Reinstating Southcross Energy's Distribution

| About: Southcross Energy (SXE)

Summary

SXE suspended its distribution in Q1 2016 commensurate with its Parent filing for bankruptcy.

SXE issued a four-year forecast as part of the parent's restructuring.

The forecast supports reinstatement of a $0.20 distribution in 2018.

Perhaps no midstream MLP has fared worse these past two years than Southcross Energy Partners (NYSE:SXE). The partnership's unit price fell from a high of $24.88 in July, 2014 to a low of $0.42 in February, 2016 before recovering to around $2.00 recently. The decline had three contributing factors: a decline in sympathy with falling petro prices, a major expansion just before the November 2014 OPEC induced price collapse, and the financial trouble of its parent, Southcross Holdings.

Impact of Oil, NG, and NGL Price Collapse

A characteristic of the MLP space for the past year and a half has been for unit prices to decline in sympathy with oil and gas prices, even if a particular MLP's revenue was not directly tied to those prices. The table below shows how this factor played out for SXE, with the average of the high and low SXE unit

price for the past 9 quarters compared with average WTI, NG and NGL prices for each quarter.

QTR

SXE

WTI

NG

NGL

1q14

17.11

98.75

5.08

11.19

2q14

20.01

103.35

4.50

10.15

3q14

23.00

97.78

3.86

9.83

4q14

16.70

73.16

3.70

7.41

1q15

14.06

48.54

2.83

5.43

2q15

13.54

57.85

2.68

5.20

3q15

8.79

46.42

2.69

4.68

4q15

4.44

41.96

2.07

4.63

1q16

2.08

33.18

1.95

3.82

Click to enlarge

The table below shows the same data indexed to the 1q14 value.

QTR

SXE

WTI

NG

NGL

1q14

1.00

1.00

1.00

1.00

2q14

1.17

1.05

0.89

0.91

3q14

1.34

0.99

0.76

0.88

4q14

0.98

0.74

0.73

0.66

1q15

0.82

0.49

0.56

0.49

2q15

0.79

0.59

0.53

0.46

3q15

0.51

0.47

0.53

0.42

4q15

0.26

0.42

0.41

0.41

1q16

0.12

0.34

0.38

0.34

Click to enlarge

SXE's unit price was pulled down with the general collapse in oil and gas, particularly after the November, 2014 OPEC meeting when it was made clear that Saudi Arabia was not going to support oil. However, SXE fared worse than the petro decline, so we must look into the other two contributing factors to see what happened.

SXE's Own Contribution to its Price Collapse

Southcross provides natural gas gathering, processing, treating, compression and transportation services, and natural gas liquid fractionation and transportation services. (For a detailed description of the Partnership see its December investor presentation here.) Its assets are located mainly in South Texas in the Eagle-Ford, with some intrastate pipelines, which account for only 8% of gross margin, in Mississippi and Alabama. Facilities include four gas-processing plants, two fractionation plants, one sour gas treatment plant and approximately 3,140 miles of pipeline. In addition a fractionator and a processing plant owned by the parent, Holdings, are integrated into the company's operations. The company's facilities, which operate at less than 60% of capacity, are located in South Texas in Conroe, Webb and Dimmitt Counties near the Texas-Mexico border. The company's close proximity to Corpus Christi provides it with an extensive potential customer base.

Like most mid-stream companies, SXE's business is based primarily on fixed fee and fixed spread contracts, with only about 12% sensitive to commodity prices, particularly to NGL prices. The following table shows the components of SXE's gross margin for the past nine quarters.

Gross Margin Components in $millions

Gross Margin

1q14

2q14

3q14

4q14

1q15

2q15

3q15

4q15

1q16

Fixed Fee

16.3

17.3

22.4

29.0

35.6

34.9

36.5

36.0

30.8

Fixed Spread

3.9

2.5

1.3

1.3

4.1

2.5

4.0

4.7

5.1

Commodity Sensitive

7.0

6.5

7.1

6.9

5.1

5.2

5.6

7.0

4.3

Total

27.2

26.2

30.9

37.2

44.8

42.6

46.2

47.7

40.3

Click to enlarge

Except for the last quarter, which saw a margin decline due mainly to a fire in one of the parents processing plants, gross margins have held up, and even grown, in the face of the oil and gas price collapse. Other operating parameters also have shown resilience. The table below, in addition to gross margin, displays cash generated from operations, EBITDA, distributable cash flow, and net income:

$millions.

1q14

2q14

3q14

4q14

1q15

2q15

3q15

4q15

1q16

Cash from Operations

14.2

9.5

(2.4)

27.0

3.4

1.2

20.0

(5.8)

(17.2)

EBITDA

12.5

10.2

11.3

20.5

17.0

18.7

23.6

24.7

20.7

DCF

8.5

7.5

5.9

13.4

7.8

8.6

12.7

11.2

10.3

Net Income

(1.3)

(3.0)

(24.8)

(2.3)

(13.9)

(15.5)

(9.7)

(16.5)

(15.5)

Operating Margin

27.2

26.2

30.9

37.2

44.8

42.6

46.2

47.7

40.3

Click to enlarge

Performance has remained fairly flat over the past 5 or 6 quarters, with EBITDA around $20 million, DCF around $10 and net income around $(15). Not great, but reasonably stable. When we look at capital spending and debt, however, we get an indication of the source of the problem.

$ millions

BALANCE SHEET ITEMS

4q13

1q14

2q14

3q14

4q14

1q15

2q15

3q15

4q15

1q16

PPE

576

617

663

948

1059

972

1087

1075

1066

1052

Joint Ventures

-

-

-

149

147

146

142

140

141

142

Total Assets

652

702

752

1205

1316

1202

1323

1329

1319

1313

Long Term Debt

267

171

227

458

471

505

556

573

605

607

Partners Capital

275

408

386

629

697

596

667

646

621

620

Total Capitalization

542

579

613

1087

1168

1101

1223

1219

1226

1227

Click to enlarge

With unpropitious timing, in August, 2014 SXE acquired the TexStar Rich Gas System for $404 million. The acquisition was made with $80 million cash, the assumption of $100 million in debt, and the issuance of 14.6 million in Class B shares to cover the difference. This accounts for most of the $231 million step up in debt and $243 million in partner equity. The rest of the increase is accounted for by a $78 million expansion of the Webb county pipeline. Obviously the timing of the acquisition just before the oil collapse put pressure on the company. Despite that, SXE went on to incur another $150 million debt mainly associated with the drop down acquisition of the Valley Wells Sour Gas System in May '15, for which SXE paid $15 million in cash and issued 4.5 million in common units at a price of $13.92, or $62.8 million in value. SXE also assumed the remaining capital spending obligations for expansion of the system, resulting in a total growth capital commitment of $108 million for the year. Hence, at the end of 2015 the MLP was left with total LTD of $605 million, an exhausted credit line, and sitting in violation of the loan covenant.

Trouble at Home

As seen above, SXE managed to retain reasonable operating numbers in the face of the dramatic down turn in oil and gas prices, but took on an overly aggressive expansion program that ran up its debt to the point of no availability in its credit line and covenant violations. One hopes in such a situation to turn to the parent for some help, but in this case the parent was in even more trouble. We do not have access to Southcross Holdings LP financials, but we can infer some of the issues.

In 2015 Holdings had three sponsors, EIG Global Energy Partners, Tailwater Capital, and Charlesbank Capital, each with roughly a one third position. Holdings in turn owned 62.2% of the equity in SXE, with the public owning 37.8% through 77% of the common units. The table below, from the 2015 10K, shows the break out by equity type.

Description

Percentage

ownership

Ownership by non-affiliates:

Public common units

37.8

%

Southcross Holdings LP's ownership:

Common units

11.5

%

Subordinated units

21.1

%

Class B Convertible Units

27.6

%

General partner interest

2.0

%

Total

100.0

%

Click to enlarge

We get a hint of the situation at Holdings by looking at SXE's distribution history:

$ millions

1q14

2q14

3q14

4q14

1q15

2q15

3q15

4q15

TTL

DCF

8.5

7.5

5.9

13.4

7.8

8.6

12.7

11.2

75.5

Distributions

(13.8)

(13.8)

(15.2)

(9.9)

(13.4)

(9.9)

(11.8)

(11.8)

(99.6)

Cash (deficit)

(5.2)

(6.3)

(9.3)

3.4

(5.6)

(1.3)

0.9

(0.7)

(24.1)

Coverage Ratio

0.62

0.54

0.39

1.34

0.58

0.87

1.07

0.94

0.76

Click to enlarge

With only a 76% coverage, Holdings may have been pushing SXE for distributions because Holdings itself was thinly capitalized. Holdings may also have wanted SXE to maintain the "minimum" quarterly distribution of $0.40 to make the subordinated units, discussed, below, eligible for conversion. At any rate, although Holdings had made capital contributions, its thin capital status was confirmed when Holdings declared bankruptcy.

The Holdings Bankruptcy

On January 8, 2016, SXE announced the suspension of the common unit $0.40 quarterly distribution. On March 22, Holdings announced a solicitation for a prepackaged Chapter 11 filing, which was filed on March 27. Holdings emerged from bankruptcy on April 13 after its lenders agreed to convert $700 million in debt for a 1/3 equity interest, taking over the Charlesbank position. For their part, the two remaining original sponsors, EIG and Tailwater, each contributed $85 million, for a total infusion $170 million in fresh capital, while retaining their original ownership interest.

Of the $170 million infusion, $40 million was used for past due payables owed SXE and $50 million was set up as an "equity cure" fund to be utilized by SXE through March 31, 2017 to cure revolver covenant breaches. Under its loan agreement, SXE can add back to TTM EBITDA any equity additions during the period to calculate Debt/EBITDA for covenant compliance. That covenant was 5.75 for 4q15 and 1q15, and is set to 5.50 for 2q16, 5.25 for 3q16 and 5.00 thereafter. SXE used $11.3 million of the equity cure fund for its 4th quarter covenant and will need an additional $0.5 million to correct the 1st quarter breach.

Of course the equity cure money from Holdings has a price attached. In exchange for the funding, new common units are issued to Holdings at a price of $1.48 per unit, provided the market price is above that figure. Accordingly, the $11.3 equity cure resulted in the issuance of 8 million new common shares, and the first quarter equity cure will require some 0.4 million new common shares.

To assess any future common distribution potential, the amount of dilution incurred under this provision is important. Therefore, before moving on to explore if and how SXE can recover from its present plight, we must comment on the nature of the various form of its partner capital.

SXE Equity Structure

The table below shows the distribution of partnership interest by type, as of the 1st quarter, 2016, adjusted for common units to be added under the equity cure provision and Class B PIK dividends due but not yet issued as of the end of the quarter. Fifty nine percent of the common units were held by the public. All other equity interest, including the remaining common, the subordinated, the Class B convertible, and GP interest were held by Holdings, the parent. Let's examine these various equity classes.

Shares in thousands of units

1q16

Common Units, Public

21,685

Common Units, Parent

14,858

Total Common

36,542

Subordinated

12,214

Units for EPS Calculation

48,756

Class B Convertible

16,534

TTL Partnership Units

65,290

GP 2%

1,306

Click to enlarge

Subordinated Units: The subordinated unit distribution was suspended in 4q14 to support the TexStar acquisition. The partnership agreement was revised then such that the subordinated units will not be paid a distribution should it cause the coverage ratio to drop below 1.0, and unless the common units have received the minimum quarterly distribution ($0.40) plus any arrearage in that number from prior quarters. Subordinated units do not accrue arrearage. The subordinated units are convertible to common once SXE has made three consecutive years of minimum distributions to the common, or one year at 150% of the minimum. Since the common distribution has been suspended, with no near term prospect of reinstatement, we can assume that conversion will not occur over the next four years.

Class B Convertible Units: The Class B units were issued (14,633,000 units) as part of the TexStar acquisition in 3q14, at an issue price of $22.17 per unit, the closing price of the common on August 4, 2014. The holders of the Class B units receive quarterly distributions in an amount "equal to $0.3257 per unit, paid quarterly in Class B PIK Units within 45 days after the end of each quarter". However, a "par" value of $18.61 per unit is used in calculating the number of PIK units to be issued. Accordingly, the number of Class B units increases by 1.75% each quarter. The General Partner retained its 2.0% interest in SXE in connection with the original issuance of the Class B Convertible Units and is entitled to a corresponding distribution to maintain its 2.0% general partner interest.

The Class B units are convertible to common units on a one-for-one basis. The conversion will occur when SXE makes a quarterly distribution equal to or greater than $0.44 per common unit provided that Distributable Cash Flow is sufficient to pay the declared distribution on all units for the two quarters immediately preceding the conversion and forecasts Distributable Cash Flow sufficient to pay a distribution equal to or greater than $0.44 for the two quarters immediately following the conversion. Under this restriction and at the current unit level, quarterly DCF must exceed $29 million to trigger conversion, versus the approximate $10 million recently available.

General Partner: The GP has "incentive distribution rights" as detailed in the table below, again taken from the 2015 10K.

Marginal Percentage Interest

In Distributions

Total Quarterly Distribution Per

Unit Target Amount

Unitholders

General Partner

Minimum quarterly distribution

$0.40

98

%

2

%

First target distribution

$0.40 up to $0.46

98

%

2

%

Second target distribution

above $0.46 up to $0.50

85

%

15

%

Third target distribution

above $0.50 up to $0.60

75

%

25

%

Thereafter

above $0.60

50

%

50

%

Click to enlarge

Now What?

SXE has suspended providing guidance. However, a four year projection was given in its March 22, 2016 8K, here, as a part of the Holdings restructuring:

Click to enlarge

The table is expanded below to include the 2014 and 2015 results. It also breaks Capex down between maintenance and growth, and Debt Service between interest and principal payments, consisting of the quarterly payments of $1.125 million on the 7 year term loan maturing August 4, 2021.

$ millions

2014

2015

2016

2017

2018

2019

Adj. EBITDA

54.5

83.9

86.3

102.0

112.7

127.5

Capex, Maintenance

(5.8)

(11.6)

(12.0)

(12.0)

(12.0)

(12.0)

Capex, Growth

(42.3)

(26.2)

(11.8)

(10.2)

Debt Service, Interest

(13.4)

(32.3)

(32.4)

(29.8)

(27.8)

(25.5)

Debt Service, Principal

(2.3)

(4.5)

(4.5)

(4.5)

(4.5)

(4.5)

Change in Working Capital

14.4

(26.1)

12.3

(11.9)

(1.6)

(10.0)

Other

0.8

9.4

(0.7)

(0.8)

(0.9)

(1.0)

Net Operating Cash

48.3

18.7

6.7

16.8

54.1

64.3

Click to enlarge

Growth Capex for 2014 and 2015 were not included since they were covered with equity and debt addition. Growth Capex for the projection period is expected to be covered by internally generated cash, with the exception of any equity cure additions which are not included in the projection. For reference, the 2014 and 2015 Growth Capex, and debt and equity additions were as follows:

$ millions

2014

2015

Capex, Growth

(234.8)

(116.2)

Debt Acquisition

90.8

151.1

Equity Additions

154.6

19.2

Click to enlarge

SXE provided little detail to support the projections, other than to say in the first quarter conference call that they were based on the futures strip as of that time (mid March), and assumed that there would be some restoration of rigs in the Eagle Ford and improvement in NGL prices. We will accept the forecast at face value and explore the consequences.

Debt Covenant Compliance

How does this forecast comply with the 5.00 debt covenant in effect at the end of 2016? First, SXE announced in the first quarter conference call that 2016 capital spending has been reduced to a range of $9 to $10 million for maintenance and $20 to $30 for growth capital. Taking the upper end, the partnership is now looking at $40 million in capex versus $54.3 in the original forecast, increasing generated cash from $6.7 to $21 million. Applying this, along with the equity cure of $11.8 already made and $4.5 million in term debt amortization, to the going in debt of $609 ($604.5 long term and $4.5 current) we obtain:

Debt/EBITDA = (609-21-11.8-4.5)/83.6 = 571.7/86.3 = 6.62

If we apply an additional $23.5 million in equity cure, we get an adjusted ratio of:

Debt/EBITDA = (571.7-23.5)/(86.3+23.5) = (548.2/109.8) = 4.99,

under the prescribed ratio.

Things are problematic for 2017, however, with a ratio of:

Debt/EBITDA = (548.2-16.8-4.5)/102) = (526.9/102) = 5.17

Since no equity cure is available after 2016, the covenant can only be reached by reducing debt to $510 million, $16.9 below the projected level. However, we exited 2016 with $14.7 million of the $50 million equity cure fund not utilized. Applying that before its March 31, 2017 expiration plus squeezing $2.2 out of capex drops the $526.9 debt to the required $510. The 2017 calculation becomes

Debt/EBITDA = (526.9-14.7-2.2)/102 = 510/102 = 5.00.

In 2018 the picture gets better. With a projected EBITDA of $112.7, SXE can comfortably support $510 in debt:

Debt/EBITDA = 510/112.7 = 4.53

Reinstating the Distribution

What to do with the $54.1 million in cash generated in 2018? The partnership agreement specifies that all available cash is to be distributed, including that reserved for growth capex, but we will assume the $11.8 growth capital is still covered out of internally generated cash. Recall also that the subordinated units are not eligible to receive distributions until any arrears on common units is paid, nor are the Class B shares eligible for cash distributions. However, the number of common units will have been greatly expanded from their current level due to the equity cure agreement. Total common units will have increased from 28.421 million at the close of 2015, to 62.296 in 2017, as parent common units expand to 40.611 million from 6.736 million as a result of the $50 million equity cure. Accordingly, the partnership could reinstate a distribution of:

Annual Distribution = 54/63 = 0.86,

Or, say, $0.20 per unit per quarter. The distribution can be expanded to $0.25 per quarter in 2019.

How Credible is All This?

I leave it to the reader to judge the credibility of the SXE four year projection. On the positive side, both NG and NGL spot and strip prices have improved since mid March. There is also a growing consensus that La Nina will contribute to a hot summer and cold winter allowing a purge of the NG inventory overhang and further improvement in NG pricing, as well as increased drilling activity in the Eagle Ford. SXE has plenty of spare capacity for growth, its gas processing facilities and fractionation plants having only a 62% and 49% utilization, respectively, in 2015. Further, SXE's facilities are located near Corpus Christi and the border, giving them access to a growing number of new petrochemical and LNG installations, and the Mexican export market.

On the negative side, SXE has provided scant data to support the projection, four years is a far horizon, and the MLP has to refinance its $450 million term loan in 2021. In the near term, rigs in Eagle Ford have fallen further from the mid March level and, ironically, rapidly rising NG prices may squeeze frac spreads.

SXE's business in not easily modeled without insider knowledge of volumes and contract terms. However, we gain some further insight by looking at what position professional analysts have taken. The table below shows the current estimates of the 3 or 4 analysts that follow the partnership, where I have used my own model to estimate net profit numbers from the given EBITDA figures:

6/10/16

$ Thousands

SXE Earnings Projection

1q16

2q16

3q16

4q16

2016

2017

By SXE

EBITDA

20,696

21,210

22,229

22,164

86,300

102,000

Net Profit $ millions

(15,520)

(13,174)

(12,072)

(11,979)

(52,744)

(32,395)

Total Units

56,685

65,649

68,168

74,543

66,261

92,389

EPS

(0.27)

(0.20)

(0.18)

(0.16)

(0.80)

(0.35)

By Analysts

Number

3

4

4

4

3

3

Average

(0.29)

(0.20)

(0.15)

(0.12)

(0.76)

(0.57)

High

(0.07)

(0.07)

-

(0.01)

(0.14)

0.14

Low

(0.34)

(0.38)

(0.31)

(0.24)

(1.20)

(1.07)

Click to enlarge

Conclusion

SXE's projection presented as part of the Holdings bankruptcy restructuring implies that distributions can be reinstated in 2018 at $0.20 per quarter, followed the next year at $0.25 per quarter. The partnership's 2018 Debt/EBITDA will be 4.53 versus a covenant of 5.0, and the availability on its revolver will be about $70 million assuming $18 million in LOCs. There are no banking restrictions on distributions other than covenant compliance.

Unless otherwise noted, all charts and graphs are by the author with data from various SEC filings EIA data.

Disclaimer: The author presents this material for the reader's information only and makes no recommendation as to the viability of SXE as an investment.

Disclosure: I am/we are long SXE.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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