| 2017 | 2018 | ||||||
| Price: | 2.22 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 77 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 171 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 561 | EBIT | 0 | 0 | |||
| TEV (in $M): | 732 | TEV/EBIT | 0 | 0 | |||
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Description
Southcross Energy Partners, L.P. (SXE) is a master limited partnership that provides natural gas gathering, processing, treating, compression and transportation services, and NGL fractionation. The company’s assets are located in South Texas (Eagle Ford and Corpus Christi), Mississippi and Alabama and include two gas processing plants with 500 MMcf/day of capacity in South Texas, one 22,000 barrel per day fractionation facility and approximately 3,138 miles of pipeline in South Texas and Mississippi and Alabama. The company also has commercial agreements in place to access its parent company’s 70,000 barrel per day fractionator in the Corpus Christi Market.
Background
SXE came public in late 2012. Its primary private equity sponsor was Charlesbank Capital Partners. In June, 2014, SXE merged with TexStar Midstream Services that was backed by private equity firms EIG and Tailwater. The company built and acquired a pipeline network and processing facilities that were designed to gather and process the wet gas streams associated with production in the Eagle Ford shale. Southcross Holdings, the private parent that owns the 72% equity stake in SXE, also built a state of the art fractionator, Robstown, which was expected to be the low-cost processor of ethane during the pending ethane boom. The assets were also designed to gather dry gas from areas anticipated to be likely sources of natural gas for export to Mexico.
However, like always happens with oil guys, prior management built a best-in-class gathering and processing asset at the top of the oil market and at the top of production of the Eagle Ford shale. The backers also completed their assets a few years before the ethane boom showed up in the Gulf Coast. Coupled with a reckless dividend policy of paying out more than cash flow in distributions to unitholders and very high debt levels ($500mm+ at both parent and Holdings), the stock crashed from the low-$20’s to $0.40 in February 2016 as bankruptcy appeared inevitable.
After a debt for equity swap and a pre-packaged bankruptcy at Holdings in April 2016 coupled with a $170mm new investment by EIG and Tailwater (Charlesbank called it a day) in Holdings, Holdings with its healthier balance sheet began to make several “equity cure” contributions to the public MLP throughout 2016. While providing much needed liquidity and funds for deleveraging, the equity cure structure was a major overhang for the units as there was the potential for substantial dilution ($50mm cure facility / $0.89 = 56mm shares of potential dilution on a base of 55mm shares prior to the cures).
Quarterly EBITDA fell from a peak of $24.8mm in Q4 2015 to $14.8mm in Q3 2016. At the end of Q3 2016, SXE had $561mm in debt with TTM EBITDA of approximately $76mm. The most recent Q3 EBITDA shows an annualized EBITDA run rate of $59.2mm, suggesting to public market investors that the company is 9.5x levered.
The company has no institutional ownership, is barely covered, and has 22mm shares publicly available in the float out of a fully diluted 77mm shares. Sounds like a train wreck, but…
We believe that SXE is one of those assets you can find only at the turn of cycles that is very highly levered and is not going out of business. While risky, it is our view that the turn is self-evident and that a new, all-star CEO, who started on January 9th, “gets it” and wouldn’t have accepted the job without the appropriate pieces in place. We believe EBITDA will soon turn higher and as the company organically deleverages, the stock will experience a 3.5x-5x return in as little as 10-18 months.
Thesis and Value Creation
1. Bruce Williamson, a new, all-star caliber CEO, joined SXE on January 9th, 2017 as its CEO after observing on the board since 2013. He is known as a “cleaner and seller” having recently sold Cleco Corporation creating substantial gains in distributions and equity value for its shareholders. He was also widely credited with having “saved” Dynegy after Enron’s implosion.
2. This is a highly levered equity that was left for dead that was recently given an extended lifeline with covenant waivers days before the new CEO joined. SXE is about to enter a period of deleveraging that has a very long runway to succeed.
3. The Eagle Ford shale, left for dead given volume declines and a shift in focus to the Permian, is springing back to life. Rig count has risen sharply in the basin and land previously held by production but not currently being drilled is trading hands and the new owners will resume drilling. There is now a line of sight on volumes bottoming and then returning to growth in mid-2017 (EIA data for oil production positive in February 2017 Eagle Ford Drilling Productivity report).
4. Ethane demand is set to explode in the U.S. creating a period of dramatically improved NGL processing margins for the company and its core and “lowest cost” Eagle Ford and Corpus Christi assets.
5. This is a highly levered equity that is entering a period of EBITDA bottoming in 1H 2017 and then acceleration, while the “market” is assuming a further deterioration:
a. Eagle Ford shale volumes will resume growth in mid-2017 which will drive profitability. In addition, the Eagle Ford has the highest number of DUC’s of any basin in the continental U.S. further accelerating volume growth and profitability for SXE.
b. The company has identified cost cuts that have yet to be revealed in its financials. Given weak sell side coverage and zero institutional ownership, no one is paying attention. Savings will be in range of $12-$17mm.
6. There are additional drivers of volume growth in the company’s area of service.
7. The company will either re-instate a dividend or be sold.
Value Target
There are only two analysts who cover the company: JP Morgan and Raymond James. “Consensus” EBITDA for 2017 is $64.5mm although it appears Raymond James is stale on the name leaving only JP Morgan. The JP Morgan analyst assumes $52mm in EBITDA in 2017 and $78mm in EBITDA in 2018. Gathering and processing comparable companies trade at 13.4x 2017 EBITDA and 11.3x 2018 EBITDA. Based on the JP Morgan analyst’s number for 2018, the stock should be trading at $4 – today. However, we believe that part of the reason for this disconnect is that the market still sees EBITDA in free fall and the equity over 9x levered.
In pulling together a bridge of earnings, we believe that Q3 2016 EBITDA of $14.8mm is close to the bottom. During 2017, we anticipate operating and overhead cost savings will contribute an additional $3.75mm in quarterly EBITDA once fully implemented, going from ethane rejection to ethane processing will add $1.5mm in quarterly EBITDA, and the resumption of volume growth will add an additional $2mm in quarterly EBITDA in the 2H 2017. We believe there is a clear line of sight on the company posting Q4 2017 EBITDA of $22.1mm, or an $88mm run-rate exiting 2017.
With small additional improvements in ethane prices and system volumes, we anticipate 2018 EBITDA of $100mm. Based on an EV/EBITDA multiple of 11x 2018 EBITDA, 77mm shares (includes full conversion of PIK units and subordinated units), and year-end 2017 leverage of $503mm, we generate a year-end 2017 target of $7.50 per share. With the resumption of a dividend in mid to late 2018, we estimate the shares will climb to $10.
Thesis and Value Creation Discussion
Bruce Williamson, a new, all-star caliber CEO, joined SXE on January 9th, 2017 as its CEO after observing on the board since 2013. He is known as a “cleaner and seller” having recently sold Cleco Corporation creating substantial gains in distributions and equity value for its shareholders. He was also widely credited with having “saved” Dynegy after Enron’s implosion.
Bruce Williamson is a respected energy executive who cut his teeth working for John Wilder of TXU legend (and now, maybe, of NRG legend) while at Shell Oil.
In 2002, he was named President and CEO of Dynegy and “saved” the business for many years after the Enron fraud. He was dealt a very difficult hand at Dynegy as it was a falling knife when he took over but he was widely considered the reason why the wheels were kept on the bus at the company for many years. As the CEO of Dynegy, Williamson received an award from the President's White Collar Task Force. Further, the former United States Attorney for the Southern District of Texas, Michael Shelby, stated that Williamson becoming CEO, "has changed the standard operating procedures in such a way that honesty and candor [are] part of the business plan," and Williamson "helped ferret out potential wrongdoers." As the CEO of Dynegy, Williamson restructured Dynegy outside of bankruptcy, and reduced Dynegy's outstanding debt by over $10 billion. Williamson resigned as CEO of Dynegy on February 10, 2011, after two takeovers of the company (both of which he supported) failed. He was forced from the company by Seneca Capital and Carl Icahn as they opposed the sale of the company in a widely publicized fight. Seneca Capital later folded because Bruce was right to recommend a sale of the company and Dynegy again slid into bankruptcy the following year. At its low when he took over Dynegy, the stock approached $1 and during its high in his tenure Dynegy was above $10.
After Bruce left Dynegy, he became CEO of Cleco in Louisiana in 2011. While there, he fixed relations with regulators, finalized the largest ever wholesale contract for the company, and transitioned the company into new markets. Dividends were increased by 60 percent and the company was sold for $55.37 per share to an investor group (stock was $32 when he started) - not a bad outcome for a regulated utility.
Based on reference checks, Bruce is “an acquired taste” but is a “stud”. Another reference check suggested that “Bruce is hard charging and high energy. He is a fixer. Make no mistake about it if Bruce is there it will be fixed and sold.”
Williamson has been on the board of SXE since 2013 and has been able to follow the situation closely. It is our view that he sees many of the same things that we are seeing and will have a limited learning curve here given his extensive background in both the oil and gas and power markets. We also believe his timing is impeccable in accepting this job.
We encourage the reader to conduct his or her own reference checks but we believe you will come to the same place. Bruce is a high-performing cleaner and seller.
This is a highly levered equity that was left for dead that was recently given an extended lifeline with covenant waivers days before the new CEO joined. SXE is about to enter a period of deleveraging that has a very long runway to succeed.
As of Q3 2016, SXE had approximately $561mm in debt.
Approximately $440mm of the debt is term debt with no covenants, limited amortization, and a cross-default with the revolver. Oddly, the term debt gets first call on any asset sales. The term debt is due in August of 2021.
Approximately $121mm of the debt is the revolver. The revolver had total debt to EBITDA covenants which were the most restrictive here. On January 3, 2017, SXE entered into an amendment with its revolving lenders scratching the restrictive covenants until the end of 2018 (or March 2019 when the 2018 10K is due). The odd thing is that we believe that SXE can come very close to paying off the entire revolver by the end of 2018 with the most recent equity cure, the Gregory and Conroe asset sales, and free cash flow.
The company has articulated that its maintenance capex is now less than $10mm per year per its quarterly calls. We estimate growth capex will be less than $10mm in 2017 and $5mm in 2018. With $30mm in interest payments in 2017 and $26mm in 2018, we expect that the company will be able to pay down $119mm (more or less the entire revolver) by the end of 2018. The company is expecting sale proceeds and insurance recoveries of $12mm in 1H 2017 from the Conroe and Gregory facilities and will pay down debt with the $17mm equity cure received in January 2017. The company pays no income tax.
We expect SXE’s Q4 2016 to show breakeven FCF as the company is wrapping up some final growth capex projects. Growth and maintenance capital expenditures will then be limited in 2017 and 2018. Guidance for 2017 was “we expect our total maintenance and capital expenditures for 2017 to be roughly half of 2016 levels”. SXE had $17.3mm in capital expenditures through the first nine months of 2016. We assume $18mm for 2017 which might be high.
Once the company pays off the revolver in late 2018, it will have another 2-3 years to put in place a replacement for the existing term facility if the company isn’t sold first. In all, we believe the company has a solid four and half years of runway (until the term facility is due in August 2021) to fix its issues.
The Eagle Ford shale, left for dead given volume declines and a shift in focus to the Permian, is springing back to life. Rig count has risen sharply in the basin and land previously held by production but not currently being drilled is trading hands and the new owners will resume drilling. There is now a line of sight on volumes bottoming and then returning to growth in mid-2017.
The EIA drilling productivity report released on February 13, 2017, showed positive month-over-month growth in oil production in the basin for the first time since March 2015:
https://www.eia.gov/petroleum/drilling/pdf/eagleford.pdf
Rig counts in the Eagle Ford/Corpus Christi area have risen from 38 in mid-October 2016 to 70 on February 10, 2017. Rigs bottomed in mid-2016 in the service area at 29. At the peak of drilling activity, the Eagle Ford service area had over 200 rigs in operation in 2013. Today, rigs are more efficient and the basin will need fewer rigs to return to growth. Also, given the lack of drilling since 2014, legacy wells are further along their decline curves and it will be easier to resume growth in the basin as production rates from the pool of existing wells declines more slowly given that decline rates are much lower two to three years out from initial production. If interested, rig counts can be sourced from Baker Hughes or www.eaglefordshale.com.
The largest producers in the Eagle Ford are Marathon Oil (MRO), ConocoPhillips (COP), Chesapeake Energy (CHK), EOG Resources (EOG), and Devon (DVN). A quick review of their investor presentations as well as their Q3 2016 earnings call transcripts reveal 1) the companies still have a substantial inventory of drilling sites in the Eagle Ford that are still increasing 2) these sites have returns that match some of the best returns in their respective portfolios 3) they are going to pick up activity in 2017 in the basin.
However, the main conflict for these large producers in the Eagle Ford is that they all control equally attractive plays that are emerging plays for them in the Permian as well as the SCOOP and STACK formations in Oklahoma. With limited capital budgets in 2015-2016, these large producers focused on drilling the emerging plays in order to hold the leases whereas in the Eagle Ford they already held the land through production and didn’t need to allocate capital to hold the land.
The sea change that has occurred in past month has been transactions where sellers have been selling Eagle Ford acreage. The largest transaction was Sanchez Energy’s (SN) acquisition of Anadarko’s complete stake in the Eagle Ford on January 12th, 2017. The significance of this transaction and the others listed below is that the seller was not aggressively drilling and that the land is trading hands to a buyer who will aggressively drill the land. While the impact of these sales will not be felt immediately in volumes, they will be realized over the next 6-18 months. In addition, there will likely be more transactions from some of the larger players listed above. Here is a list of transactions:
1. EV Energy Partners Announces a $59 Million Acquisition in the Eagle Ford and a $52 Million Divestiture in the Barnett Shale (February 1, 2017)http://ir.evenergypartners.com/releasedetail.cfm?ReleaseID=1010056
2. Hawkwood Energy Acquires East Texas Assets from Halcon Resources (January 25, 2017) http://finance.yahoo.com/news/hawkwood-energy-acquires-east-texas-190900811.html
3. Sanchez Energy and Blackstone Energy Partners to Acquire 155,000 Acres in the Eagle Ford for $2.3 Billion (January 12, 2017) http://investor.sanchezenergycorp.com/phoenix.zhtml?c=248475&p=RssLanding&cat=news&id=2237282
4. Austin Company Acquires Texas Oil and Gas Assets from SM Energy for $800M (January 3, 2017) http://www.bizjournals.com/austin/news/2017/01/03/austin-company-acquires-texas-oil-and-gas-assets.html
5. Carrizo Oil & Gas Announces Eagle Ford Shale Acquisition and Estimate Third Quarter Production (October 24, 2016) https://globenewswire.com/news-release/2016/10/24/882203/0/en/Carrizo-Oil-Gas-Announces-Eagle-Ford-Shale-Acquisition-and-Estimated-Third-Quarter-Production.html
The developments occurring in the Eagle Ford haven’t escaped the attention of the larger midstream companies operating in the play. On Enterprise Product Partners (EPD) Q4 2016 call on January 30th, 2017:
Anthony Chovanec – SVP Enterprise Products (EPD)
“We think the Eagle Ford is a sleeper that people aren’t paying attention to and I'll tell you what we like about what we see in the Eagle Ford is rig counts were up substantially and people don't realize that they've moved significantly off of their low and continue to add two to five a week.
"So we like what we see in the Eagle Ford, our break evens in the primaries - the Eagle Ford are competitive with the Permian, as we run our half cycle economics. The other thing was - last thing we see in the Eagle Ford is we're seeing smaller players come in. So we think the Eagle Ford is going to be an area where you are going to from a couple handfuls of very large players to smaller players, which is really opposite of what's happened in the Permian.”
Anthony Chovanec – SVP Enterprise Products (EPD)
"Rig counts bottomed in the Eagle Ford at 21, I think we ended over 50 this last week, so already significant improvement. But you're going to see, and I don't know exactly how much, you're going to see a lag from the time you start drilling and completing to the time the new production comes on."
"And that lag is this month's, so call it you know, people projected to be anywhere from 90 to let's say 150 days from the time you deploy rigs, to the time you put that production on. So we're going to see in the Eagle Ford something that’s no sooner than back half of '17 loaded, no sooner than, as far as increases in production.”
James Teague – CEO Enterprise Products (EPD)
“We still think that the Eagle Ford is going to be a bright shining star before it is all said and done and create opportunities.”
Kinder Morgan (KMI) also echoed similar comments on its January 18th, 2017 conference call:
Steve Kean – President and CEO Kinder Morgan (KMI)
“Producers have continued to lower their breakeven prices with respect to the Eagle Ford's specifically, which was hit especially hard, was hit especially hard by the downturn. Acreage has now started to change hands from capital constrained players to new owners who we expect will do more with that position. We expect to see volumes in the Eagle Ford, both gas and oil, to continue to decline in the first part of 2017 before flattening and then starting to grow as 2017 progresses.”
Ethane demand is set to explode in the U.S. creating a period of dramatically improved NGL processing margins for the company and its core and “lowest cost” Eagle Ford and Corpus Christi assets.
With the emergence of shale in the U.S., supply of NGL’s has experienced rapid growth as shale basins produce substantial amounts natural gas liquids (NGL’s). In the U.S., NGL’s account for twenty percent of natural gas production by volume at the wellhead with ethane making up the largest fraction at approximately 43%. Other NGL’s are propane, butane, isobutane, and natural gasoline. A link is provided that shows the different types of NGL’s and their industrial uses:
http://www.eia.gov/todayinenergy/detail.php?id=5930
For ease of discussion, the main focus is ethane. Ethane is derived from natural gas liquids and is separated at a fractionator from the other NGL’s. It is used primarily to make the chemical ethylene, which is the building block of most plastics.
Large supplies of NGL’s from the U.S. shale boom have made potential ethane production in the U.S. abundant, encouraging the development of exports to Europe, Asia and the developing world for both ethane and ethylene. The midstream world anticipated such a development and began to build (as far back as 2011) export facilities for ethane, propane, additional gathering and processing assets in the appropriate basins, Y-grade pipelines to transport NGL’s to the appropriate markets, and fractionators. From all appearances, the midstream companies have been two to three years ahead in their buildout of infrastructure as compared to the completion of the demand centers of the export facilities and ethylene crackers.
However, after extremely long lead-times to build these massive projects the era of ethane has arrived! To give some perspective on the magnitude of these developments, current U.S. domestic consumption of ethane is approximately 1.1mm barrels per day with just under 0.1mm barrels per day being exported from legacy facilities.
http://www.eia.gov/todayinenergy/detail.php?id=25632
In the first quarter of 2016, Sunoco Logistics Partners LP opened its Marcus Hook, Pennsylvania ethane export terminal which was the first deep-water export terminal in the U.S. The facility currently exports more than 35,000 barrels per day of ethane and expects it to ramp significantly in the 1H 2017 to 70,000 barrels per day (for ethane as well as butane and propane). The ultimate size of this facility is expected to climb to a capacity of 675,000 barrels per day for all products. Currently, all export volumes of ethane are contracted out to Europe and India.
Enterprise Products Partners opened Morgan’s Point in September 2016. Morgan’s Point is the world’s largest ethane export terminal and is located along the Houston ship channel. Morgan’s Point has the capacity to ship up to 200,000 barrels per day.
In all, as these projects ramp and others come on-stream, U.S. export capacity for ethane is expected to grow from 90,000 barrels per day at the beginning of 2016 to over 468,000 barrels per day in early 2018 (with much of that capacity now online).
In addition to the massive surge in direct ethane export capacity, chemical companies also predicted the surge in ethane supply and began construction of massive ethylene plants across the U.S. with a significant concentration in the Corpus Christi and Gulf Coast markets, where SXE has some of the most advantageous access with its pipeline network and other assets. By year end 2018, US in-service ethylene capacity will be 80 billion pounds per year, or 17.4 billion pounds per year more than in September 2016, an increase of 28%.
On January 19th, 2017, Lyondell opened its 800 million pounds per year ethylene expansion in Corpus Christi. This expansion represents a 50% increase in the facility’s capacity to 2.5 billion pounds per year. This expansion is directly in SXE’s service area.
Soon, Occidental Chemical Corp. (OxyChem) and Mexichem SAB de CV (Mexichem) will commission their 50-50 joint-venture Ingleside Ethylene LLC 1.2 billion pound per year ethane cracker at Ingleside, Texas (part of Corpus Christi harbor) in early 2017. This facility is also directly in SXE’s service area.
In addition to the projects described above, there are several other major ethylene projects coming online in the coming years, many of which are nearing completion in 2017:
Other openings in 2018-2021 are Indorama Ventures, Formosa Plastics, Shin-Etsu Chemical, Sasol, and Axiall/Lotte representing another 362,000 barrels per day of ethane demand.
Between the export capacity and these ethylene projects, the incremental demand at full capacity for ethane will be approximately 1,000,000 barrels per day by 2021 with more than 550,000 barrels per day of that growth expected in 2017 alone (includes ramp of Morgan’s Point)!
Attached below is a link to the EPD presentation. Pay particular attention to pages 24-30 that has a detailed description of some of the dynamics going on with the Gulf Coast being “short NGL’s”.
http://www.enterpriseproducts.com/investors/presentations
So where is all of the ethane going to come from? Since 2011, it has been unprofitable in most cases to separate ethane given the spread between its energy value and that of natural gas (however, the U.S. still produces 1.1mm barrels/day so there are contracts in place that force the separation of some ethane from the NGL stream).
The most profitable areas from which to ship NGL’s would be those closest to the Gulf Coast demand areas, which happens to be the Eagle Ford and SXE’s area of operation. Goldman Sachs estimates the cost to ship NGLs from different basins to the Mont Belvieu ethane hub as follows:
Note: Spot price of ethane on February 14, 2017 is $0.2606 per gallon making transport from the Rockies, Marcellus, and Bakken uneconomic. Either ethane prices go higher or supply gets delivered from low cost basins, both of which benefit SXE.
Midstream companies have been rejecting ethane and today, the U.S. “rejects” approximately 600,000 barrels/day of ethane back into the natural gas stream. Much comes from the Marcellus given its limited profitability, however, even the Eagle Ford has seen substantial rejection of ethane in the last year. According to SXE’s Q3 2016 conference call, “Our NGL production for the quarter of about 30,000 barrels per day, down from 36,000 barrels per day in the prior quarter, reflects the combination of lower processed gas volumes and ethane rejection at our Woodsboro plant during August and September.”
If the reader has a Bloomberg, he or she can got to "HHMBPEMM INDEX" which shows the energy equivalency of separating ethane from the NGL stream. When the spread is positive, excluding separation costs and transport, ethane should be separated. When the spread is negative, ethane should be "rejected" back into the natural gas stream. The chart on Bloomberg demonstrates that prior to 2011, ethane to natural gas spreads were as high as $10 per barrel. Since then, it has been unprofitable to separate ethane as the spread has hovered at or below zero for most of that period of time. This trend started to change in mid-2016, fell back in Q3 2016, and is now decidedly positive. Based on our calculations, the spread for March is approaching $4 per barrel and based on the forward curves of both ethane and natural gas, the spreads surpass $5 per barrel in early 2018 and $10 per barrel in early 2019.
According to Goldman Sachs, “We believe ethane rejection should begin to subside in 2H17 and lead to increased earnings for NGL-levered stocks with underutilized pipeline and fractionation capacity.” That is exactly why we are long SXE! Not that one shouldn’t trust Goldman’s conclusions but we calculated the current expectation of ethane margin given the spread between the Mont Belvieu forward curve for ethane and that of the forward curve for Henry Hub natural gas. The data links can be found here:
Ethane prices - http://www.cmegroup.com/trading/energy/petrochemicals/mont-belvieu-ethane-opis-5-decimals-swap.html
Natural gas prices - http://www.cmegroup.com/trading/energy/natural-gas/natural-gas.html
To convert ethane to its equivalent MMbtu of natural gas, one multiplies the current spot price of ethane per gallon of $0.2608 times 15.04 = $3.92. One then has to subtract the current spot price of natural gas of $2.96 to see if the spread is positive or negative. Today, the spread is positive by $0.96 on an MMbtu basis. From our work, the anticipated spread for ethane is expected to be positive now for as far as the two forward curves offer contracts. This is positive for SXE as the processed volumes in Q4 2016 and beyond will improve from the 30,000 barrels of NGL's processed in Q3 2016 (August and September they rejected ethane).
Based on the trajectory of the forward curve, our estimate is that SXE will realize $5mm in incremental EBITDA in 2017 from ethane separation (6,000 barrels/day x $2.50/barrel margin) and an additional $10-$15mm in annual EBITDA in 2018 (6,000 barrels/day x $5/barrel margin) at constant volumes. If the company is able to secure additional wet gas streams and/or volumes grow organically through increased drilling, the estimates climb higher.
This is a highly levered equity that is entering a period of EBITDA bottoming in 1H 2017 and then acceleration, even as the “market” is assuming a further deterioration:
According to the management on SXE’s Q3 2016 call, “Our processed gas volumes in October remain steady with our Q3, 2016 average.” In addition, “We’re still seeing here, the first week of November, we’re seeing volumes remaining steady with the Q3.”
In addition, given the above discussion on ethane, it is possible that the company returned to some level of ethane production in Q4 2016 as the ethane spreads turned decidedly positive for the quarter. We know from the Q3 2016 call that, “Our NGL production for the quarter of about 30,000 barrels per day, down from 36,000 barrels per day in the prior quarter, reflects the combination of lower processed gas volumes and ethane rejection at our Woodsboro plant during August and September.”
The lone analyst at JP Morgan is assuming quarterly EBITDA to be $13mm for Q4 2016. We believe there are a lot of moving parts and aren’t willing to call for a sequential uplift in EBITDA, yet. However, with volume upticks, improvement in ethane margins, and soon to be implemented cost cuts we believe sequential quarterly EBITDA improvement will begin in 1H 2017 (might be flat for a quarter vs down again at JP Morgan).
Eagle Ford shale volumes will resume growth in mid-2017 which will drive profitability. In addition, the Eagle Ford has the highest number of DUC’s of any basin in the continental U.S. further accelerating volume growth and profitability for SXE.
We have covered the recovery in volumes in detail above in the Eagle Ford discussion. Attached below is a slide that shows the drilled but uncompleted inventory at the end of 2015. We believe that the level of DUC’s are now in the 900 range:
If the link doesn't work go to www.southcrossenergy.com, IR, Presentations, page 11 of the December 2015 presentation
According to the DVN Q4 2016 conference call on February 14, 2017:
“We're real pleased with where we are in the Eagle Ford. And if you go back and look at the pace of our activity, it's greatly slowed down in 2016 versus 2014 and early 2015. In fact, we were bringing on about 70 to 75 wells per quarter in that timeframe. In Q1 of this year, we were down to 22 wells brought on in the quarter. Second quarter there was only five, third quarter was only five. So we've seen the rate drop off there, but it is now stabilized, and we have four frac crews in the field that are lowering our DUC inventory down.”
“That's being done for a couple of purposes, but the primary purpose is to get information on the staggered lateral approach to the development, which is incorporating the upper Eagle Ford. And that information we're looking forward to having in 2017, which will shape what I think will be an accelerated pace of activity in the second half of 2017, which will have the potential for a material rate impact going into 2018.”
“The wells are just now starting to flow back on a few of those new completions. We're not ready to talk about that, but we're highly encouraged that some of the well rates that you've seen in the past we're going to materially beat as we go forward. So that play is setting itself up for what I think will be an accelerated ramp-up in the second half of 2017.”
According to the EOG Q4 2016 conference call on February 8, 2017:
“Pioneer will resume limited drilling and completion activity in our Eagle Ford asset beginning in the second quarter. We plan to complete and place on production twenty wells during the year, including nine drill and complete wells drilled about a year ago and eleven new wells where we will test design changes expected to significantly increase the recovery.”
In the slide below, the company estimates what can be achieved if its system reaches full capacity, which is now 500 MMcf/day. In the slide, the company estimates an incremental $58mm of additional potential annual margin from an increase from current volumes of 300 MMcf/day to 500 MMcf/day. Our expectation is that we will see volumes grow in 2H 2017 and accelerate through 2018. We assume a 5% lift in volumes beginning in Q3 2017 and more in Q4 which should equate to a $2mm quarterly ($8mm annualized) lift in EBITDA at SXE.
http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NjA0OTExfENoaWxkSUQ9MzE2MDc5fFR5cGU9MQ==&t=1
Same presentation as above, page 12
The company has identified cost cuts that have yet to be revealed in it financials. Given weak sell side coverage and zero institutional ownership, no one is paying attention. Savings will be in range of $12-$17mm.
On its Q3 2016 call, SXE revealed a substantial cost savings plan but it has not publicly released the plan in an 8-K or press release. On the call, “A comprehensive cost reduction plan has been approved by our Board of Directors and is expected to reduce our recurring burden (operations and maintenance expenses AND G&A) by another 10% to 15% on top of previously mentioned savings.” On the same call, the company announced another $2mm in annual opex savings from the closure of the old Conroe facility and the consolidation of the Gregory facility into the Woodsboro processing plant.
In Q3 2016, operations and maintenance expenses were $17.8m. Cash G&A expenses were $5.6mm. Combined, $23.4mm. A 10% savings would account for a quarterly reduction of $2.34mm. A 15% savings would account for a quarterly reduction of $3.51mm. Inclusive of the additional $2mm in savings identified on the call, the quarterly savings are expected to be $2.84mm-$4.01mm.
Our view is that this company was a bloated battleship. The company had been in aggressive build mode and had not been held accountable for margin. We view the probability of success as very high for these cuts and believe we have already seen some progress.
· The Conroe gas processing facility was over 50 years old and was closed in Q4 2016
· The Gregory gas processing facility was 50% destroyed by a fire in 2015 and not reopened. It is being transformed into a pumping station and the flexibility of the system allows for the volumes to be directed to Woodsboro.
· In an 8-K filed 11/17/2016, the company revealed that it consolidated the rolls of Chief Accounting Officer and CFO into a single position effective 12/2/16. We assume there is more to come in the corporate office given Williamson’s reputation.
We assume that approximately $3.75mm of these cost savings will be reflected by the Q4 2017 quarterly EBITDA number, or $15mm on an annualized basis.
There are additional drivers of volume growth in the company’s area of service.
Besides organic growth in volumes from the recovery in the Eagle Ford. There are several other drivers of volume growth in the Eagle Ford.
First, EOG has recently shown very impressive IP rates from its Austin Chalk acreage. The Austin Chalk overlays the Eagle Ford in many areas and is often referred to as the Eastern Eagle Ford. Unlike the Permian with it multiple stack pay zones, the Eagle Ford has been considered a single pay zone play. However, as the Austin Chalk story plays out, it is expected that the Eagle Ford can become an even more lucrative multi-stack play. According to Anthony Chovanec on EPD’s Q4 2016 call, “The other thing that’s going on in the Eagle Ford, that is missed on many people, is its beginning to participate in its own stacks and what I mean by that, is people aren’t just drilling in the Eagle Ford there anymore. You know, they are also drilling - mostly drill in the Austin Chalk.”
Second, there are two substantial LNG export facilities that are expected to come online in 2018. The Cheniere LNG project in Corpus Christi and the Freeport LNG project located between Corpus Christi and Galveston. The two projects will have a combined capacity of 5 bcf/day when fully operational. Both of these projects are in SXE’s zone of operations and the company would be among the lowest cost midstream companies to deliver gas.
Third, there is substantial and growing pipeline takeaway capacity for natural gas exports to Mexico. These pipelines originate in the heart of SXE’s service area. Some analysts believe that the Austin Chalk will become the natural gas supply zone for natural gas exports to Mexico. Regardless, there are several pipelines for export currently under construction that will draw up to 5 bcf/day of additional natural gas for export into Mexico (for reference, the U.S. domestically consumes in the ballpark of 70-77 bcf/day).
The company will either re-instate a dividend or be sold.
Given our assumption of $100mm in EBITDA for 2018, the company will cross below the 5x leverage ratio and will be allowed to pay a dividend (our guess is mid-2018) per the terms of the amended revolver. With $100mm in EBITDA, $26mm in interest payments, $10mm in maintenance capex, the company will have available $64mm for distributions. A healthy MLP should only pay 0.9x DCF, so the company will have a pool of $57mm for distributions. Out of 77mm shares, only 61mm are eligible to receive dividends, excluding the PIK and subordinated units. Our estimate for a dividend therefore would be approximately $0.90 per share which would imply an equity value of around $9 per share.
However, what is more likely given Bruce Williamson’s history and the fact that the subordinated units are worthless given that they don’t receive dividends until unitholders are caught up on the $1.60 per share in annual dividends owed to common shareholders in arrears, is a sale of a company. These assets will be very valuable to another player in the basin as there is still room to rationalize gathering and processing assets. Given the company’s prime, beach-front assets in Corpus, we believe that this is the most likely exit for the private equity backers.
Appendix
Company projection of forward EBITDA post Holdings emergence from bankruptcy in April 2016. Our view is that they were optimistic by 18 months and overstated capex, for example, capex for first nine months of 2016 has been $17.8mm:
https://www.sec.gov/Archives/edgar/data/1547638/000154763816000054/exhibit991partnershipfin.htm
Interesting article suggesting market will need most of ethane being rejected today in the next couple of years. The main takeaway is likely that ethane prices go much higher:
Q4 2016 earnings will be released in early-mid March. This is an opportunity to learn progression on volumes, cost cuts, and get introduced to the company’s new CEO in his first conference call.
Q1 2017 earnings will be released in early-mid May. The big question for the call will be how much and how fast on cost savings.
Q2 2017 – Q4 2017 Eagle Ford basin volumes resume growth as recent rig count additions work through the system. SXE’s volumes should bottom before the basin given its small size somewhere in Q4 2016 or Q1 2017.
The long term ethane thesis should begin to play out during all of these periods. An investor can routinely track ethane margins on Bloomberg or through the links provided below in the ethane discussion. In addition, an investor can track Eagle Ford rig counts at Baker Hughes or the broader Eagle Ford area at www.eaglefordshale.com.
Customer and volume win announcements
Q4 2016 earnings calls of big Eagle Ford producers: MRO (2/15/17), CPK (2/23/17), EOG (2/27/17)
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