Today, we are initiating coverage on Rose Rock Midstream (RRMS). This midstream MLP is a great value play with a high dividend as well as strong growth potential through a drop down model that we believe has upside to the mid-$50s over the next twelve to eighteen months. We are confident this drop down strategy will be employed by the company over the next two to four years that will increase both the size, revenue, and distributable cash flow for RRMS.
Not only does the company have value as equity play but we also like them as a dividend play with a very strong, safe 5% yield that should continue to grow as well.
Rose Rock Midstream LP was formed by SemGroup Corporation (SEMG) and is in the business of gathering, storing, and transporting crude oil. They're situated just east of the Rocky Mountains with their main storage facility in Cushing, OK. This storage terminal has the capacity to store 7.25 million barrels of crude and they plan on adding an additional 350,000 barrels of storage capacity (by end of 2013). Along with the storage of crude, they own 34% of the White Cliffs Pipeline in addition to their 640-mile pipeline system. They also push most of their business through their 16-lane truck facility in Platteville, CO. This facility connects to the origin of the White Cliffs Pipeline allowing them to service producers, marketers, and refiners of crude oil. The Platteville Facility also has an additional 220,000 barrels of storage capacity.
Statistics about Rose Rock Midstream and energy industry:
- The industry landscape is unique because while RRMS specializes solely in crude oil support activities, its major competitors are involved in both oil and natural gas operations.
- Crude oil storage and transportation only makes up 10% of the industry's revenue (natural gas makes up 65% with refined petroleum making up 15%) the main area of growth and profitability lies outside of crude oil.
- According to the DOE's Energy Information Administration, production of crude oil will grow through 2016 where it will then level off and begin declining after 2020. However, the DOE predicts that natural gas production will steadily grow through 2040 resulting in an overall increase by 56%.
- The Bakken Shale ranks as one of the largest oil developments in the U.S. in the past 40 years. It is estimated to hold around 4 billion barrels of oil equivalent in place. Continental Resources believes that the Bakken Shale will yield around 24 to 40 barrels.
- The Denver Julesberg Basin is expected to have 3.8B barrels of oil beneath the plains in Colorado, which is the main place for RRMS' business. At current drill rates, this basin could operate for another 50 years or more.
- RRMS owns one third of the White Cliffs pipelines. The pipeline's initial design of capacity was 30,000 barrels of crude oil per day, now the number has been increased to 70,000 barrels per day. The pipeline is still expanding with a new construction of a 12-inch diameter pipeline looping the existing pipeline. The construction will add on around 80,000 barrels per day to 150,000 barrels per day capacity.
The increase in domestic crude oil and natural gas usage can be attributed to technological advancements in drilling and refining these resources. Due to these factors, RRMS needs to diversify the energy resources it supports or it will be unable to maintain profitability and unable to continue investments in technology.
The focus of our analysis on Rose Rock Midstream will be the potential for the company to grow through drop-down potential from their parent company, SemGroup. RRMS has a lot of potential to see future drop downs that we believe can pay off with strong growth in revenue, income, and (best of all) distributable cash flow to their investors. In the company's latest earnings report, the company listed some of these potential drop downs. We want to examine them, place value on them, and use them to help us price the potential of the company.
The potential drop downs moving into 2014 and beyond that the company wants to perform are:
- White Cliffs Pipeline (RRMS owns 51% currently)
- Glass Mountain Pipeline
- Wattenberg Oil Trunkline
SemGroup has expressed that the company desires to become a GP Holdco, and it is in their interest to line up their assets more accordingly. By giving RRMS transportation, storage, and marketing assets, it can allow for SEMG to be able to become a GP as well as improve the prospects of Rose Rock Midstream to increase distributable cash flow. Let's take a look at the value of these various entities.
The White Cliffs Pipeline is a 527-mile, 12-inch diameter common carrier, crude oil pipeline that moves crude from the DJ Basin to the Cushing oil hub. The pipeline begins in Platteville and terminates in Cushing at Rose Rock Midstream's storage facility. RRMS is the current operator of the pipeline and also operates a 100K-barrel storage facility along with 16-bay trucking facility next to the pipeline's origination. In the latest quarter, RRMS bought another 1/3 of SemGroup's stake from the company, bringing their total ownership to around 34%. The company will fund this drop down with debt and units of SemGroup stock for a total of $275M ($173M by debt).
The potential for White Cliffs is tremendous. The pipeline is currently undergoing a 100% capacity increase that will be completed by mid-2014 and allow for the transportation of 150K barrels per day. As 34% owner, the company will see a much larger amount of the gains from this increase coming into RRMS. White Cliffs is a fixed-fee pipeline that has seen increasing volumes each year. The company is projected to make around $70M - $75M in adjusted EBITDA per year off the Pipeline once the project is completed, leaving $35-$40M to SEMG. The company has expressed that they do want to drop down the rest of the White Cliffs Pipeline to RRMS:
The timing for the remaining third SemCrude pipeline will be determined. As we've indicated few times we're going to continue to execute the strategy of drop down to focused on the Crude assets. So it could be that we elect to put either one vertical trunk or the Glass Mountain pipeline in before the last third. That option remains at our board disruption and so we'll continue to monitor the timing and the impact on their right now obviously we're focused on next one third to get that done by year end.
The company, highlighted, that they want to get the vertical trunk or Glass Mountain pipeline dropped down to RRMS next, so let's turn our attention to those potential adds for RRMS.
The Glass Mountain Pipeline is a new pipeline that will go into effect in Q1 2014, as it will finish construction at the beginning of the year. This pipeline is a 210-mile pipeline that was constructed through a joint venture with Gavilon, LLC. The pipeline will help pump oil from Western Oklahoma and Mississippi Lime region. The pipeline will be able to pump 140K barrels per day with 440K barrels of storage. The pipeline will terminate at the Cushing facility and RRMS will operate as the pipeline operator. SEMG owns 50%, and they anticipate $20M in EBITDA coming from this pipeline per year. The company has expressed that this is a potential drop down, and based on the pace of these, we could expect either a portion or full drop down in 2014.
The Trunkline that the company is highlighting is their Wattenberg Oil Trunkline. The line is a 37-mile pipeline and gathering system in the DJ Basin to move crude oil from Noble (NE) production to the White Cliff Pipeline to then move to Cushing. The pipeline started service in November of 2013. In the latest quarter, Platteville saw a 4% volume increase from Wattenberg, and it appears to be a solid bet because it is being pushed by Noble's presence in the DJ Basin. This was another that they highlighted they want to drop down, and we can expect that to happen fully in the next 12-18 months as well. Noble signed a long-term agreement with SEMG to provide the midstream operation, so it is a natural drop down fit for Rose Rock. The amount that the company will make is confidential and not shared, but based on other deals, it should be around the $20-$30M annual EBITDA range.
These three projects seem to be natural fits to move easily into Rose Rock, especially since the company already owns part or is a part of the operations of all of them. The other drop downs that SEMG has hinted at include SemGas and SemCAMS as well as SemLogistics. SemGas owns and operates 1229 miles of gathering pipelines for natural gas in Kansas, Oklahoma, and Texas along with three process facilities. Rose Rock is not a part of SemGas, but it is a natural midstream play. The difference is that it is in natural gas, and RRMS only operates as a crude oil midstream play. Moving here would definitely be a major shift. SemCAMS is a Canadian natural gas midstream entity as well. Finally, SemLogistics is a storage facility based in the UK in Wales. It stores crude with up to 8.7M barrels of storage potential. Here again this could be a drop down play, but it is located in a market where RRMS has no current business.
The table below highlights the potential drop downs with the potential increase in adjusted EBITDA for Rose Rock:
Potential Drop Down Asset
TTM Adjusted EBITDA (data collected from earnings presentation)
White Cliffs Pipeline (Final 1/3 of SEMG's share)
Looks likely but after Glass Mountain and Wattenberg
Glass Mountain Pipeline
Likely in next 24 months
Wattenberg Oil Trunkline
Likely in next 24 months
Only in best-case scenario for next five years
Only in best-case scenario for next five years
Only in best-case scenario for next five years
As part of these deals, however, the company will have to take on debt packages or add shares. In the scenario, let's assume they take on debt. The company will have to add in another $275M in debt to take on the last 1/3 of White Cliffs Pipeline. If we put the value of White Cliffs at $820M (about the total paid for when RRMS owns all 100% of SEMG's share), and we know it produces about 80M in EBITDA per year, we can understand the company paid roughly 10x EBITDA for the pipeline. Therefore, we can understand that the debt additions for RRMS will be about 1.1B in added debt if all the parts are dropped down. We will be using this information in our pricing model.
This catalyst seems strong for RRMS, but we want to apply some original analysis that has not been done by other analysts or the company to see how much these drop downs can mean for the company in added share value.
In our secondary catalyst, we want to focus in on the strength of the DJ Basin and locales where Rose Rock does business, which gives us confidence for growth in the business as well as in the company's industry, which should lead to full capacity of assets like White Cliffs and the Trunkline.
The main area where RRMS does business is in the Denver-Julesberg Basin, which may be the next best oil boom after Bakken. One of the main plusses of the area is the cost of doing business. In North Dakota, wells cost $8M-$10M on average, whereas with DJ, the average cost is much lower - around $4M. Operators believe it is economically attractive, and that may be why it is starting to boom. 2013 production, even with massive floods, was running at a 44% clip above the 2012 levels of production.
The reserves are estimated to have between 3.5B-4B in barrels of oil inside of it, which can be drilled for 40-50 years at a pretty strong clip. That may be why there were 50 rigs in November 2013 and Noble , one of RRMS' partners in the Trunkline, leased 640K acres and dedicated half their capital budget to the area.
It is a major growth area, and RRMS as well as Sem are nearly completely tapped out. Thus, the reason they are doubling capacity in White Cliffs and should run at full capacity on long-term licenses, meaning consistent revenue with strong potential for earnings and… dividends. SemGroup seems dedicated to building here, and we expect drop downs of the rest of the White Cliff and Wattenberg in the next couple of years.
The company also does business in the Glass Mountain Pipeline, which is located in the Mississippi Lime Play. This area does not look quite as strong as DJ, but the prospects are still solid. The region is under rebirth due to horizontal drilling with a 55/45 mix of oil to natural gas liquids. The area has seen solid growth, but given that a lot of the area was previously mined, there are questions to the longevity of this region.
In our pricing model, we came up with a $55 price target for the next twelve months in our mid-case scenario. We will take you through the prospects for the company, breaking down revenue, EBITDA, CapEx, and more.
This pricing model is 100% original and is based on our research of the company above. This has not been done on Seeking Alpha or any other website ever before, so you are seeing an opportunity being laid out and priced for you in The Oxen Group cash flow model for the first time.
Revenue - The prospects for revenue are mostly based on the ability for the company to add assets. Since the company is a fixed fee provider and they are maxing out most of their current assets, the company will gain revenue at the rate at which they can expand capacity and their offerings. We predict a 10-12% CAGR rate of growth of revenue based on the continued drop-down method as well as expanding capacity for the business. In the best-case scenario where all six potential businesses are dropped down, the company would vastly exceed this growth. In the worst-case, where we only see one or two of them come through we are likely overestimating.
In 2014 alone, the company is expected to see a 100% increase in capacity for their White Cliff Pipeline as well as added 1/3 share of ownership. This alone should help the company's White Cliff Pipeline increase from around 30M to 100M by the end of 2015. Further, the company has a fixed-fee revenue model in most of its major revenue sources, so it's a matter of increasing capacity. We expect more drop downs in 2015-2018 that will help to increase revenue. So, we are modeling based on not the increase of oil demand but rather the increase of capacity that already has fulfilled demand. The DJ Basin is a strong growth area of oil drilling, and the company has double the White Cliff capacity because they believe they can easily max out 150M barrels per day.
EBITDA and Margins - In the best-case scenario (keeping margins consistent), the company would have around $260M in EBITDA if all six businesses were dropped down, which means shares are vastly undervalued. White Cliffs will grow to around $150M in EBITDA. We add in $45M for Trunkline and Glass Mountain. We can add in $65M for SemGAS, SemLogistics, and SemCAMs. That best case is also not including growth of other current businesses for RRMS. In the worst-case scenario, we see five-year EBITDA only growing to around $125M with just one or two of the most likely candidates dropping down. In the most likely scenario, we see another 1/3 of White Cliffs bringing that to $150M in 2018 along with $45 from Trunkline and Glass Mountain. Finally, the company has around $35M in current EBITDA from that business, putting around $225M for EBITDA in that year.
How will margins fare? Margins dropped a lot over the past couple of years as the company took on a lot of costs to build out in the DJ Basin and Mississippi Lime, and we believe as they increase assets, it will spread their fixed costs more thinly as well as capacity increases, leading to an increased operating income. With margins and EBITDA potential rising, we foresee EBITDA at $175M in 2018.
CapEx/Depreciation - This area is one of question because these drop downs beg the question of how can they be financed. Thus far, the company has combined debt and equity. They have had some smaller acquisitions done through CapEx, and given that the company wants to grow its footprint as well as increase midstream assets, they should continue to see CapEx in the $110M - $130M range. In the worst case, we could see this rising to even $150M+ as maintenance costs as well as general acquisition costs would be high.
Debt - Currently, RRMS' debt outstanding stands at $85M. With the added $175M from White Cliffs, we know debt outstanding will be at $260M in 2014 already. From there, in the scenario we laid out the company would have $1.1B debt added in by 2018. In the likely scenario, though, where the company sees drop downs of the first three opportunities, we see the company adding around $725M in debt. Some of this debt will be paid off by 2018, but a number we used for our model to understand share valuations was $900M in debt. By doing this, we can price in the nature of debt burdens from drop downs but at the same time value the company in the likely scenario with additions from drop downs.
Here are our calculations for EBITDA/Operating Income for RRMS in the next five years given the drop downs of the last 1/3 of White Cliffs, Trunkline, and Glass Mountain Pipeline. Income taxes are in the next line. We added in depreciation and subtracted out CapEx. From there we get a total cash flow for RRMS.
Changes in W/C
Total Cash Flow
Next, we need to discount the cash flow using a cap rate and WACC. The WACC for the company is 8.7%. We used a growth cap rate of 3.7% for our model that expresses better than industry growth standards, but we also see a lower WACC due to the company's low tax structure. The final thing to do is add in cash, subtract out debt, and divide by shares outstanding. We had noted debt would be around $900M, which will be from the additional drop downs. Those may be paid through some equity, but either way they negatively affect our model and make the company's equity value less. We come up with a final equity value of $1.4B.
The equity value is calculated in the following way:
We projected the above operating income, taxes, depreciation, capex, and changes in working capital as we have discussed (at length) above. From there, we need to discount the cash flow. For 2014-2017, we come up with:
The PV factor comes from the WACC calculation that yielded 8.7%. For 2018, we use a residual calculation:
|Residual Cash Flow||$114.75|
|Divided By: Cap Rate (r-g)||3.70%|
|Equal: Residual Value||3,101.35|
|Multiplied by: PV Factor||0.716278349|
|PV of Residual Value||$2,221|
The cap rate is at a growth level of 3.7%, which is the basic assumption that we have based on our thesis about the company.
From there, we add the PV of cash, the PV residual value, cash, and subtract debt. We then take that equity value and divide it by units outstanding of 25M.
|Sum of PV of Available CF During Projection Period ('08 - '11)||$92.05|
|Plus: Present Value of Residual Available Cash Flow Value||$2,221|
|Fair Market Value of Enterprise||$2,313.48|
|Less: Interest Bearing Debt||900.00|
|Plus: Excess Cash||2.00|
|Implied Equity Value||$1,415.48|
|# of Outstanding Shares|
When we use these numbers in our model, we come up with a $55 ($56.55 to be exact) price target in the mid-case scenario. With shares at just under $40, we are seeing around 40% growth in share value based on our five-year model. That growth along with a 5% yield that will likely rise with the business growth, is a winning investment.
We are pricing the company at about 11x free cash flow for 2018, which is low for the industry. We are using 2018 since that is our five-year model. The current price/FCF, which is market cap divided by FCF, EQT Midstream (EQM) prices at about 66x free cash flow, currently. EQM's market cap is 2.9B. Their FCF is 44M. 2910/44 = 66. Kinder Morgan prices at about 42x free cash flow using the same calculation method. This is current price/FCF, and with RRMS we are looking at 2018. So, we understand its apples and oranges. The takeaway point, though, is that RRMS, given the thesis we have laid out, is very undervalued at current prices. And, it should see a lot of distributable cash flow and share valuation growth if it will move towards the median of valuation by 2018. This is discussed further in the next paragraph. Additionally, we have used FCF in our model as we believe it's a better gauge of where distributable cash flow will go, and we are looking at a growth name that has limited DCF currently. It's a much less interesting comparison to compare it currently since the size of RRMS and its assets are young.
Why Rose Rock?
In the MLP space, there are many tempting names with strong dividends and cash flow distributions. Yet, very few that we have researched have the combination of both the strong dividend and growth of their business that looks as solid as RRMS. Additionally, more growth means a higher distribution of cash flow to the company as well. RRMS is a very young company still acquiring assets and increasing capacity, which makes them appealing. Even still, the current median dividend for MLPs is 5.8%. RRMS sits at just under 5%, so the company offers a very comparable dividend but with the exciting growth in revenue, EBITDA, and cash flow that will allow for investors to see their dividend grow.
There are some definite risks here with our RRMS analysis. In a worst-case scenario with little drop downs existing, shares have much less potential in the $40 - $42 range and are not an attractive buy. Yet, this assumes that only 1-2 out of the six potential drop downs does occur. Further, it assumes flat margins that are currently extended low due to weakness with the high amount of growth of assets in the last couple of years. Further, we expect strength in the DJ Basin, which would be a major variance if it were not strong. The only other major risks we can assess are unforeseen risks, such as, natural disasters and the unknown of oil drilling supplies.
In conclusion, we believe opportunity is ripe for Rose Rock Midstream. The company has fascinating and strong growth prospects, and we believe their business is ripe for growth. The DJ Basin is strong, and RRMS is in the thick of it. Further, the company has a great parent company that wants to pass along their assets to them at affordable rates and expects to continue strategic drop downs that fit with RRMS' strategy.