Description

Summit midstream (SMLP) was last written up in February 2021 by offtherun; I’d encourage you to read that write up for background as a lot of it still holds up. They are currently undergoing a strategic process (which they launched in October); my TL;DR is that I suspect the process will wrap up successfully imminently, and that the stock will go for a large premium to current prices.

I was going to wait to post this until after Q4 earnings, as I suspect the outlook could be particularly soft given the natural gas environment (as I write this, nat gas is trading ~$1.60 versus >$3 last fall; obviously there’s a seasonal component to nat gas but when you’re getting articles like “Tumbling US natural gas prices prove unstoppable, hurting producers” I think you can look beyond seasonality….), but I suspect this opportunity will be gone after they announce earnings , so I decided to accelerate to today.

Why the suspicion this opportunity will be gone? On February 23, SMLP put out a PR that said they’d “report operating and financial results for the fourth quarter of 2023 and provide an update to its strategic alternatives review on Friday, March 15, 2024”.

That’s a really interesting date; to my knowledge, SMLP has never released earnings that late. Since 2014, they’ve consistently released earnings towards the end of February (the one exception was 2021, when they released FY20 earnings on March 4). In fact, here’s SMLPs last few years of earnings announcements. You can see an extremely consistent schedule: quarterly earnings are released at the start of the following month (i.e. Q3 earnings are released in early November), while full year earnings are released on the last Friday of February.

Just based on that pattern, I generally would have expected SMLP to be reporting earnings on February 23. Instead, they released their PR and scheduled earnings for the last possible day.

My suspicion is that SMLP changed their reporting because they are in late stage deal talks and have line of sight into signing a deal. In fact, given that they PR’d the earnings timing on the day they’d normally announce earnings, I would not be surprised if they thought they could get the deal over the finish line by February 23 and ended up getting stuck at the one yard line, thus leading to the delay.

In any event, I suspect that a deal is imminent, and given the material undervaluation at SMLP, I suspect any deal would be at a huge premium to today’s share price. My guess is that a deal comes in the mid-$20s (and the buyer makes a fortune on it); however, given the asset value and how leverage SMLP is, if the bidding was competitive enough it would not be hard to envision a deal price that starts with a “$3”.

Let me back up a bit. SMLP is a MLP that owns a bunch of natural gas assets (mainly gathering). These assets come in two flavors: gas oriented (taking away from wells that are focused on drilling gas) and crude oriented (taking away gas that is a derivative production of a largely crude oil focused operation, aka associated gas).

 SMLP has been on a long road to get to the current sales process; since 2019, they’ve internalized their GP, cleaned up their cap structure, and swapped some non-core assets for assets that better fit their portfolio (in the process selling at mid-teens multiples to buy at low to mid single digits).

 Despite that movement, SMLP knows they’re in a weird spot. The market for publicly traded MLPs isn’t exactly hot given where interest rates are (which has given yield focused investors an alternative to generally dividend focused MLPs) and that most of their peers have gone off the board. With a market cap under $200m (and no dividend), SMLP knows that the status quo can’t hold.

The thought process here is simple: SMLP is guiding to $300m in LTM EBITDA by H1’24. Let’s take them at their word (2023 EBITDA will be ~$270m and accelerating, so this isn’t some huge jump though I suspect the current nat gas environment will make that tough); their EV is currently ~$1.6B, so that puts them at ~5.5x EBITDA.

There are some issues with that EBITDA number I’ll discuss in a second, but that multiple would be an insanely low price. SMLP’s investor deck breaks out their peer multiples and some precedent transactions and notes the huge gap in multiples, with peers averaging a ~9.4x multiple..

Remember that SMLP is quite levered, so one turn of EBITDA multiple would have an enormous impact on their market cap. In fact, with ~10.4m units out and $300m in H1’24 LTM EBITDA, one turn of multiple would add ~$29/share of value….. or >150% of today’s share price!

Now, you might think that Summit is cherry picking multiples and precedent transactions to get a number that shines the most light on them. And there’s probably a little truth to that suspicion…. but we can stress test this assumption by looking at other sources. For example, DCP was acquired earlier this year, and their proxy lists Summit as a peer and includes the transactions Summit did in 2022 as precedent transactions. DCP uses a peer EBITDA multiple of 8.0x - 9.0x, and lists precedent transactions at ~7x (including Summit’s 2022 deals). Take the lowest multiple (~7) and apply it to Summit’s $300m EBITDA target, and you get a per share number that’s so silly I won’t put it in writing (alright I will; it’s over $60/share).

I don’t think shareholders are going to make out quite that well (though huge premiums in neglected MLPs are not unheard of; BKEP went for a ~50% premium), but given the huge leverage and stub equity value I do expect a full sale would go off at a substantial premium to today’s share price.

Why don’t I think shareholders will do quite that well? I think there are five issues / bear points that I’d point out to throw cold water on hoping for a mind blowing premium

First, I think there will be some anchoring; with SMLP’s share price stuck in the high teens, I think bidders would have trouble going too far over a “$3” price even if the total dollar difference between a bid that starts with a “2” and a “4” honestly isn’t that big given the huge leverage.

Second, SMLP’s assets are a real mash up in vastly different markets, which somewhat limits the operating synergies if you’re selling the whole thing. You could sell each piece one by one to a buyer with synergies, but that would take a while and introduce all sorts of sales drags and leakage. If SMLP is looking to sell everything at once (as I think they are), the mish-mash of assets will work against a big premium.

Third, ~10% of SMLP’s EBITDA is coming from shortfall payments (MVCs). To simplify, an MVC is a guarantee from a producer to move a certain amount of product (i.e. we’ll move $100 of gas through your pipes every month, and if we don’t you can charge us like we did move $100). These MVCs will expire in 2026; obviously a producer isn’t going to value those expiring MVCs like normal earnings for a variety of reasons (they limit immediate upside; any earnings growth from volumes going up is offset by MVCs going down, and when they expire they create a mini-earnings cliff if the volume hasn’t materialized). Anyway, I don’t think these are ultimately a deal breaker, but it’s just worth keeping in mind the $300m EBITDA number SMLP is touting is not a completely clean / pure number.

Fourth, it’s worth noting that ~25% of SMLP’s EBITDA comes from their DJ Basin assets, which SMLP acquired last year for ~4x. I do think this was a good, synergistic acquisition and SMLP has improved their value…. but it’s always a little strange to take an acquisition from last year and instantly nearly double its multiple / value (as we would if we valued all of SMLP at 7x versus the 4x they paid for these assets!).

The final worrying part here is SMLP is purely nat gas dependent, and nat gas has come way down since they announced their strategic review in early October (again, the “tumbling nat gas” headlines). Below is the nat gas curve today versus in early October; you can eyeball it and 2024 and 2025 prices are off $0.50-$1.00. SMLP gets paid for moving nat gas over their pipelines, and higher prices encourage more drilling and more gas production, so those lower gas prices muddies the near to medium term growth outlook for SMLP.

So, sure, there are negatives. But the bottom line is SMLP is way too cheap and ultra-levered; any acquisition will likely be at a substantial premium to today’s share price.

However, what I love about SMLP is that if I’m wrong and an acquisition doesn’t play out, there should be huge upside over the near term. Again, SMLP’s earnings are just starting to inflect up; given the leveraged structure, even small changes in earnings will drop huge levels of cash flow down to the equity.

I expect SMLP will sell themselves in this strategic process, but if I’m wrong I think the path for value realization for SMLP is clear. They’ll have a clear window for refinancing in mid-2024, and once they’ve done that they can reinitiate a dividend and start trying to lure in dividend focused MLP investors (as well as qualify for MLP indices, which I believe generally require dividend payments). EBITDA seems set for continued growth as more wells come online (again, I’m assuming that the recent natural gas weakness hasn’t completely derailed customer’s growth plans); the combination of continued growth, a growing dividend, and debt runway should create a pretty attractive equity.

And I haven’t even mentioned the most important part of the story yet. That would be SMLP’s investment in Double E.

Some background might be helpful. In 2018, SMLP reached an agreement with XTO / Exxon as an anchor customer for their double E project. They lined up all the financing for the project in 2019, and it went into operation in mid-2021.

Double E is a crown jewel asset. To simplify, the Permian is undergoing a mammoth oil boom, and it is overstocked with associated gas (natural gas produced as a byproduct of oil production). That means there’s insane demand for something like Double E that can transport this gas. On top of that crazy demand, Double E is a 1.35 Bcf/d pipeline, and it has 1.0 Bcf/d of that committed from Exxon (about as good of a counter party as you can get!).

Assets like Double E tend to go for very solid multiples. This is not a perfect comp as he assets were slightly different, but something like NEP’s sale of their Texas natural gas pipelines late last year for ~10x EBITDA serves as a nice marker of the multiples these can trade for. The combination of a super investment grade counterparty, long term commitment, and huge demand for the asset’s transportation tends to result in an asset that is super financeable, strategic, and goes for a premium price (note: I’ve also talked to multiple industry people who are familiar with the Double E asset who confirmed I was thinking roughly correctly on the value / strategic front here).

SMLP is projecting $45m in EBITDA for their share of Double E based on their current 1.35 Bcf/day capacity. There’s also the possibility to expand Double E, which would take its EBITDA to ~$60m/year (using SMLP’s numbers). At a ~10x multiple, Double E would be worth ~$150m on the lowest end and >$250m on the high end (after deducting all of Double E’s debt).

SMLP’s total market cap right now is <$200m, so there’s a decent argument that the Double E stake alone is worth all of SMLP’s market cap, leaving any upside from the rest of the business for free!

Importantly, the company’s Double E interest is held in a non-recourse subsidiary (i.e. outside of their debt, meaning it can be returned to shareholders even if the current debt package restricts other payments). So if SMLP doesn’t sell themselves now, I’d expect SMLP to look to monetize Double E in some way, shape or form in order to return capital to shareholders.

So that’s the investment thesis in a nutshell. I think

• SMLP is undervalued, likely due to its just quirky structure limiting buyers
• SMLP has huge downside protection; it’s cheap, earnings are inflecting up, and the Double E stake alone supports basically the whole market cap
• SMLP is undergoing a sales process that I think will be successful and result in a nice premium

There are three other things worth mentioning before wrapping this up.

First: management incentives. I’ve spent a lot of time talking about SMLP’s value; honestly, I’ve yet to talk to an investor who has done work on SMLP and doesn’t think asset value is materially higher than today’s share price (in particular, just about everyone notes the Double E value). The real question here is management; this is an MLP without a control shareholder. That can be the recipe for disaster / value destruction; management has wide latitude to do any deal they want inside of that structure, whether it’s good for minority investors or not. In a truly draconian scenario, SMLP could structure a deal that hits shareholders with a huge tax bill and destroys enormous value but gets management paid.

That is admittedly a risk here…. but it’s just hard for me to see how management does that. Most of the “huge tax” risks relates to retiring debt at a huge discount and passing that to shareholders; if that happened here, it wouldn’t be ideal but the huge discount would create enormous equity value and position them to generate enormous cash flows given the leverage.

I have talked to management and IR a decent bit here; my read is that they are pretty eager to sell the company (though that could easily be a sales job). They basically told me they announced the sale process because they want to sell, and they thought a public announcement could help close the bid ask spread between the initial offers they were receiving and what they’d take. My read on their body language is they are telling the truth, and it does appear all of their actions over the past few years have been to position themselves for this situation (selling noncore assets, internalizing the GP, etc. …. however, I’d note insider ownership isn’t that high here, and while management has been shifting a bit more of their pay into incentive / stock comp recently (so, again, you could argue they’ve been positioning for exactly this moment to sell), you could easily make the argument management would do better remaining a stubco and continuing to collect paychecks for a few years. Again, I don’t think that’s the case; management sounded like they wanted to wrap this up when I talked to them and like they knew the status quo couldn’t hold, but it’s worth considering.

That bleeds into my second point: it is possible SMLP decides to conclude the strategic review by doing a merger of equal style deal instead of selling themselves. They could find some private equity pipeline company and do a stock deal that lets the company come public and while solving a lot of SMLP’s scale / leverage issues. I would not be too excited for this plan, and when I talked about it with management it sounded like they were much more interested in it than I would be. Would a stock deal that kept SMLP public / effectively used them as a buyer be ideal? No, absolutely not….. but given the valuation of SMLP, it’s hard for me to see how any deal that gets them scale (and, importantly, gives them line of sight to returning a bunch of cash flow to shareholders) really hurts equity holders from these prices.

Finally, just a note on SMLP asset quality outside of Double E. I tend to think of their assets as a big mash up that are probably on the lower end of quality. That doesn’t mean they’re bad; just that they’re not worth huge premiums / multiples! I would support that with the fact SMLP bought a good chunk of these assets last year at a 4x multiple and how much of their earnings are coming from MVCs that expire in the short term. However, I’ve talked to industry people who are all over the place on the quality of these assets. No one thinks these are the best assets in the world, but some think these are pretty good assets (i.e. better than average), and some agree with my take that these are below to well below average. That disparity of viewpoint as honestly a good thing; all takes is for one buyer to think these assets are worth 8x instead of 7x or 6x to get a nice premium for them, and given the leverage on SMLP a nice premium could result in a mammoth return for equity holders.

Alright, I’ll wrap it up here and field comments in the questions… though I hope / suspect this will be off the board come mid-March, so hopefully I won’t be fielding them for too long!

PS- just a note on downside. I think SMLP is running a serious sales process and will hit credible bids…. but what happens if they don’t sell themselves? I think in the medium to longer term the stock goes higher as earnings inflect up and SMLP’s cash flow causes rapid deleveraging / the company does a full refi and initiates a dividend, but in the immediate term it’s worth noting SMLP’s stock was trading ~$14/share before the sales announcement and the MLP index is up slightly since then (AMLP is up ~9% since the announcement) . So the downside in a break is maybe $13-14/share (assuming a somewhat sloppy exit in an illiquid stock), which seems like a great risk reward versus the potential for a bid with a large premium and considering the asset value here.

PPS- while insider ownership isn’t huge, it’s worth noting that SMLP management has generally been converting their cash bonuses into stock recently (see their 2022 proxy, “As discussed further below, as part of our “cash-to-phantom program,” Messrs. Deneke, Mault, and Johnston each elected to forfeit cash retention in exchange for phantom units generally subject to the same terms and conditions as the cash retention component forfeited. See “—Long-Term Equity-Based Compensation Awards” for more information.”), so while you’d love to see more insider ownership / better alignment you could certainly point to that decision and say management sees both the value here and the near term unlock possibilities.

Catalyst

Sale of company