Description

Overview

SemGroup Corp. equity (“SEMG”) is a compelling long with multiple concurrent transformations, numerous upcoming catalysts, and over 100% upside to our price target. While not without risks (mentioned below) rarely do we come across a business with such a wide moat, defensive characteristics, and compelling upside.

SEMG is an energy midstream company in the midst of three concurrent transformations; a major earnings growth inflection, an accretive balance sheet deployment and the structural conversion from a corporation into a more tax efficient GP holdco structure.  Looking out 2 -3 years, pro forma for these transformations, we believe SEMG will be an asset light GP holdco with a potential dividend approaching $3.25 / share, a $1.5bn net cash position from asset drop downs and a $400mm+ stake in NGL Energy Partners (“NGL”).  Valuing the core company at dividend yields anywhere near those of existing midstream GP holdcos results in a share price (2 – 3x) the current $51.86.  An under-levered balance sheet at that point would offer additional upside were the company to return cash to shareholders or pursue further acquisitions.  We view the recent rate fear / hedge fund de-risking driven 10%+ pullback in SEMG shares of the past weeks as a highly opportune entry point.

SEMG was previously written up on 2/23/11 by Stanley339. The story has continued to evolve in a positive way, hence this update.  We encourage you to read his thoughtful write-up (http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/44199) and description of SEMG’s various businesses. Additional disclosure on the businesses can be found at on the company website (http://ir.semgroupcorp.com/corporateprofile.aspx?iid=4135511).

In the interest of timeliness and brevity, we will skip the blow-by-blow description and analysis of each of SEMG’s discreet assets.  Obviously the underlying fundamentals and attractiveness of these assets are core to our thesis and SEMG performance, but this write-up will focus primarily on the multi-factor transformation underway while characterizing fundamentals as largely a continuation of the current favorable status quo.  In other words, one can debate out-year Cushing storage pricing or Mississippi Lime gas processing volumes, but we will not focus on these details here as to do so would miss the forest for the trees.

SEMG is a midstream energy company with oil and gas gathering, processing, marketing, transportation and storage infrastructure assets.  These assets include Cushing crude storage, the White Cliffs crude pipeline from the DJ Basin to Cushing, oil and gas gathering and transportation pipelines in the Mississippi Lime and gas processing plants in the Mississippi Lime and Montney / Duvernay.  The company also owns a liquids tank storage terminal in the UK and asphalt mixing terminals in Mexico, neither of which we view as core.  Nearly 90% of SEMG gross margin is from long term fixed fee contracted business with no commodity exposure.  Two thirds of earnings are from the company’s crude operations, where fundamentals are excellent and poised to remain so for many years.  The company’s non-core businesses are small enough a percentage of total projected EBITDA that they no do not pose material downside risk to estimates.  Should non-core operations improve, it would represent upside to our forecasts.

Earnings inflection

SEMG has guided to 2013 EBITDA of $165 - $175mm, a figure we believe should grow to more than $400mm in 2016.  By virtue of its well positioned mid-con footprint, SEMG possesses a long runway of low risk, fully contracted brownfield expansion projects as well as new greenfield opportunities.  The company will continue to focus on long term, fixed fee contracts with stable counterparties, further increasing earnings quality.  We wish we could claim this EBITDA growth forecast was based on our proprietary insight; rather it is simply the sum total of project-by-project capex forecast and EBITDA creation multiples that the company provides in its regular investor presentations.  Select growth projects include doubling White Cliffs pipeline capacity, building the new Glass Mountain crude pipeline and expanding gas processing capacity in Oklahoma.  We are aware of few businesses with the outlook to grow as quickly with as little micro or macro risk as SEMG in the coming years (absent commodity implosion, interest rate explosion or other economic horrors).  These fully contracted projects represent true idiosyncratic growth.  Other midstream operators face similarly robust demand for new energy infrastructure projects, but in this case, their scale is a hindrance, as it is much more difficult to achieve comparable growth rates for a $100bn EV midstream company as it is for SEMG at $2.3bn.

On top of the attractive organic growth runway, on 5/1/13, SEMG announced the $300mm acquisition of Mississippi Lime gas gathering and processing assets from Chesapeake Energy (CHK).  These assets will require $125mm of additional build-out capex and are highly complementary to SEMG’s existing footprint in the region.  While SEMG has given limited disclosure around valuation, management has publicly compared the acquisition multiple to the creation multiple of a recent organic investments, built out at multiples of 6 – 7x.

Balance sheet deployment

So how will SEMG fund the organic build out and strategic acquisitions?  At 3/31/13, SEMG had $126mm of net debt, or 0.6x the midpoint of 2013 EBITDA guidance.  Needless to say, this is extremely low for a fixed fee midstream business and is a legacy of SEMG’s 2008 bankruptcy.  (As an aside, SEMG was put in bankruptcy by irresponsible commodity trades by former leadership, totally unrelated to the asset base or current management. Risk management guidelines put in place during the bankruptcy protect against future speculating debacles, which current management has reiterated they have no intent to pursue.)  SEMG’s unlevered balance sheet is a significant source of additional value, which we expect to be realized in the coming years. 

Management has publicly stated a targeted SEMG debt level of 3.0 – 3.5x EBITDA.  Thus, along with internally generated FCF, SEMG will be able to fund this massive growth ramp entirely with low cost debt and most importantly without equity dilution.  To date SEMG has funded growth projects out of revolver capacity, but at present SEMG is in the market for $350mm of senior notes to fund the CHK acquisition.  We would expect the SEMG balance sheet to mature in coming years as the company adds a level of sophistication to the capital structure not currently present. 

Pro forma for the pending bond deal and additional revolver draw to fund growth projects later this year, we forecast SEMG debt to EBITDA to exceed 4x by year end.  However, despite the significant capex through the course of ’14 – ’16, we forecast SEMG to de-lever over the period as EBITDA from the new projects and acquisitions come online.  By 2016, we forecast SEMG to remain below its leverage target at 2.2x EBITDA, offering potential for additional upside via incremental balance sheet optionality.

Corporate transformation

SEMG’s status as an asset heavy c-corp is a result of historical legacy, which management intends to remedy over time.  (Incidentally, current management was installed during the bankruptcy and has designed and executed upon the aforementioned strategy with poise. Realizing the significant opportunity ahead of them, they smartly rejected a $24 bid from PAA in October 2011)  In December 2011 SEMG listed Rose Rock Midstream (“RRMS”), a publicly traded MLP of which SEMG is the GP and also owns a majority LP stake.  To date, SEMG has dropped ~$60mm of EBITDA into RRMS and we expect periodic drop downs to continue in the coming years and beyond.  Ultimately we expect all of the assets to be dropped into RRMS, with SEMG acting as a pure play GP holdco.  SEMG has acted as incubator for new growth projects given superior financial flexibility at SEMG vs. RRMS at present.  At some point, once RRMS achieves critical mass, we would expect growth projects to be funded at the RRMS level, although this is some years off.

Importantly, we believe the transformation of SEMG from an asset heavy corporation to an asset light GP holdco will inevitably shift its valuation metrics from EV / EBITDA to dividend yield and P/DCF. We believe the combination of EBITDA doubling and a valuation rerating will propel SEMG substantially higher over the coming months and years. 

Presently, SEMG and its dynamic opportunity set is not well appreciated by the Street and investors for the following reasons: (1) SEMG’s enterprise value is small relative to peers and until recently it has not been active in enough fee paying M&A and capital raising activity to justify Wall Street’s attention, (2) SEMG is a post bankruptcy re-org equity that has remained under the radar despite exiting some time ago (3) the SEMG narrative has shifted dramatically since its ’09 emergence given changes in the North American energy landscape (4) the stock’s LTM performance can intimidate all but the most dispassionate of value investors from taking a fresh look (5) there is virtually no current Wall Street coverage that buy side investors can rely upon to articulate the transformative opportunity; the few analysts that cover SEMG are not focused on it (6) Street estimates and price targets look out only YE’13 and therefore myopically miss the dynamic value uplift inherent in SEMG’s ongoing transformation.

Financials / price target

A number of methodologies suggest SEMG shares can appreciate 2 – 3x as the transformation unfolds. 

First, most simply, based on $400mm+ of 2016 EBITDA, we believe SEMG in its current corporate structure will generate roughly $6.15 per share in distributable cash flow.  This assumes no incremental tax savings from the transfer of assets into the MLP structure.  Further, at that point SEMG will only be levered at 2.2x debt / EBITDA, well below the company’s stated 3.0 – 3.5x target.  Valuing distributable cash flow at a 6% dividend yield ($101/sh) plus an additional 0.8x turn of debt to take the company to the low end of its range ($8/sh) yields a price target of $110, or 2.2x the current $51.86.

Second, in evaluating what SEMG would look like to a potential acquirer (of whom there are most certainly many), we strip out the roughly $65mm tax burden the company would owe in 2016 based on the earnings level above (ownership by an acquirer in an MLP structure would eliminate any existing tax burden) and apply the same capital structure adjustment (as any acquirer would likely be operating at leverage levels of 3.0x or greater).  Under these assumptions, SEMG would generate $8.57 of distributable cash flow per share.  Valued again at a 6% FCF yield would imply a target price of $143, representing a 2.8x MOM.

Finally, we have attempted to model the ongoing transformation SEMG will undertake as it continues to grow and drop assets into RRMS.  Obviously this exercise is highly assumption driven (drop down pricing, timing, RRMS financing, etc.), which is why we have cross checked with the methodologies above.  In this scenario, based on the RRMS GP / LP waterfall, we believe SEMG would be able to pay $3.25 / share in annual dividends funded by its GP / LP stakes, have a net cash position of $1.5bn (as a result of drop down proceeds) and continue to own a $400mm stake in NGL.  Adding these three sources of value (again, applying a 6% dividend yield to the core cash flows) results in an implied valuation of $105 / share, 2x the current share price.  Accretive deployment of the sizeable cash balance, which we view as likely, would offer additional upside optionality.

Catalysts

• CHK deal closing
• New project completion and earnings ramp
• RRMS dropdowns
• Dividend increases
• Further balance sheet deployment

Risks

• Project execution (which we view as limited)
• Further back up in rates (hedgeable)
• Significant commodity price declines (particularly oil below $60-65 whereby onshore oil production could decline materially, also hedgeable)
• Poor uses of capital (we view as unlikely given management track record)
• Nationwide fracking regulation (we also view as unlikely given state / local jurisdiction)
• Challenge to broader (not SEMG specific) MLP tax structure in Congress (unlikely, but also hedgeable)

In summary, we view SEMG equity as a uniquely compelling opportunity to buy a cheap, particularly well-positioned North American midstream company on the cusp of a dynamic cash flow inflection. The company is poised to finance a significant build-out that will double cash flow without any equity dilution but rather with low cost debt and FCF.   Simultaneously dropping assets into the MLP will enable the entire portfolio to re-rate to yield oriented MLP valuation metrics.

Catalyst