A Deeper Dive Into SMLP
An overview of company's assets, valuation and potential catalysts
Today, I’m sharing my additional research and thoughts on Summit Midstream Partners (SMLP), a portfolio idea that I highlighted several weeks ago. You can find the pitch summary here. For a quick recap, SMLP is a natural gas gathering-focused MLP that has recently divested several of its non-core assets. Pro forma for the divestitures, the company is cheap, trading at only 6x 2024E pro forma EBITDA compared to 8x+ multiples for peers and SMLP’s recent divestitures.
However, with SMLP stock already up nearly 2x since the first divestiture announcement in March, it is important to have a more granular look at the company’s assets and their normalized profitability to estimate the company’s value and, thus, the potential remaining upside.
Another important question is, "How does the underlying value get realized?" The key to answering this question is to consider the potential catalysts.
So this article focuses on the following aspects of the investment thesis:
An overview of SMLP’s key assets and their historical and expected/normalized operational performance.
An updated sum-of-the-parts valuation.
A look at the potential catalysts that could help unlock value, primarily the C-Corp conversion and potential dividend reinstatement.
TL/DR: Even after the share price run-up, I continue to think that SMLP is an attractive setup. The company continues to trade significantly below its fair value while there are two looming catalysts, namely potential dividend reinstatement and the C-Corp conversion.
Now, let’s dive in.
Assets And Their Operational Performance
SMLP operates natural gas gathering, processing, and transmission assets located across five shale basins in the US (see the slide below). SMLP’s assets generate revenues primarily from transportation and processing fees that are largely based on the natural gas volumes (as opposed to prices), resulting in very stable revenue streams. The company boasts multi-year contracts (>7-year average weighted contract life), with a significant part of the customer base comprised of tier-1 O&G E&P players such as Exxon Mobil and Chevron. The key driver of revenue growth is new well connections, i.e., crude oil or natural gas wells that are connected to SMLP’s existing midstream infrastructure network.
Below is a more detailed overview of SMLP’s key remaining assets by segment and their historical/projected operational performance.
Barnett
The Barnett segment includes SMLP’s DFW Midstream system located in Texas, comprised primarily of natural gas gathering pipelines. Services are provided on long-term, fixed-fee contracts, with a weighted average remaining life of 4 years as of Dec’23. The key customer is the French oil supermajor TotalEnergies.
Barnett segment’s average throughput and utilization have been in decline in recent years, driven largely by a low number of new well connections (see the table and the slide below). More recently, 2023 operational performance has been impacted by a customer shutting down its production (c. 30MMcf/d or 15% of 2022 Barnett volumes) due to low natural gas prices, with the segment recording $26m in segment-level EBITDA (vs $32m in 2022). However, management has stated that it expects the customer to return to production in the near term. This, coupled with the projected significant new well connections (15-20 guided for H1’24 vs 0-12 annually during 2019-2022), is expected to lead to increasing volumes. Given these points, I use $30m as Barnett’s normalized 2025 EBITDA estimate. Worth noting is that the incremental capex required for new well connections is expected to be minimal.
Piceance
The segment comprises SMLP’s Grand River natural gas gathering system located in the Piceance Basin. The system primarily gathers natural gas produced from wells in the liquids-rich Mesaverde formation. The asset boasts long-term, fixed-fee contracts, with a weighted average remaining life of 9.7 years as of Dec’23. Key customers include Caerus Oil and Gas and Terra Energy Partners.
Natural gas volumes gathered/processed by the asset, and hence EBITDA, have been steadily declining in recent years (see the table below). This has been driven primarily by a lack of/limited new well connections during 2019-2022 (see the chart below), leading to lower asset utilization. While new well connections picked up significantly in 2023 to 56 (vs 0-9 during 2020-2022), management expects no new connections in 2024, which is expected to lead to a “modest decline in volume and EBITDA compared to 2023” ($60m in 2023 EBITDA). This, coupled with Barnett’s historically declining throughput/utilization, suggests that penciling in $50m in 2025 EBITDA is likely to be reasonable.
One aspect worth pointing out is that Piceance generates a significant portion of its EBITDA from minimum volume commitments (37% in 2023). These are contracts obligating customers to transport specified minimum volumes of natural gas. Given that these MVCs are expected to expire in the coming years (weighted average life of 3.2 years as of Dec’23), the segment’s EBITDA might potentially decline going forward, barring any significant increase in natural gas prices.
Rockies
SMLP’s Rockies segment encompasses two midstream assets targeting crude oil-oriented formations in the Williston and DJ Basins:
Polar Midstream and Epping: crude oil and produced water gathering systems and transmission pipelines located in North Dakota (Williston Basin). The asset generates long-term, fee-based revenues, with customers including Chord Energy, Zavanna, Enerplus, and Kraken Resources.
Niobrara G&P System: natural gas gathering and processing systems located in Colorado and Nebraska (DJ Basin). These systems generate long-term, fee-based revenues from customers including Bison Oil and Gas IV, Chevron, and Civitas Resources.
During 2017-2019, the Williston Basin sub-segment's throughput and EBITDA grew significantly due to a large number of new well connections, before experiencing a Covid-induced slowdown in 2020-2022 (see the table below). In 2022, SMLP divested one of its Williston Basin assets and acquired several additional assets located in the DJ Basin. This led to significant increases in volume and profitability, with EBITDA reaching $87m in 2023 (vs $58m in 2022). Management has guided for 100-130 further new well connections (vs. 23-61 during 2020-2022 and 159 in 2023), which is expected to boost average throughput by c. 25% compared to 2023 levels. Moreover, the company expects $5-$10m in incremental savings from the ongoing optimization of DJ Basin acquisitions, including debottlenecking initiatives. Therefore, penciling in $110m in Rockies 2025E EBITDA appears to be reasonable, if not conservative.
A quick note on capex: Management has guided for $20-$25m for total company growth capex in 2024 and stated that most of it will be related to new well connections in the Rockies segment.
Permian
The Permian segment houses SMLP’s crown jewel asset, a 70% ownership stake in Double E, a natural gas transmission asset located in the Delaware Basin (part of the Permian Basin). Double E has a transmission capacity of 1.35 BCf/d, with over 1 BCf/d already committed under long-term contracts, a large portion of which are expected to come from the anchor customer Exxon Mobil.
Since Double E became operational in 2021, the asset’s production has been rapidly ramping up (see the table below), reaching 467 BCf/d (36% of the current capacity) in Q1 2024. During the Q1 2024 earnings release, SMLP highlighted a new 10-year 75 MMcf/d contract with Matador Resources and noted the receipt of additional non-binding bids for 10-year contracts totaling 150 MMcf/d.
Management has estimated that at full current capacity, the company’s share of Double E’s EBITDA would stand at $45m (vs. $24m in 2023). On top of that, SMLP has highlighted plans to expand Double E to 2 BCf/d capacity, which is expected increase the asset’s EBITDA contribution to $60m.
While management has noted that reaching 1.35 BCf/d and 2 BCf/d capacity would require incremental capex of $20m and $60m respectively, it is expected to be financed with non-recourse asset-level financing.
Updated Sum-Of-The-Parts Valuation
Below is my 2023-2025 EBITDA bridge, with estimates of the profitability for each of SMLP’s assets as well as corporate overheads:
Piceance: $60m >> $50m.
Barnett: $26m >> $30m.
Rockies: $87m >> $110m.
Permian: $24m >> $45m.
Corporate overheads: $25m >> $27m.
This results in $208m in 2025E EBITDA, implying a 5.7x multiple at the current share price levels.
So, what could be the potential upside from here? As shown in the SOTP calculations below, valuing Double E at 10.5x EBITDA and SMLP’s remaining assets at 8x implies a price target of $76 per share, suggesting a potential doubling from the current share price levels (see the table below). The margin of safety seems sufficient, as even with a much more conservative valuation, there would likely be some upside from the current share price levels. Valuing SMLP (including Double E) at 6.5x would imply a price target of $38 per share. Note that this valuation multiple is likely too conservative, given that SMLP’s comps AM, CEQP, OKE, DTM, ENLC, and ETRN are currently trading at 8-11x forward EBITDA multiples, while comparable industry transactions have been completed at substantially higher 10x+ multiples (see the slide below).
Potential Catalysts
With seemingly significant latent value in the stock, the question is, "What are the potential catalysts that could help unlock the underlying value?"
One potential near- to medium-term catalyst is the planned C-Corp conversion. SMLP’s management has recently stated that it is “making good progress in preparing for the previously announced C-Corp conversion,” and the company expects to seek shareholder approval for the conversion during the equity holder meeting in Q3’24. The conversion would likely lead to a significant share price re-rating, given that the current MLP structure limits the pool of potential investors and liquidity, as passive indexers are unable to own MLPs. These dynamics have been well explained by the management of Calumet Specialty Products, another MLP with a planned near-term C-Corp conversion. See the excerpt from CLMT’s Q1’24 earnings call below:
Let's turn to Slide 4, and I'll start with an update on our C-Corp conversion. In short, the conversion remains on track, and we are optimistic that we'll complete the process in the next 60 days. […] We continue to be optimistic about the opportunity this conversion provides for Calumet and our unitholders. Our current shareholder base is comprised of our general partner, insiders, a small group of loyal and significant deep value investors and a broad set of retail investors. It's a good, stable investor base, but it lacks large institutional investors and passive index funds. Passive investment strategies now make up over 50% of the public equity market, yet they own almost 0 Calumet as most indices can't hold MLPs by Charter. From a pure technical trading lens, this conversion is arguably one of the most important strategic steps the company has ever taken. Since we initially announced the conversion, we've seen an increase in our average daily trading volume of a little over 20%. The trading volumes are still quite illiquid compared to most publicly traded companies, and this conversion is a major milestone in removing that burden. For example, Calumet C-Corp peers typically have 20% to 30% of their shares outstanding held by passive indices. And again, we have almost none. The ability to add significant demand to the investor pool is exciting in itself, but we think it's compounded with the fact that Calumet presents a compelling opportunity to larger active institutional investors. We've been on the road talking to this group since our announcement. And like I mentioned with passive indices, our MLP status put most of this group practically off limits. Of course, this all changes post conversion.
Several other points suggest that SMLP stock might potentially re-rate in a conversion scenario:
In December 2019, Hess Midstream completed its conversion from an MLP to a C-Corp. HESM shares had been gradually rising months before the announcement as well as weeks after the conversion, before a Covid-induced slump. However, HESM shares have since recovered from Covid lows and are currently trading approximately 60% above the C-Corp conversion levels.
After facing pressure from activist shareholder Energy Income Partners to pursue a C-Corp conversion in late 2020, midstream MLP Magellan Midstream Partners provided an assessment of the potential benefits of the conversion. As shown in MMP’s presentation from Feb’21 below, C-Corporations had generally been trading at higher multiples than comparable MLPs.
More recently, after Magellan’s announced merger with ONEOK in 2023, Energy Income Partners opposed the transaction due to the taxes expected to be payable by Magellan equity holders. As part of its opposition, the activist highlighted the outperformance of large private equity players Blackstone, Apollo, and KKR after their transition from MLP to C-Corp structures versus their competitors which were already structured as C-Corporations (see the table below). The outperformance was observed both after the C-Corp conversion announcement as well as after the conversion completion.
Another, and perhaps equally important, catalyst could be the potential dividend reinstatement. Amid higher leverage and subsequently declining EBITDA generation due to Covid, SMLP was forced to suspend the regular distribution back in 2020. However, with EBITDA picking up in recent years and SMLP receiving significant proceeds from divestitures, the company now seems to be in a solid position to reinstitute the dividend shortly. During 2014-2018, SMLP boasted a distribution coverage ratio of 1x-1.2x. Assuming a 1.2x DCR on SMLP’s 2025E distributable cash flow, the company could pay out a dividend of $6.90/share, implying a 20% dividend yield. This is admittedly substantially above historical 2014-2017 dividend levels (5%-12%), so a more realistic target is probably a 10% dividend yield. At this dividend level, the DCR would stand at 2.4x, implying plenty of headroom to reinstitute the dividend. This move would likely help lure in dividend-focused MLP investors, thus creating upward pressure on the stock price.
There seem to be several hurdles before the dividend can be reinstated, but I’d expect these to be resolved in the near-term:
Achievement of SMLP’s net leverage target ratio of 3.5x. The company seems to be on track to reduce net leverage from 3.9x currently to its 3.5x target. After the recent divestitures, SMLP has already launched tenders to repurchase part of its debt (up to $19m in March 2024 and up to $215m in May 2024). With continuing cash flow generation, I’d expect the company to reach the target net leverage level shortly. Management has recently reiterated that reducing leverage to the target net-debt-to-EBITDA ratio remains the key priority.
Look, I think we're -- target goal #1 is to kind of maintain leverage and try to achieve our long-term target of 3.5x.
[…]
Obviously, we paid down the revolver, a big chunk of the revolver. And you may have noticed in the release and some of Heath's commentary, we've got a tremendous amount of liquidity. I think this is a balancing act, Gregg. So I think some additional debt pay down, I wouldn't be shocked if you saw us come out and maybe try to do some additional debt paydown and balance kind of the liquidity profile with continued debt repayment.
Refinancing of SMLP’s debt. The majority of SMLP’s outstanding debt matures in 2026 ($995m). Management has stated that it expects to refinance the debt by the end of the year. See the quote from the Q1’24 conference call below:
We've always kind of said Q1 '25 is kind of the back end date. Obviously, the market seems to be very open right now, and we're seeing a lot of constructive prints. The harvest deal that got done was an interesting comp for us. But Gregg, as you know, we need to kind of sort out an extension of our bank deal. So I view it more along the lines of that takes a little bit more time to get everything ironed out, but it's safe to say that we're working on that real time. And when we are positioned to get that extension done, evaluate the market at the time, I think we're kind of in the window here between now and the end of the year of trying to get something done on the refi.
Payment of accrued distributions on the preferred stock. There are currently $36m in accrued and unpaid distributions on the preferred stock that would need to be repaid before initiating a common unit distribution. Management highlighted this during the Q2’23 conference call when speaking of the preferred stock:
Yes, Gregg. I mean it's not a huge chunk of the capital structure. It's perpetual. We can continue to kind of accrue distributions there. I think where you'll see us maybe more actively think about alternatives on that piece of paper is when we're ready to turn on kind of a common distribution and we've got some wood to top to get to kind of our leverage target.
M&A Risk
One of the risks in this setup is management pursuing value-destructive acquisitions. During the recent conference call, SMLP’s management stated that further asset sales are unlikely while mentioning potential M&A in the Permian and Rockies segments. Management has hinted that it sees an opportunity to double SMLP’s size with acquisitions in these two segments:
Yes, I think the long and short of it is we think we are kind of done in terms of pruning assets. I mean, obviously, that's -- they're at the right value. I think, we would continue to consider it, but that's not kind of in the base plan. I would think, as you see on the balance sheet, we've got kind of 3.9x levered now. We think we've got an ample amount of liquidity with an undrawn revolver and close to, what, $350 million of cash on the balance sheet. So that's more than enough liquidity to really support an M&A strategy around our Rockies and Permian segments.
[…]
And then as you think about -- we keep a pretty, pretty exhaustive list of kind of high priority targets from a bolt-on acquisition perspective. And I'd tell you, they're all primarily highly synergistic to our existing footprint. And we see a number of opportunities in the Williston, and to a greater extent, in the DJ.
[…]
Yes. Gregg, if we could get them all done, I feel like we could double the size of Summit. Obviously, that's a pretty ambitious strategy. But I would think about them ranging from as low as $15 million of EBITDA to as high as $50 million to $60 million.
This language is not what I would like to hear, as I am not as sanguine about relying on M&A to drive further stock price re-rating. However, SMLP’s management has demonstrated a solid track record on this front, acquiring DJ Basin assets in 2022 at 4x EBITDA while disposing of its non-core assets at a combined 15x+ multiple. This gives some confidence that management will be highly selective with respect to M&A to avoid any value-destructive transactions.
Conclusion
In summary, even after the share price run-up, I continue to think that SMLP is an attractive setup. The company appears to be trading significantly below its fair value, while there are two catalysts: potential dividend reinstatement and the C-Corp conversion. I expect these to play out over the coming quarters.