Tidewater Midstream And Infrastructure (TWM.TO) – Large Asset Sale – Upside TBD

Current Price: C$1.03

Target Price: C$1.42

Upside: 40%

Expiration Date: Q4 2023

This idea was shared by Value9.

 

Last month Tidewater Midstream And Infrastructure sold its key midstream asset Pipestone for C$650m, equal to two-thirds of the company’s EV. The deal is set to close in Q4’23. Pro forma for the sale proceeds and excluding TWM’s public stake in LCFS, the remaining refinery and midstream assets are now trading at only 2.5x 2023E EBITDA, significantly below peer levels and the cost basis of the assets. The stock has barely budged on the news, which I believe has created a pretty compelling setup. I expect TWM shares to re-rate once the Pipestone sale closes, but there are also a few other potential catalysts down the road.

Pipestone, the asset that is being sold, is a high-quality sour gas plant with 110 MMcf/d throughput and 20,000 Bbl/d liquids handling capacity. The remaining TWM’s assets are Prince George Refinery in BC, a 69% stake in publicly listed Tidewater Renewables (LCFS.TO), and several midstream gas processing assets in Alberta.

This is how TWM will look like pro-forma for the sale:

 

Pipestone sale is likely to close successfully in Q4

Pipestone is a high-quality asset that is 100% contracted with investment-grade tenants, has 63% of its revenue mix in take-or-pay contracts, and average contract term of 8.5 years. Together with the existing gas plant, TWM is also selling an expansion project Pipestone Phase II, which would double the plant’s throughput capacity, as well as two other interconnected terminal/storage facilities. The buyer of these assets is AltaGas, a large energy infrastructure company with a C$7bn market cap. The acquisition will strengthen AltaGas’ presence in the region, where it already has a nearby refinery and other midstream assets a bit further away.

The sale is conditioned on certain regulatory approvals, which I expect to be mostly customary – it is a rather small deal and will increase the buyer’s processing throughput capacity by only 10%.

A more interesting condition is a requirement for positive FID (final investment decision) on Pipestone II expansion project. FID is a critical milestone in large energy projects – in this stage owners evaluate and decide whether to proceed with the project or not. As I understand, AltaGas will review Pipestone II project economics, costs, profitability, supply availability, customer demand, technical challenges, etc. And then will decide whether Pipestone II investment makes sense. Any required permissions, financing, and engineering/design plans also need to be in place for FID to be completed. Overall, this is pretty much the last step before the construction stage can start.

So for the sale of Pipestone assets to close, AltGas must give a go-ahead for the expansion project. Is this likely? I think yes.

Pipestone II will basically be a replica of the currently operational Pipestone Phase I plant. The plants will be co-located and all of the FID-related aspects, e.g. availability of the input resources, customer demand, operational costs, regulatory environment, should be pretty similar or even identical for both assets. The engineering and design plans should also be very similar to the Phase I plant.

The FID process for the expansion is already in advanced stages, with the acquisition presentation stating that the project is “Near FID.” TWM has been considering this expansion already for a while and all of the required permits are ready. The key roadblock so far has been the financing due to the large project size and TWM’s already high leverage. Pipestone II expansion is expected to cost around C$300m.

Analysts were previously concerned about this cost estimate, given that another TWM’s project, the HDRD facility at LCFS, recently left a bad taste in investors’ mouths due to multiple delays and budget overruns. However, management has clearly stated that this is a completely different and much simpler project, and they are comfortable with the budget estimate. From Q1’23 conf. call:

Analyst: And then I guess, on the Pipestone 2 expansion, looks like you’re still evaluating that project. I guess just given this latest 30% overrun on the HDRD, can you comment on where the latest cost estimate for Pipestone 2 might be at today versus the previous $300 million marker? And maybe just remind us if any of the inflationary pressures can be recovered through customer contracts to perhaps maintain that 6x build multiple on the project?

TWM CEO: Yes, sure. So let me just differentiate a little bit on those 2 construction projects. HDRD is first of its kind. So we’ve got — engineering is new. You’ve got some fairly funky catalysts and some interesting metallurgy involved as opposed to looking at Phase 2 of Pipestone, which is really a replica of Phase 1. So any of the question marks that we went through on Phase 1 are now behind us. And basically, the engineering and construction are just going to be a lot simpler. So it makes us very comfortable in terms of our capital budget on Phase 2. And yes, we are still evaluating and working through things. And part of our structured process here is talking to partners as well as potential buyers.

[…]

And it’s not so much — it’s not a cash flow issue as much as it is — really a large project. Given the size of our company and the CapEx requirements for Phase 2, just in general, even with the economics being excellent, it’s a big project for the size of our company to do it on our own.

AltaGas is a very serious buyer with multiple midstream assets in the region. I am pretty sure the buyer has carried out full diligence on TWM’s Phase I plant before signing the binding agreement. In its acquisition presentation, the buyer has also signaled it’s pretty confident about the FID so far, given the strong customer demand in the region and synergies with the Phase I plant.

The risks of this deal getting derail due to FID for Pipestone II seem to be small, and the condition was probably put in just as a precaution. I expect the acquisition to proceed smoothly and close as expected in Q4.

 

Remainco assets are undervalued on cost basis and EBITDA

As the table below illustrates the Remainco currently trades at a material discount to its sum of the parts valuation even if operating assets are marked just at their cost basis. As I elaborate below, the actual private market valuation of each of these assets is likely to be higher than the historical acquisition costs, even if it is hard to pinpoint to exact figures. At the very least, this indicates a good downside protection.

Prince George Refinery (PGR)
The refinery has 12,000 bbl/d capacity and mostly produces low-sulfur diesel and gasoline for the greater Prince George region in BC. The location is highly strategic with only one other refinery nearby. There’s a substantial undersupply of refining power in the area, which has resulted in elevated crack spreads and PGR usually operating at full capacity. The refinery also has onsite storage capacity in excess of 1 MMbbls and flexible logistics.

PGR was acquired in Oct’19 for C$215m or 2.9x EBITDA. The crack spreads were materially lower back in 2019 (around C$50-C$60/bbl vs C$85/bbl in Q2’23. At the time, management was boasting how opportunistic and cheap the acquisition was – the purchase was made at a few turns lower EBITDA multiple than peer valuations.

Deep Basin
This encompasses midstream assets with 780 MMcf/d processing capacity, including Brazeau River Complex gas processing and NGL fractionation facility as well as Ram River Gas Plant, a sour gas processing facility with sulfur handling solutions. These assets were purchased through several smaller acquisitions mostly during 2016. I’m sure I haven’t collected all the parts, but at least several different acquisition announcements indicate that the total cost basis should be higher than C$55m (here, here, here). The company has then spent an incremental C$85m+ upgrading the assets, expanding the capacity at BRC, building a fractionation facility, relocating the idled turbo expander, etc (here and here), bringing the total cost basis to C$140m.

Acheson blending terminal and propylene splitter
Acheson was acquired in 2016 for C$11m. The acquired assets included 33 mmcf/d processing capacity, 250km of related pipelines and 600 acres of heavy industrial land. At the time, TWM said that the land alone was estimated to be worth C$15m-C$30m and had been previously appraised to be worth C$50m in 2008. Since then, TWM has grouped certain other co-located assets with Acheson and made some other upgrades, including a newly built propylene splitter. Besides the retained 600 acres of industrial land, Acheson now boasts a six-fold higher 200 mmcf/d capacity and 800km+ pipeline network. The asset is now likely to be worth multiple times more what TWM paid in 2016.

Tidewater Renewables (LCFS.TO)
TWM holds a 68.85% stake in Tidewater Renewables. LCFS was IPO’ed in mid-2021, raising money to buy some midstream assets from TWM and start building a new renewable diesel/hydrogen facility, the first one of this kind in Canada. The midstream assets generate around C$40m annual EBITDA. The renewable facility, HDRD complex, has just finished the 2-year-long construction process and was supposed to start operating last month. Management expects it to generate C$90-C$115m annual EBITDA once fully ramped up. HDRD complex is co-located with TWM’s PGR refinery.

I am less confident in assessing the valuation of the Remainco assets from the earnings perspective as disclosures are limited. However, the figures I come up with point to the same direction – Remainco is materially undervalued.

Excluding LCFS operations, Remainco earnings mix will be heavily skewed towards the refinery. The 2022 consolidated EBITDA mix was 40% midstream, 40% refinery, and 20% LCFS. With the Pipestone sale, the majority of that 40% earnings from midstream will go.

Estimating 2023 EBITDA guidance for the remaining TWM assets is a bit tricky, as the company does not segment the earnings and provides only consolidated EBITDA guidance. However, using some other available data points, I estimate EBITDA for the remaining refinery/midstream assets to be around C$80m. Calculations are illustrated in the table below.

It could be argued that this C$80m EBITDA figure is a bit too low and doesn’t reflect the actual earnings power of the assets. In H1’23, TWM’s PGR refinery had a major maintenance turnaround when the facility was offline for 6 weeks, whereas Brazeau River Complex was also shut-down for 3 weeks due to forest fires.

Pro-forma for the sale and excluding LCFS stake, the remaining assets now trade at 2.5x EBITDA. This looks too low vs peers. Refinery companies are trading at around 4xEBITDA (e.g. VLO, CVI, PARR), whereas midstream peers (e.g. OKE, AM, CEQP) trade at 7x-9x forward EBITDA multiples. TWM’s Pipestone gas plant was just sold for 8.5x 2024E EBITDA.

If TWM’s operating assets were to re-rate to 4.5x 2023E EBITDA, which seems reasonable given where peers trade, the stock would be worth C$1.42/share, implying a 40% upside from the current levels.

 

Private equity control and new management in place

Two private equity firms, Birch Hill (22.7%) and Kicking Horse Capital (4%), control 29% of TWM and have significant influence over its management. Last November, TWM had a major management shakeup when the previous CEO/founder resigned and TWM’s chairman was replaced by Thomas Dea, the president of Kicking Horse Capital.

The previous CEO/founder of TWM was not popular with shareholders due to his massive spending spree on various projects, which increased company’s debt and led to a highly dilutive equity financing at C$1.2/share last year. However, both Birch Hill and Kicking Horse Capital participated in the financing.

Soon after Dea took over as chairman, TWM announced a strategic review, which has now concluded with the sale of Pipestone. The presence of these two major shareholders significantly reduces the risk of further capital destruction at TWM and increases the likelihood that we will see other value realization events down the line.

 

Other paths of value realization

The main catalyst for TWM’s re-rating will be a successful Pipestone sale. But there are also a number of other ways to win here.

Due to 69% ownership of LCFS the company not only fully consolidates the financials but also provides guidance only on a consolidated basis. The added complexity, visually high LCFS debt, and elevated capex are likely a drag on TWM’s share price. Management seems to be well aware of this and during Q2’23 call said they are considering trimming LCFS ownership and deconsolidating the financials. Such a move would not only help investors to realize the value of the current LCFS stake but would also make the cheapness of the remaining operating assets much more evident. From the Q2 call:

Well, in my mind, a lot of the complexity comes from consolidating our results with LCFS, with the renewables business. We’ve always said that it is not our end goal to own 70% of the renewables business sort of as — in an ongoing way. And we also look at that asset as probably most investors look at it. We think we’re at the finish line. We think it’s tremendously undervalued, certainly relative to anything else in that space. But until we get the thing up and running and cash flowing on a steady basis, we’re probably going to see discount.

So I think that’s probably the easiest way to reduce some of the complexity in Tidewater Midstream is to get to a more normal holding position and to sort of stop — well, eventually stop consolidating those results. But I think that would go a long way to simplifying things, I’m not sure how long it will take, though.

Tidewater Renewables (LCFS) might also be undervalued. I don’t want to expand too much on this and confuse readers with the investment thesis in another publicly listed company, but I think the dynamics here are worth highlighting. LCFS is currently trading at just 4x the projected ramped-up EBITDA once its renewable diesel/hydrogen facility is fully online. Low valuation and investor skepticism regarding management’s projections are not surprising given several project delays and material budget overruns so far. LCFS has basically become a ‘show me’ story with investors waiting to see the real earnings power of the renewables facility rather than following management’s word on it. The market is now pricing in a very large execution risk. However, the project is no longer in the construction phase and was put online last month. If the earnings will eventually turn out to be closer to management’s projections, LCFS share price could skyrocket, giving a material positive boost for TWM as well. From Jan’23 TWM’s call (at the time LCFS was trading at C$11.4/share vs the current C$7.8/share):

Obviously, renewables currently has about $50 million of EBITDA. And these results, again, are consolidated into the Tidewater Midstream results. And again, that’s why you’ll see both debt, obviously, as well as our cash flow once it gets consolidated. But if you look at renewables as a stand-alone business and again, it trades on the TSX as well, it’s a — these renewables companies have tend to trade in the 10x multiple range.

Again, this is not guidance or anything. This is just where things are tending to trade in the renewable space. We’re going to have about $150 million of EBITDA there. That should be a considerable bump over the — what, $650 million EV enterprise value that it currently trades at. So we’re looking for to demonstrate that the facility works to demonstrate that the economics are as we model them, and we are hoping to see that, that gets revalued.

While management has so far stated that the proceeds from the sale of Pipestone will be used to repay debt and fund general corporate expenses, I think capital return to shareholders is not completely out of the cards yet (might be just wishful thinking on my side). TWM will receive half of the C$650m sale proceeds in cash and the other half in AltaGas stock. Taken in aggregate this more than covers the company’s current net debt, while at the same time, there is no need to repay the existing debt in full. Given that TWM has already completed maintenance turnarounds at its refinery and midstream assets in 2022 and 2023, there should be no significant short-term capital expenditure needs either.

Exiting the stake in AltaGas may take some time, especially if the sale terms include lock-up provisions. However, once that is done and TWM deleverages to more comfortable levels, there should still be a significant amount of proceeds available for distribution to shareholders. Both Birch Hill and Kicking Horse, two of TWM’s largest shareholders, are currently sitting on material losses on their investment in TWM and are highly incentivized to the shares upwards. Substantial capital return might be the best way to lift TVM’s share price, and it is something that the company can easily orchestrate given the size of Pipestone’s sale proceeds. I expect to hear more on this after the closing of the Pipestone sale. Management promised to update guidance and issue a strategic outlook once the deal is completed.

 

Potential risks

• The termination of Pipestone sale. AltaGas is definitely a credible buyer and, given the seemingly low risk regarding the Pipestone II FID decision, I believe the deal will proceed smoothly. However, even if the sale was to get terminated, the downside should be limited. Pre-announcement levels are only 6% below the current prices. One could argue that the pre-announcement price already incorporated some premium due to the ongoing strategic review, so the stock reaction could be steeper.
• Exposure to AltaGas stock price. Half of the C$650m Pipestone proceeds will come in the form of 12.5m AltaGas stock (around 4.4% stake) issued at C$26.07/share valuation (currently C$26.06/share). It’s not clear yet if the issued shares will include any lock-up requirements. Nonetheless, I believe any risk from the buyer’s stock volatility is minimal. AltaGas is a large midstream/utility company with a very stable share price over the last 2 years. Gradual disposal of AltGas stake in the open market should also be possible as the daily trading volume is around C$16m. A spin-off of the stake to shareholders could be another option.
• Execution risk at the new LCFS renewables facility. The market is currently pricing LCFS like the management’s projected earnings will mostly turn to nothing. I believe this is way too conservative and LCFS shares already reflect a pessimistic outlook. Meanwhile, good earnings and any material re-rating of LCFS should have a very positive effect on the TWM price.
• Management wasting sale proceeds on some other projects. I would be quite surprised by this given that the company has clearly changed course since the previous CEO/founder resigned and Kicking Horse took the chairman’s role last year. The strategic review and the Pipestone sale were the two big positive moves since then. I think it’s likely the current direction of value realization will prevail and we will see some further positive developments down the road.