Thursday, August 27, 2020

Summit Midstream

While many parts of the market have somewhat recovered towards or even above their pre-COVID highs, the energy industry has not fared as well. Over-capacity has resulted in product pricing that is still low. Unfortunately, predicting cash flows in upstream energy companies is very difficult. Not only is it hard to determine the price the company will receive for its product, but it's also tough to know what it will cost to pull the product out of the ground.

But midstream companies can offer a little bit more cash flow certainty. The fees for gathering and processing are set out in contracts, which often specify minimum usage requirements and last many years. In a lot of cases, the product continues to flow through existing wells and pipes, without much need for capex. And yet, one can find companies in this space whose stock prices are as decimated as any solvent upstream company. Consider Summit Midstream Partners (SMLP).

Unit prices are down 50% since the beginning of June and 75% so far this year. But despite now having gone through a disaster of a quarter from a demand point of view (lockdowns leading to production shut-ins, incomplete wells etc), they estimate adjusted EBITDA for 2020 of about $255 million and capex for the year of around $40 million. Enterprise value is $1.9 billion, for a fairly attractive EV/FCF ratio, with a weighted average contract length of almost 9 years.

There is an opportunity here to make multiples of the current share price, however. That's because only a small part of the company's enterprise value is in the form of equity: the company's market cap is just $45 million. This is a highly leveraged situation, resulting in a high-risk / high-reward scenario.

The company has taken a number of steps to reduce leverage. It has been buying its debt at a discount, and continues to do so, having just come out yesterday with a $60 million offer to purchase 2022 and 2025 bonds at big discounts to par. It has converted some of its pref shares to common (at a huge discount to par). And it has also stopped distributing cash to shareholders, keeping that $76 million in annual distribution to instead reduce leverage. While these latter two moves make the company's equity safer in the long run, I suspect they are putting major pressure on the current unit price, leading to this opportunity: yield-chasers want nothing to do with this company anymore, and are likely voting with their feet.

The company is also seeking to partner for its capex obligations in its growth segments, and is open to asset sales to reduce leverage even further. In the company's legacy areas, it requires only maintenance capex ($0.3 million in Q2) and generates solid cash flow ($35 million in Q2 segment adjusted EBITDA) that it can apply towards debt.

In my opinion, this is a situation where the odds are very good for the investor, especially considering the returns could be multiples of the current stock price. But, because the downside risk is high, I only make this a basket position, similar to what I do with financials, home builders, shippers etc. where leverage is high and the potential for total loss is not zero. The counterparties to the contracts could go under, though this is mitigated by a diversified asset-base across several formations. (A couple of customers have already gone bankrupt, and Summit has renegotiated the terms before they went to court, lowering fees but increasing incentives for further drilling.) Political issues could also result in uneconomic terms for producers: a Democrat sweep in November could lead to environmental policies that would be detrimental to an energy company with such high leverage. The company may not be able to refinance its near-term debt.

But overall, I see this as an asymmetric bet that belongs as part of a diversified portfolio.

Disclosure: Author has a long position in SMLP

5 comments:

Brian H said...

Thanks for the interesting idea. It is quite asymmetric and it's interesting how tactical and active they're being in addressing the current issue.

It's hard to think of a worse 4 years than the last 4 for energy investors. A Biden win I suspect would be far more favorable for energy incumbents across the board, as more restrictions, regulations, costs would likely inhibit supply growth and new entrants.

Unknown said...

Interesting.

The gain on the repurchase of debt might result in phantom income. See p. 44 of the most recent 10-Q.

Thoughts on that?

Thank you.

John





Jake said...

They have a maturity in 2022... Do you think they can refi that?

Saj Karsan said...

Thanks Brian, but because there is a decline rate associated with wells, I don't agree that it would be good news for the companies paid by volume to carry these liquids if regulations increased costs.

Hi John, one-time gains from debt repayments at discounts are not included in estimates of adjusted EBITDA that I discussed in the article.

Hi Jake, I don't know. This is why it's a basket position for me. If they can keep deleveraging, generating cash and keep expenses low, I think they should be able to, but there are no guarantees here.

Anon said...

What causes me a pause in these types of companies is that their current dismal financial picture is a result of management's poor past investing decisions. This will be a good investment if management improves in this regard.

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