmt only paying out 80% of Gross FCF as they get comfortable with the stability of the cash flow at SemStream and SemMexico.  However, given the lack of leverage mgmt could easily payout 95% and use debt to fund any short falls as they grow the cash flow base.  This would be the preferred scenario and a 20m shortfall in distributions made up for with leverage could be sustained for 10 years with only 1 turn of debt.  We hope management chooses this route but it is not clear at this time how agressive they will be with payouts.  A number of MLPs payout more than 100% at times using debt in this manner.  If SEMG pays out only 80%, hopefully the market will price in more distribution growth and award a premium to the industry multiple.

Path to ~100% upside:

Were management to enhance balance sheet leverage upon MLP conversion one could see significant upside.  If we start at 185m of EBITDA for 2012 and assume 3 additional turns of leverage are deployed at a 12% ROI (EBITDA-Maint Cap ex) and SEMG pays a 7% rate on the new leverage that would imply 12% - 7% * 555m of capital deployed and 28m more gross distributable FCF a year; ~160m in total.  A 95% payout ratio would imply 152m of cash distributions a year.  Hopefully, the growth in EBITDA would cover potential variability in Semstream / SemMexico.   Assuming the market is willing to ascribe a 6% distribution yield to the business the equity would have a valuation of ~2.5B vs. ~1.3B today. 

Options on growth

185 seems like a reasonable EBITDA target for 2012, but if propane spreads do not collapse it seems plausible 2012 EBITDA could come in over 200m.  This would entail White Cliff's ramping faster than expected (oil is ripping) mgmt going after lost businesses in the propane division, deploying a new cryogenic plant at SemGas, increasing volumes at SemCams, and strength at SemLogistics where there is opportunity to utilize the in-land distribution pipeline, or attract higher margin products.

Disclosure:

We and our affiliates are long SemGroup (SEMG) and may long additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of SEMG. This is not a recommendation to buy or sell shares.  Our research should not be taken for certainty.  Please conduct your own research and reach your own conclusion.   

Catalyst

• Will guide 2011 EBITDA / Cap ex in late March 2011 for 4Q earnings call
• Analyst coverage
• Re-finance balance sheet to lower cost of capital
• MLP conversion (likely to happen this year)