Description

Summit Midstream Partners, LP (SMLP)

Recommendation

SMLP is an over-levered, independent natural gas, crude oil and produced water gathering and processing limited partnership with operations across six resource plays in the continental U.S.  It was formed in May 2012 and began operations in October 2012.  After a series of transactions in 2020, SMLP now owns 100% of its GP and there’s full alignment between unitholders and the GP.  Public shareholders own 100% of the outstanding units.  

The Company has experienced a rough few years to put it mildly.  It is yet another casualty in a string of many where aggressive dropdowns from a sponsor at inflated prices eventually led to ruin.  As recently as FY18, SMLP was paying annual distributions of ~$34.00/unit (units trade at ~$20.00 today) whereas today it's zero. Below is a 5-year chart of the units:

The good news is that they’ve somehow managed to survive. And while the name appears to be orphaned and left for dead by investors, likely because distributions have been suspended and will continue to be for at least another year, the future doesn’t seem hopeless as the chart above suggests.  I’ve been a bondholder of the 5.5s for several quarters but as the price creeps closer to par, have started to dip into the more junior and riskier parts of the capital structure.  While there’s a lot more wood to chop, I’ve been impressed with the capital allocation actions taken by management to derisk the balance sheet in a very short period of time.  These actions, which eliminated $783mm of obligations at face value (at a cost of $305mm), have been highly accretive to unit holders given the substantial purchase discounts that have been captured across the capital structure.  

Buy unsecured bonds.   The 5.5s at 94 are no longer super interesting but still offer a CY of 5.9% and a YTM of 9.9%.  The risk here is on the lower side as the Company will likely do a 2nd lien offering to pay off the bond at maturity.  The recent credit amendment with a carve out for junior lien debt telegraphed the outcome.  The 5.75s at 81 are more interesting as they offer a CY of 7.1% and a YTM of 11.6%.  The valuation here is reasonable as the bond creates the Company at around 5.0x EBITDA.

Buy 9.5% preferreds.  These trade in the high 30s and the Company recently tendered for a big chunk, paying 33.  The distributions are currently suspended but continue to accrue.  With 5.2 turns of leverage ahead of them, I think the risk/reward here is attractive, particularly ahead of the potential resumption of the distributions as early as in FY22.

Buy common units.  The market cap of SMLP is only $137mm and there are ~$1.5bn of obligations senior to the units.  Obviously, this security has to be considered very speculative and should be sized accordingly.  But the valuation at ~6.5x EBITDA is not extreme and you get free optionality on the Double E pipeline project that is scheduled to come online later this year.  As I discuss below, there is significant potential value to the equity from this project that doesn’t appear to be reflected in the current valuation.  Meanwhile, the Company will continue to generate free cash flow allowing for further deleveraging – for FY21, I’m estimating $85mm of cash generation but could be higher depending on capital expenditure spend.  

Core to my thesis is that energy should disproportionately benefit from reopening the economies around the world and post-covid normalization.  Refined product demand should recover and lower oil production supports improvement in both oil and natural gas prices.  NGL inventory drawdowns driven by ethylene steam cracker restarts and Asian LPG export demand should drive improved light end pricing and processing economics thus incentivizing greater NGL-directed natural gas drilling.  Where could the units trade post recovery?  No one really knows when there’s this kind of leverage involved.  If they tripled in price, you’d still be creating the assets at less than 8.0x EBITDA, again ignoring any Double E benefit.  Assuming we do see increased drilling and higher throughput volumes as the country normalizes, it’s reasonable to believe that the Company resumes paying distributions next year, which would result in a significant rerating of the units.

It should be obvious that there’s regulatory risk here with the new administration.  What they intend to do with fracking and what that means for the fossil fuel industry is beyond my pay grade.  My working assumption, perhaps a foolish one as a generalist, is that the administration will take a moderate/centrist approach to the industry without sweeping legislative reforms that really harms the O&G industry. 

There’s also the terminal value/energy transition risk that has long been debated by folks looking at valuing and investing in midstream assets.  Do I have a strong view on the useful life of SMLP’s assets?  I’d be lying if I said I did.  To me, this is a special situation and not a bet on an entire industry.  I believe SMLP will throw off plenty of free cash flow in the near to mid-term and if debt maturities can be extended, this name will work even if industry multiples don’t expand.

Finally, speaking of debt maturities, if the Company can’t extend the credit facility past its maturity in May 2022, then its game over for the Company and investors will lose money.  The recent amendment to the credit agreement suggests that the bank group continues to be very accommodative to the Company and my working assumption is that the facility will be extended.

Summary of Recent Actions

Management came to the conclusion in 2019 that the Company was well on its way to insolvency if the status quo was maintained.  They had to aggressively attack the balance sheet and that is exactly what has happened in a remarkably short period of time.  In late 2019, SMLP began implementing a plan designed to strengthen the balance sheet, increase financial flexibility and reduce costs to mitigate the impact of industry headwinds.  They had a four-step plan and they’ve executed on it nicely. 

First, the Company agreed with its then GP sponsor, Energy Capital Partners, to acquire Summit Midstream Partners, LLC (also called Summit Investments). This transaction came with 5.9mm SMLP common units that were owned by ECP. Total consideration for this transaction was $35mm in cash plus 10mm warrants.  SMLP's acquisition of Summit Investments includes all of its subsidiaries, including SMP Holdings. SMP Holdings is the owner of the GP interest in SMLP. It owns 45.3mm common units and a $180mm deferred purchase price obligation receivable. SMP Holdings also had a $158mm term loan (non recourse to SMLP) that was outstanding.  Also in connection with the transaction, ECP agreed to provide a first lien senior secured loan to SMLP to provide the partnership with additional liquidity. This transaction aligned the Company with the interests of common and preferred unitholders and creditors. ECP's directors, who had controlled the board, resigned and the new board going forward will be comprised of a majority of independent directors.

Second, the GP buy-in transaction enabled SMLP to suspend its common and preferred unit distributions in May 2020, which at the time accounted for ~$76mm of annual cash outflows. These savings along with liquidity from the $35mm loan proceeds from ECP provided significant financial flexibility to prioritize delevering the balance sheet.

Third, post the GP buy-in transaction, the Company repurchased ~$307mm of face value of senior notes.  In total, 46% of the two bond issues have been repurchased and retired at a weighted average discount of 37%.  Additionally, in July 2020, 62,816 preferred units were exchanged for 12.3mm common units in a cashless exchange. This reduced the outstanding preferred balance by $62.8mm, which implied an 84% discount based on trading prices then.  In December 2020, the Company tendered for 75,075 preferred units at a price of $333.00/unit, for a purchase amount of $25mm, implying a discount of 67%.  

Fourth, the Company retired the $155.2mm non-recourse loan at SMP Holdings via a consensual out of court restructuring.  This transaction also fully settled the $181mm deferred purchase price obligation. Total consideration for this transaction was a $26.5mm payment to SMP Holdings. SMP Holdings used this cash together with the 34.6mm SMLP common units that were pledged as collateral for the loan as consideration provided to the lenders. 

Putting this all together, these transactions collectively eliminated more than $783mm of obligations (at a cost of $305mm) since first initiating the GP buy-in transaction in May 2020.  The chart below summarizes all the transactions and their impact on the balance sheet (note that it does not reflect the preferred tender from December):

The following chart shows the simplification of the Company’s organizational structure post all these transactions:

Quick Comment on Potential Adverse Tax Consequences

I’m sure you’re wondering after reading the above section whether there will be any significant tax consequences for unitholders, common and preferred.  Clearly a lot of claims were repurchased or settled at large discounts in FY20 and corresponding large gains have already been booked on the P&L with some more to come in Q4.  How much exposure the unitholders have, which holders in particular have exposure, when it is safe to buy, etc. are all valid questions to ask if considering investing in SMLP.  I’m aware of the risks and have tried getting clarity from more experienced folks but am not qualified or comfortable to say with any confidence that I have good answers.  The K-1 will be out shortly and so perhaps we won’t have to wait long to get all the answers.  It’s a risk but I think you can mitigate it by sizing the position accordingly.  

Business Overview

The Company’s midstream energy infrastructure assets gather natural gas from pad sites, wells and central receipt points connected to its systems. Natural gas is then compressed, dehydrated, treated and/or processed for delivery to downstream pipelines serving processing plants and/or end users. The Company also contracts with producers to gather crude oil and produced water from wells connected to its systems for delivery to downstream pipelines and third-party rail terminals and disposal wells.  

A majority of the volumes that the Company handles have a long-term, fixed-fee rate structure providing some stability to cash flows as revenues are not completely subject to volatile commodity prices. The majority of the gathering agreements are underpinned by areas of mutual interest (AMI) and minimum volume commitments (MVC). AMIs provide that any production drilled by customers within the AMIs will be shipped on the Company’s gathering systems. MVCs are designed to ensure that SMLP generates a minimum amount of gathering revenue over the life of each agreement in the event of a customer’s decision to cancel or delay drilling and/or completion activities or temporarily shut-in production.  The weight average contract life is 8.7 years and fee-based gross margin is greater than 95%.  However, the Company is exposed to some commodity price risk from selling natural gas and/or NGLs and condensate under various arrangements with customers.  These activities account for ~12% of revenues.   There is indirect exposure to changes in commodity prices in that persistently low commodity prices will cause delay and/or cancelations of drilling and/or completion activities or temporarily shut-in production, which would reduce the volumes of natural gas and crude oil (and associated volumes of produced water) that go through the Company’s gathering systems. 

The Company operates systems in the following six basins:

• Appalachian Basin, which includes the Marcellus and Utica shale formations in West Virginia and Ohio.  The two systems in this basin are Mountaineer Midstream and Summit Utica.

• Williston Basin in North Dakota, which includes the Bakken and Three Forks shale formations.  The two systems in this basin are Bison Midstream and Polar & Divide.

• Denver-Julesburg Basin, which includes the Niobrara and Codell shale formations in Colorado and Wyoming.  Niobrara G&P is the system in this basin.

• Permian Basin, which includes the Bone Spring and Wolfcamp formations in New Mexico.  Summit Permian is the system in this basin.

• Fort Worth Basin in Texas, which includes the Barnett Shale formation.  DFW Midstream is the system in this basin.

• Piceance Basin in Colorado, which includes the liquids-rich Mesaverde formation as well as the emerging Mancos and Niobrara Shale formations.   Grand River is the system in this basin.

Given the current balance sheet and cash flow constraints, SMLP will concentrate the majority of the capital expenditure budget on what it considers are core areas - Utica Shale, Ohio Gathering, Williston Basin, DJ Basin and Permian Basin.  Core focus areas are well positioned for highly accretive growth as oil and gas market fundamentals improve.  Legacy areas in particular are much less prone to cash flow volatility given the mature wedge of low declining PDP production and high levels of MVC underpinnings throughout 2026.

SMLP also has two equity investments.  It operates Double E Pipeline, LLC, which is developing natural gas transmission infrastructure that will provide transportation service from multiple receipt points in the Delaware Basin to various delivery points in and around the Waha Hub in Texas. It also has an equity investment in Ohio Gathering, which operates extensive natural gas gathering and condensate stabilization infrastructure in the Utica Shale in Ohio.  

Double E Project

Double E is a 135-mile project that is owned by SMLP (70%) and ExxonMobil (30%).  It will interconnect with three major eastbound pipeline projects: Kinder Morgan’s Gulf Coast Express and Permian Highway Pipeline and Energy Transfer’s Trans-Pecos Pipeline. The 1.35 Bcf/d pipeline will allow for increased transportation to the Waha hub in West Texas of Permian supply, which is forecast to reach 15.5 Bcf/d in 2023, further connecting the core producing basin to downstream demand markets.  Despite the broader industry downturn, the Double E pipeline continues to be a critical natural gas infrastructure project that is necessary to provide incremental takeaway capacity to help eliminate flaring and support further development of the northern Delaware Basin, which remains one of the most economic regions for oil and gas production in the world. 

Last month, the Company announced that the project received its Notice to Proceed with construction, as well as approval of its Implementation Plan, from the Federal Energy Regulatory Commission.  SMLP expects the project to come online in Q4 2021.  It’s 70% share of the development capital is estimated to be ~$300mm, of which about $175mm remains to be spent.  Earlier this month, the Company got a commitment letter from three banks that provides up to $175mm in financing to fully fund the development costs to finish Double E.   

Double E would be among a handful of other pipeline projects aimed at transporting supply out of the once-constrained Permian.  Kinder Morgan brought the Gulf Coast Express pipeline into service in 2019 and the Permian Highway Pipeline online in 2020. The 2 Bcf/d Whistler project, backed by MPLX, WhiteWater Midstream and a JV between Stonepeak Infrastructure Partners and West Texas Gas, was the third greenfield project out of the basin when it came online in 2020.  Double E’s projected in-service later this year would coincide with an expected recovery from the pandemic as the country rapidly gets vaccinated. 

What’s Double E worth to SMLP?  It’s hard to say since management hasn’t publicly provided any guidance, as far as I can tell.  But we can try and triangulate based on the limited information that has been disclosed.  We know that a bank group provided $175mm in financing to the project (for SMLP’s 70% share).  I’m not a O&G commercial banker but it seems reasonable to assume that they would make this loan at or around 4.0x their expectation for EBITDA (again, for SMLP’s 70% share).  This implies that EBITDA is expected to be in the $40 – 50mm/year range.  Based on my scan of how midstream businesses are valued today, I’ve assumed an 8.0 – 9.0x EBITDA multiple range to value this asset.  Obviously, this is a brand new constructed asset and so in theory, may command a premium multiple.  This provides a valuation range of $300 – 450mm for Double E.  Netting out the bank financing and the max redemption amount of preferred stock (discussed below), I arrive at SMLP’s equity value in the project of $30 – 170mm.  My gut tells me that the number is closer to the high end of the range than to the low.  Bear in mind that SMLP’s market cap is only $137mm and this asset is housed within an unrestricted subsidiary.  Its possible, unless I’ve missed something critical, that Double E on its own provides substantial asset coverage for SMLP’s market cap, if not all of it.    

Capitalization

The Company has a market cap and enterprise value of $137mm and $1.76bn, respectively.  At the secured level, there’s a $1.1bn senior secured revolving facility that matures in May 2022. As of Q3, I estimate the outstanding balance on the facility to be $925.3mm (pro forma for final $27mm DPPO payment in October, $64.8mm for the purchase of the 5.75s in October, and $25mm for the preferred tender in December).  I estimate that availability on the line is ~$86mm but could change since we haven’t gotten new disclosure post recent credit amendment.  This along with the $50mm of cash on the balance sheet and the cash flow generation provides sufficient liquidity to run the business for at least the next year.  The facility provides a basket for the issuance of up to $400mm of junior lien debt which I suspect will be tapped to take out the 5.5s next year.  The facility has a first lien leverage and a total leverage covenant of 3.50x and 5.75x, respectively.  As of Q3, the Company was in compliance with all covenants – total leverage ratio and senior secured leverage ratio were 4.9x and 2.7x, respectively.

The Company also has two unsecured bond issues with a total face amount of $493.5mm.  The 5.5s mature in August 2022 and the 5.75s mature in April 2025.   

The Company also has two preferred unit issues.  The first is what they call Subsidiary Series A Preferred Unit that currently has a notional amount of $85.8mm.  This security sits at an unrestricted subsidiary of SMLP called Permian Holdco, which owns the 70% interest in Double E.  In connection with the formation of Permian Holdco, SMLP entered into an agreement with TPG Energy to fund up to $80mm of capital calls associated with the Double E Project.  The distribution rate is 7.00% per annum and can be PIK’d until the earlier of June 30, 2022 or the first full quarter following the date the Double E pipeline is placed in service.  The units have priority over the common unitholders with respect to the cash flow from Permian Holdco. If the units were to be redeemed today, the redemption amount would be ~$105mm when considering the applicable multiple of invested capital metric and make-whole amount provisions.

The other preferred issue sits within the restricted group and is called Series A Preferred Units.  SMLP issued them in 2017 with a notional amount of $300mm.  The balance is now down to $174.4mm after last year’s exchange and tender.  Currently suspended, the distribution rate through December 2022 accrues and are cumulative at the rate of 9.50% per annum; thereafter, it accumulates at L + 7.43%.  The unpaid distributions currently totals ~$19.7mm.

SMLP currently has 6.1mm common units outstanding.  Additionally, the old sponsor was given 0.67mm warrants with a strike price of $15.345/unit as part consideration for the GP buy-in transaction last year.  In my model, since they’re in the money, I’ve added these units to the share count and adjusted the cash balance accordingly. 

Summary Financials

The last couple of years have been challenging for SMLP as well as the entire midstream sector. The prospects for FY20 were weak even prior to covid as many midstream executives were expecting further declines in drilling and completion activities across N.A.  The O&G market was in an oversupply situation, which obviously weighed on commodity prices. The natural gas market was particularly challenged as production surplus and one of the warmest winters on record crushed forward prices.  Not surprisingly, upstream companies responded to lower prices with lower rig counts and deferred completion activity. Then covid hit which resulted in a collapse in demand and things got even worse for producers.  

Pre-covid, SMLP had guided to EBITDA of $260 – $285mm for FY20.  The mid-point of the guidance assumed a 45% reduction in new well connects on its systems in FY20 as compared to FY19.  Lower volumes due to covid impact will result in FY20 EBITDA coming in around $255mm.  The core regions will show a small decline in Y/Y profitability whereas the legacy regions will experience sharper declines.  For FY21, I’m assuming some Y/Y improvement in profitability but not much.  I’m forecasting EBITDA of $260mm for the year which assumes marginal improvement in the core regions and slower declines in the legacy regions.  We haven’t gotten guidance for capital expenditure spend for FY21 yet, but I’m assuming $115mm for the year, nearly double what was spent in FY20.  Based on this forecast, cash generation should approximate $85mm for the year.  

The P&L has benefited, even in a difficult macro environment like the current one, from having a diversified asset base.  When some systems/regions are declining, others are stable or even growing.  

Valuation Thoughts

I believe the business is worth $1.6 – 2.3bn.  I’ve assumed that the Company is capable of generating $240 – 280mm in EBITDA in the short-term.  Barring one or more customer bankruptcies out of the blue, this range doesn’t feel like a stretch given the long-term contracts and MVCs in place.  A below market 6.5 – 7.5x EBITDA multiple range seems appropriate given the balance sheet risks here. Included in this valuation is my estimate for SMLP’s equity value of $30 – 170mm in Double E that was discussed earlier.  Obviously, this assumes that the project is completed on schedule and on budget and has agreements in place with customers that deliver the type of profitability that SMLP was anticipating.  This gets me to a wide valuation range of $9.00 – 109.00/unit for the Company, which is not unusual for a security with this profile in a highly cyclical industry.  

Please find below industry valuation multiples for a group of MLPs, both large and small. The larger, more diversified names trade around 10.0x EBITDA whereas the smaller ones are in the 8.0x range.  I feel comfortable underwriting SMLP at 6.5 – 7.5x.     

Catalyst

* Vaccination and post-covid normalization

* Extension of the credit agreement in FY22

* Refinance of the 5.5s in FY22