Edwin Tan /E+ via Getty Images

Edwin Tan /E+ via Getty Images

CSI Compressco (NASDAQ:CCLP ) has been in a rough situation for quite some time. The 2020 Debt Exchange apparently only kicked the can down the road on balance sheet repair, and the compression market recovery has been very slow to materialize - so much so that even high-quality peers in the sector are seeing negative improvement in earnings compared to 2020. Higher costs have pressured the business, and it could get worse: unlike other midstream firms that index contract prices to inflation, that protection is not built into CSI Compressco agreements.

Getting rid of the remaining stub of 2022 Unsecured Notes left after the debt exchange has been a thorn in the side of the bull case, but many felt the new general partner has been viewed as a potential savior. Reality is that like most private equity players, Silverhawk has played hardball as it gets more involved. The merger between its wellhead gas gathering and processing business is small in scope, but the bigger pain point is the secondary offering to settle the 2022s. I actually don't think the acquisition of Spartan assets is poor or oppressive, but instead just a culmination of a near worst-case scenario looking forward from the start of the pandemic.

No need to get too in the weeds as I suspect most reading this know the terms, but the transaction announced concurrent with Q3 2021 earnings has two components: selling 42mm units at $1.35 per share to private investors to call in the 2022 Unsecured Notes and issuing another 48.4mm units to bring the Spartan Energy business into the fold, combining the operations of the new general partner with CSI Compressco.

Let's start with the last component: Spartan combining its wellhead services business with CSI Compressco. Funnily enough, the slide deck presentation did a pretty poor job of detailing what Spartan Energy actually does, and I've found a lot of investors are a bit confused on the value proposition. The company is primarily operating in two areas: gas treatment and natural gas liquids ("NGLs") recovery. Its gas processing assets handle sour gas, removing nasty components like carbon dioxide, hydrogen sulfide, and sulfur dioxide from the stream. Exploration and production ("E&P") want to do this to improve the value of their natural gas, and in fact, it has to be done in many cases in order to be able to deliver the product into the pipeline network as these contaminants degrade equipment. Its refrigeration units condense natural gas liquids ("NGLs") out of the natural gas stream, boosting revenue and once again ensuring natural gas delivered into the pipeline systems is to spec.

To be clear, this is not exactly the same as what DCP Midstream (DCP) or Targa Resources (TRGP) are doing at their large-scale processing plants - where most natural gas is processed in fact. But in some cases, natural gas needs to be treated near the wellhead due to heavy contamination before making it to a major facility. In others, produced gas can be of such quality that producers might just use on-site skid processing to remove the minimal impurities, and can then just pipe it into larger pipelines rather than having to transport to a major processing plant. Or, some producers with minimal production might opt to capture NGLs on-site rather than pay to ship product longer distances to have that condensate available. These kinds of unique operations are the kind of business that Spartan aims to capture. Niche in nature, but a clear need.

Overarching macro themes from the above are shared with compression: higher gas to oil ratios over time, natural gas production growth due to overseas liquefied natural gas ("LNG"), and ESG initiatives in upstream (less flaring, methane emissions). There are also clear cross-sell opportunities, although no targets or estimates were laid out as part of the presentation. Further, these kinds of assets have similar contract structures to compression: contracts tend to last a couple of years, with costs incurred by the customer on initial installation and demobilization. Costs to remove equipment plus bring in someone new acts as a pretty good barrier to competition.

Given that, I think that most investors would assume they are worth similar multiples. 48.4mm new common units were issued to acquire the Spartan operating business and eliminate the CSI Compressco incentive distribution rights ("IDRs"). The latter was so far out of the money that they really should not have had much - if any - value when the transaction was analyzed by the conflicts committee. Calling it a zero, this means that CSI Compressco is paying $98mm (including assumption of debt) to acquire a bit more than $17mm in EBITDA.

While the conference call had management state that they did not use multiples as a driver in how they valued the business, the math is pretty simple. $98mm implies 5.8x EBITDA, which I think is more than a fair valuation for the business assuming that is run rate and sustainable. Remember that CSI Compressco - for all its flaws - trades at 7.8x EBITDA today. One can argue that the legacy compression business in the middle of a turnaround and that future earnings will be much better, but even at its peak of high utilization pre-pandemic and drilling slowdown, CSI Compressco was only looking at $120mm or so in annual EBITDA (6.0x EBITDA on peak earnings). Solid deal price in my view.

In August of 2022, the remaining stub of its 7.25% Senior Notes mature, so those notes officially moved to "current debt" within the most recent 10-Q. Recall that this stub exists because many investors were frozen out of participation in the CSI Compressco debt exchange, as the new bonds were only able to be owned by institutional accredited investors while these old bonds were open to anyone. What resulted was an "exchange" where the big money players were free to participate, leapfrogging ahead of smaller investors (the new notes are secured) if CSI Compressco ended up folding.

The balance outstanding totals $80mm, and CSI Compressco had $23mm in cash as of quarterly close. Simple napkin math tells you that CSI Compressco had a $57mm problem to solve inside of the next year, which is why the company issued 42mm units at $1.35 per unit. The size of this secondary stock offering did not come out of thin air and was done expressly to get rid of the outstanding 2022s. Not a penny more, not a penny less.

Realistically, everyone up in arms about this deal is getting upset because of this part of the puzzle - not the Spartan acquisition. Issuing all of these units to eliminate the 2022s is extremely dilutive and is basically the worst-case scenario. All the reports citing the high DCF yield on the units, and here the company is forced to dilute those interests in order to get rid of bonds. Yuck.

But it's not terribly surprising that we ended up here. Terms under the debt exchange were harsh, the company was essentially frozen out of using its compression assets as a source of capital via asset sales; the new secured debt prevents that. Those notes, given they are backed by substantially all of the compression equipment, would also not approve the sale of secured assets to pay down debt that is more junior in recovery than their own. With all of the assets frozen, there were just a few options to tackle the 2022 Unsecured Notes:

The Second Lien Notes have traded hands below par in the markets and already carried a double-digit coupon, which means that Option 1 and Option 2 would never price at a reasonable rate - or at least to independent third parties. Creditors are not lining up to extend unsecured credit when second lien secured debt is being taken as payment-in-kind ("PIK"), issuing new notes ahead of it. Further, implied interest coverage would be far too low.

With $75mm in fixed expenses in this business ($55mm in current run rate interest expense, $20mm maintenance capital), there was also no path to paying down the debt with the entirety of free cash flow. Even assuming CSI Compressco earned $100mm in EBITDA (well above even currently annualized Q3 2021 rates), it would only book another $25mm in free cash flow before August.

Spartan is backed by Silverhawk, who is no small player in energy. There is a lot of buying power behind it, and $80mm would be no problem to float. It also owns common units it acquired as part of the general partner buyout. That ownership does give some incentives to not permanently damage the outlook for CSI Compressco if it is to remain public, but rarely does private equity do anything other than extract every possible dollar that it can. Why issue a convertible preferred at a low rate from Silverhawk when they can justify gaining stronger control via another secondary of the common?

Harsh? Maybe. Illegal? I don't think so, investors would have a hard time presenting a case that there was a viable third-party solution. I think it would have been better if there was a rights offering so existing public owners could participate in buying more units, but it's not like there was a sweetheart deal involved.

Plenty of dilution taking place here, with a bit more than 90mm units getting issued. It's a tough price to pay, but at least the debt profile is clear through 2025. Even with the new assets, leverage remains lofty at 5.5x. To get the balance sheet back down to normalized levels that make rolling over the 2025/2026 maturity wall, CSI Compressco is going to have to get down into the 3.5 - 4.0x range. That's a long way away and implies $150mm in debt paydown over the next three years. That is assuming the legacy compression business gets back up to $100mm in EBITDA - not plodding around at the rates that it is now.

There is a path to that kind of deleveraging, but it's narrow. $120mm in EBITDA pro forma backs into about $40mm per year in free cash flow, and that's ignoring the growth capital spending that the new entity is attempting. Every dollar is going to get thrown at the balance sheet or to small tuck-in growth projects I think, and that means the current distribution will see no change until the maturity wall is addressed. That's a long time for a partnership to pay basically zero in distributions, especially given the yield offered by other energy plays. The Unsecured Notes were a fine play that made it by, but I don't think the common is worth having much interest in for now.

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This article was written by

Author of Energy Investing Authority

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I have a decade of experience in both the investment advisory and investment banking spaces, with stints in portfolio management, residential mortgage-backed securities, derivatives, and internal audit at various firms. Today, I am a full-time investor and "independent analyst for hire" here on Seeking Alpha.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.