Description

Summary: HIF-U is a classic misunderstood event-driven situation involving a stable, profitable, fundamentally sound company that has experienced a temporary market dislocation as its recent suspension of distributions has driven away its core base of yield-seeking investors. Value investors will quickly recognize that the underlying economics of the business have not changed and the suspension of distributions is due only to temporary working capital constraints caused by extreme external factors (aberrant weather and record high heating oil prices) that have already begun to correct themselves. The opportunity here is not only to benefit from a generous cash flow yield once distributions are fully reinstated (probably in 2006), but also to benefit from unit price appreciation of 20% to 90% (to C$7.50 – C$12.00) over the next 12 to 18 months as yield-seeking investors once again return to HIF-U in anticipation of those distributions.

Company Description

• Description: Heating Oil Partners Income Fund (the “Fund” or “HIF-U”) is a Canadian income trust that owns 88% of Heating Oil Partners, LP (“HOP”), one of the largest US residential heating oil distributors (based in CT). In addition to residential customers (~40% of 2005P revenue), HOP also delivers to commercial accounts (~30%), provides fleet refueling services (~20%) and installs & repairs heating equipment (~10%).
- Well-positioned: Operates in northeastern US, where 75% of domestic heating oil consumption occurs (32% of homes in HOP’s area use heating oil). Second largest provider delivering ~200M gallons to 150K customers using 11 regional distribution centers & 365 trucks.
- Seasonality: 70-75% of residential liquid product sales earned between Nov. and Mar. and positive GAAP earnings concentrated between Oct. and Apr.
- Ownership: HIF-U owns 88.1% of HOP. Minority holders are John Hancock Life Insurance Company (8.3%) and management (CEO Mike Anton, CFO Paul Forrest & former CEO Joe Glick hold remaining 3.6%).

• Canadian Income Trust:
- What is it? See HOP’s prospectus for details, but in summary, an income trust is a Canadian structure that allows companies to issue tax-efficient combined debt & equity securities to yield-seeking investors. Most available cash flow is then distributed to unitholders in the form of regularly scheduled distributions representing both interest & dividend income. In this case, HOP is held by a Canadian holding company that issues debt & equity to Fund unitholders in order to finance its purchase of the underlying HOP units. So, each Fund unit in essence represents 75% debt & 25% equity. This structure is considered appropriate for companies in mature industries with strong, stable cash flows, low cyclicality & low capex requirements. Although around for decades, this structure really peaked in popularity 2-3 years ago, and now represents approximately 6% of the entire Canadian equity market. The structure is somewhat analogous to the new income deposit securities (“IDS”s), now debuting on the US Amex.
- Why be one?
- Tax benefits: The above structure has allowed the Fund to offset taxable income of HOP with holding company interest expense, in essence eliminating corporate taxes. The resulting flow-through tax effect is similar to that of a Master Limited Partnership ("MLP") in the US (of which Star Gas Partners is one – further discussed below), but HOP does not qualify for MLP status as heating oil is not recognized as a natural resource (whereas propane is, for instance).
- Greater access to capital: This structure provides HIF-U with greater liquidity (approximately four times the implied equity market cap. of the underlying units) and a ready base of yield-seeking investors and research analysts (four currently cover HIF-U). Without a similar structure, HOP would likely be a small orphan equity on a US exchange, trying to get its story heard.

• Industry: HIF-U and Star Gas Partners (“SGU”) are the only 2 public players in the domestic residential heating oil industry with ~4% and ~9% market share, respectively.
- Consolidation: Since inception in 1995, HOP has acquired and integrated 41 distributors & service businesses. The industry consisted of 4,800 dealers in 1980 and has fewer than 2,300 today. Increased access to financial capital is one of the primary benefits to consolidation and is further described in the sections below.


Investment Thesis

• Why has the unit price fallen? HIF-U’s unit price has plummeted from a high of C$14.45 in February to just C$6.30 today. The most recent drop (from C$8) is linked to the temporary suspension of dividends anticipated on Oct. 18 & announced on Oct. 29.
- Fundamental investor mismatch: Income trust investors are typically yield-seeking. When HIF-U announced that working capital constraints (not operational or profit-related issues) necessitated the temporary suspension of this distribution, yield investors fled. To these investors, intrinsic value is often subordinated to current income. It is this fundamental mismatch in the investor base created by the temporary dividend suspension that provides such an attractive opportunity for value investors.
- Star Gas Situation: SGU announced suspension of its dividend on Oct. 18, knocking 10% off of HIF-U’s value. Because SGU is the only public comp, the two companies trading patterns are highly correlated (86% over the past 12 months). As such, there is likely some belief in the market that the reasons for SGU’s suspension are attributable to HIF-U as well. However, in this case, we believe that SGU’s situation is much more complicated than HIF-U’s and that it may be suffering from operational issues which are not affecting HOP at all.
- Weather: Because of seasonality described above, the winter heating season (Nov. – Mar.) has a disproportionate impact on all business aspects. The ideal climate for HOP is a predictable one – internal budgets are determined using the most recent 10-yr. avg. heating degree days (“HDD”s) for the regions in which they operate. The negative consequences of falling materially outside of these norms are described below. To a large extent, HOP’s recent difficulties are the result of the highly abnormal winter weather patterns of the past 3 heating seasons. The winter of 2002 was an unseasonably warm winter (warmest in ~5 years), which was then followed by one of the coldest in the past 30 years with avg. HDDs of 30% above the year prior. Those years were then followed by a seemingly avg. 2004 winter, although intra-period weather was extremely erratic, making it very difficult for HOP to match capacity with demand (increasing delivery & service expenses). Equally as important (& further described below), 2004 was characterized by record high heating oil prices (only being surpassed by those of the current 2005 winter).
- Working Capital ("WC"): To a company valued almost solely as a multiple of its dividend, cash flow is paramount. As HOP has been consistently cash flow positive (Net Income + D&A), the largest determinant of funds available for distribution has been the change in WC. HOP typically collects from residential customers in 30-35 days (commercial in ~20), but must pay suppliers within ~5-7 days. As the price of the underlying commodity rises (No. 2 heating oil, which is correlated very closely to the price of crude oil), the need for more WC increases, placing a temporary strain on HOP’s liquidity. However, the increase in WC required declines to zero as prices stabilize & then will actually reverse as prices return to trendline levels, creating a release of WC. As HOP continues to operate profitably through 2005, it will collect on its inflated A/R and rebuild its customer credit balances (as new customers are signed up at higher prevailing market prices). This, coupled with the temporary suspension of distributions, should leave HIF-U with a lot of financial flexibility going into 2006.
- Heating Oil Prices: The spot price of heating oil rose 103% from Oct. 2003 to Oct. 2004, reaching a record of US$1.67/gallon which led both SGU and HIF-U to announce the temporary distribution suspension in light of the above WC concerns.

• Why is this better than Star Gas?
- No customer attrition issues: On Oct. 18, SGU reported the temporary suspension of dividends in part due to “the effects of unusually high customer attrition principally related to its operational restructuring undertaken in the past 18 months”. In an industry characterized by very low customer turnover (generally less than 3% per year), SGU has apparently managed to stimulate much higher attrition rates primarily by consolidating its calling efforts to a new center. In general, customers seem to prefer the neighborhood feel that this fragmented industry provides and the “impersonalization” of the customer service effort was ill-received, especially during a period of rapidly rising heating oil prices. This, combined with technical difficulties during the transition that made it difficult for customers to reach a representative have apparently recently lead to waves of customers choosing to leave SGU for local alternatives. Bears also argue that attrition rates may experience added pressure in a rising rate environment as customers become more concerned with reducing their total heating bill than with receiving the additional premium priced services of SGU or HOP. HOP’s management has been unequivocal in its representation to us that these attrition issues are unique to SGU and that HOP’s attrition rates show no notable difference from historical trends. They also disagree with the premise that attrition increases as heating oil rates rise and point to the fact that 95% of their residential customers are enrolled in 12 month price protection plans (“PPP”s) under rates locked in at time of signing, reducing potential benefits of switching as rates rise.
- No per gallon margin compression: SGU also sites “the inability to pass on the full impact of record heating oil prices to customers”. Clearly the Street is also expecting SGU’s margins to contract. HOP’s management has clearly stated to us that HOP's per gallon gross margin will remain constant & is not a function of oil prices. Whether customers choose to purchase as needed (spot) or to enroll in a long-term PPP, HOP's margin is the same and will not be reduced to lower the total fuel bill to the customer. However, during periods of very high prices, conservation efforts may somewhat reduce HOP’s volumes sold, spreading fixed costs over fewer revenues (although heating demand is fairly price inelastic).
- No major unhedged positions: Although not mentioned specifically by SGU, there is some speculation that the company may have taken an aggressive amount of hedging risk and is experiencing the negative effects of that decision as heating oil prices have continued to rise. If true, SGU likely signed customers into PPPs without adequately hedging the price risk, perhaps believing that prices had already peaked. Depending on how aggressive SGU was and when these customers were signed up, the negative impacts of this decision could weigh on results throughout the winter. In contrast, HOP has adopted an agnostic approach to oil prices by hedging the majority of estimated fuel demand for 100% of its customers. This is done through either futures or options purchased immediately when a customer signs up for a PPP. These hedges typically represent ~80-85% of that customer’s anticipated demand & only the marginal usage is then spot purchased as necessary.
- Transparency: Given recent events, SGU’s mgmt. is only referring investors & analysts to press releases and an external PR firm. This only increases uncertainty & fuels speculation about the severity of these issues & potential others. We believe this taint has also had an unwarranted negative effect on HIF-U's valuation. However, we have found HIF-U’s management to be quite accessible & willing to discuss its business in great detail. In this case, investors have the ability to do the fundamental research & due diligence necessary to satisfy themselves that these situations are not at all analogous, but few seem to have done so thus far.

• Should unitholders want a cold winter or a warm one?
- Colder is better: When temperatures drop, there is a direct positive correlation with heating oil usage. When volumes rise on constant per gallon margins, obviously revenues & profitability increase. Because warm winters can negatively affect volumes and profitability, HOP purchases weather insurance derivatives to mitigate exposure to this risk.
- Bell curve winter: Notwithstanding the above, HOP would prefer a bell curve winter to a very cold one. As mentioned earlier, internal budgets are determined using the most recent 10-yr. avg. HDDs. To the extent that weather deviates materially from expectations, certain strains may occur. For instance, unusually cold winters may lead to excess overtime for drivers, increased spot rate prices for marginal heating oil requirements (beyond hedged volumes) and increased emergency repair calls. Conversely, unusually warm winters could lead to lower consumption than anticipated, spreading fixed costs over smaller revenues. After the extreme and erratic winters of the last 3 years, HOP is hoping for a return to the norm.

• Should unitholders want heating oil prices to go up or down?
- Lower oil prices: This is the best case scenario for HOP in the short-run because it alleviates the only real current issue – potential WC constraints. As described above, as heating oil prices decline, cash tied up in the WC cycle is reduced and is able to be released back to unitholders. In fact, since SGU announced its dividend suspension on Oct. 18, the spot price for heating oil has fallen 25% (from US$1.65/gallon to US$1.25). The forward contract rates have experienced a similar fall as well. When SGU & HIF-U made public their working capital constraint issues, they were looking at Feb. 2005 (peak volume) forward rates of US$1.45–US$1.47/ gallon, roughly 11% higher than today’s price of ~US$1.31. In fact, if current rates continue to return to more normal levels or even just stay where they are, HOP should have no serious WC constraints & could potentially even begin partially redistributing sometime in 2005.
- Higher oil prices: Higher oil prices are not necessarily such a terrible thing for HOP either. Although cash tied up in A/R swells, this is partially offset by increasing customer credit balances (liability account) as HOP collects higher fixed monthly payments from new PPP customers in advance of actually purchasing & delivering their oil. The real benefit, however, is that the industry is comprised of thousands of “mom and pop” regional distributors that have more limited access to capital than HOP does. Consolidation at reasonable prices will only accelerate as these small business owners find themselves faced with the increased barriers to entry of higher WC requirements forcing the decision of whether or not to potentially mortgage personal assets in order to cover WC needs. HOP, however, has not only shown its ability to renegotiate its credit agreements to achieve greater flexibility (Nov. 15), but also that it clearly has ready access to additional equity financing (C$35M July offering was oversubscribed). In a scenario where profitability is largely preserved through fixed gross margins, but WC requirements may fluctuate based on external factors such as weather and oil prices, it is those with such ready access to capital that will benefit the most. As a result, the current competitive environment should improve and benefit HOP as weakened competitors are forced out of business. This environment should also present HOP with a number of attractively priced acquisition candidates through which to extend its growth.

• Is working capital really a constraint? Although much is made of the WC issue as it is responsible for the suspension of dividends, one should be careful not to overstate it by extrapolating peak prices through the winter to conclude that HOP will be unable to adequately finance its operations from its current WC line. Just last month, HOP was able to secure an amendment from its bank lending group effectively increasing its WC facility from US$30M (US$45M during peak winter months) to US$57.2M (new US$42.2M year-round facility plus a US$15M termed-out portion to begin amortizing in January). The banks were willing to grant this flexibility because these lines are secured by high quality receivables and highly fungible inventory. Management has emphasized the security of HOP’s A/R by stating that they actually have the ability to put liens on their customers’ homes as a last resort to recover amounts due. Should oil prices rise and more financing become necessary, the banks understand that HOP’s underlying profitability is not impaired (except perhaps by the nominal incremental interest expense on the marginal facility increase) and that their capital will be released back to them at the end of the heating season. It is difficult to envision a situation where the lending group would rather see HOP unable to meet its obligations than to marginally increase a profitable loan to a very stable company with high value secured assets.

• Where should the units trade?
- Valuation summary: Since its IPO, HIF-U has traded at a yield of between 10% and 12% or between C$11.00 and C$14.00 per unit, when the Fund was paying an annual distribution of C$1.40 per unit (a figure that was somewhat aggressive given that approximately 14% of the distribution represented a return of capital dividend in 2004). Given that the underlying economics of the business have not changed materially, but have primarily just been temporarily impacted by inflated working capital requirements, it is not unreasonable to assume that HIF-U could return to issuing a distribution of C$1.00 per unit by 2006. This figure would allow for a more conservative payout ratio than the company has used historically as well as further deterioration in the US dollar versus the Canadian dollar. Such a distribution valued at the midpoint of the historical yield range (11%) would imply a unit price of approximately C$9.00 within 12-18 months or ~43% upside from current levels with very limited downside risk.
- Potential acquisition candidate: Now that SGU has announced the US$475M sale of its propane business (Nov. 18) in addition to the negotiation of favorable bank group waivers and financing commitments (Nov. 5), the company is no longer facing an imminent liquidity crisis. In fact, SGU management must now decide what to do with the US$175M or so that will remain after satisfying working capital needs and repaying certain debt instruments. Excess cash that is neither being used to grow the business nor being distributed to unitholders will likely be required to be used to repurchase some portion of the US$265M of outstanding senior notes. It is therefore not unreasonable to assume that SGU may try to take advantage of the current negative environment and the depressed valuation of HIF-U to significantly grow its business. The footprints of the two competitors appear to be tremendously complimentary and SGU could likely rationalize distribution centers and delivery routes given that both companies operate primarily within the same geographic region (the domestic northeast). Other potential benefits of consolidation include increased financial flexibility, greater liquidity and improved purchasing power.
- Potential upside: As discussed previously, the increased working capital constraints caused by the current pricing environment have raised the barriers to entry (and ongoing sustainability) for players in the residential heating oil industry. It is likely that consolidation will continue and even accelerate as a result of these circumstances, providing a ripe growth vehicle for HOP as it seeks to increase its distributable cash flow through accretive acquisitions. To date, HOP has acquired 41 distribution and service businesses, boosting Sales from US$150M in 1999 to an estimated US$485M for 2005 (a 22% CAGR). During that same time period, EBIT is expected to increase by a similar rate from US$2.8M in 1999 to an estimated US$9M in 2005.


Risks

• Near-term sustained spike in oil prices: As described in detail above, this could put an additional strain on working capital facilities. This effect would be temporary, however, and would reverse as oil prices return to more long-term trendline levels, thereby releasing capital back to the banks and unitholders. The threat of this has already subsided substantially (as heating oil prices have already fallen ~25%) since SGU and HIF-U announced the temporary suspension of distributions in late October.

• Abnormal weather: The potential negative effects of adverse winters have already been discussed. It is important to note that HOP has purchased weather insurance contracts in the form of weather derivatives since 1997 to mitigate its exposure to volume risk associated with uncertain warmer than normal conditions.

• Phantom dividend income: Because Fund units represent both debt and equity, a portion of the distribution to unitholders represents interest income, a portion is dividend income and a portion is typically a return of capital dividend. Whether or not the Fund is actually distributing cash or not, it seems that unitholders will still at least be accruing interest income on the portion of their units representing the underlying debt securities. For the 2003 tax year, the C$1.40 distribution represented approximately 54% interest income (C$0.75), 32% dividend income (C$0.45) and 14% return of capital (C$0.20). Even if HIF-U were not to issue any distributions whatsoever in 2005, unitholders would still record phantom (or accrued) interest income of C$0.75 per unit for tax purposes. At a 35% tax rate, this would imply a tax burden of approximately C$0.26 per unit on no cash received. Although this would not be a true economic loss (other than the time value of paying the taxes in advance of actually receiving the eventual distribution), it would require unitholders to either pay this tax bill out-of-pocket (representing approximately 4% of the investment at current market prices) or sell units to meet the tax burden. As neither of these scenarios is unitholder friendly, we believe that HIF-U will choose to make a limited distribution at least large enough to cover the tax burden created by the phantom interest income. With the working capital improvements implied by the recent fall in heating oil prices, we do not think that this will be too difficult.

• Currency risk: Substantially all of HOP’s operations are in the US and both revenues and expenses are collected and paid in US dollars. However, as the distributable cash flow (in US dollars) is converted into Canadian dollars for distribution to unitholders, the negative impact of the falling US dollar versus the Canadian dollar is apparent. The US dollar depreciated 25% from the beginning of 2003 until the end of November (it has since rebounded about ~4% during December), essentially implying a ~25% reduction in the distribution. However, HIF-U has had in place a currency hedge pegging the exchange rate at the January 2003 level (C$1.55) through May of 2005. More importantly, US investors are naturally hedged here as any currency-related decrease in the distribution (and therefore corresponding decrease in the unit price assuming a constant yield) will be exactly offset by the increase in the Canadian exchange rate when converted back to US dollars.

• Deductibility of interest expense: Although management feels very confident that HIF-U will continue to retain its tax-efficient status, there does exist the possibility that the IRS may one day choose to challenge the notion that Fund units represent true debt and equity (as opposed to merely equity) and attempt to disallow the interest expense from the Fund notes that is currently offsetting the positive net income at HOP. This would then trigger US taxes at the holding company level. However, even if this were to happen and HIF-U were to lose any subsequent appeals, there would actually be no effect on taxes paid until at least 2008 given the large amortization expenses resulting from the amortization of intangibles (mostly customer lists) that have arisen from HOP’s many acquisitions. Management would then still have time to evaluate alternate tax-efficient structures.

Catalyst

• Continuing retreat of heating oil prices
• Bell-curved (normal) winter
• Acquisition by SGU
• Reinstitution of dividend distributions
• Discovery by value / event-driven hedge funds looking closely at SGU situation