Description

Inergy, L.P. NRGY ($30.29) [$820Mn]

This is a relatively straight-forward story. Inergy, L.P. is a propane distribution MLP (70% residential, 23% commercial & 7% other), which has been growing mostly through acquisition for a number of years. The company has completed approximately 41 acquisitions since 1996. The company has stated it intends to grow its distribution by 10% or more per year and has delivered on this. This has been accomplished primarily through the aforementioned acquisitions and partly because organic growth in propane distribution has been in the 2-5% range, depending on geography.

The reason for this writeup is the company’s most recent acquisition-- the propane division of star gas partners (SGU)-- and the subsequent financing of it appear significantly more accretive than, I think, is being recognized by the market and, when completed, will serve as the catalyst for significant price appreciation in the Inergy common units (in addition to the yield).

The acquisition is expected to be completed this month and should not have any regulatory hurdles as the combination will result in NRGY becoming only the 5th largest propane distributor in a highly fragmented market. What is different about this acquisition is that it is very substantial (about doubling the company’s size), very accretive initially, and that synergies are not expected until the 2005-6 winter heating season, providing future accretion as well. As a result, while management has a stated goal of 10% growth in the distribution, I believe this acquisition will provide the opportunity for 20% +/- growth in the distribution for each of the next two years. Assuming additional tuck-in acquisitions are completed over the next 18 months, normalized weather, and that NRGY continues to trade at a yield consistent with growth MLPs and consistent with where it has been valued in its recent past, the units could easily trade into the low/mid $40s over the next year or so.

The company has just released its ebitda projections for the combined entity for 2005 (the projections also include a smaller acquisition also just recently completed— Moulton gas). The ebitda projection is $114-$122 million. Below the ebitda, there will be cash interest expense of $32m, cash taxes of $1m and maintenance capex of $7m. This yields distributable cash flow (DCF) of approximately $78M, using the midpoint of the ebitda guidance ($118M). Keep in mind that DCF is the gross amount of cash flow that is available to be distributed—but that it is split between the general partner and the common unit holder based on a preset formula. In addition, I am basing my conclusions for this writeup on the assumption that 100% of the DCF will, in fact, be distributed. (This has been the case since the company came public in 2001, though it technically does not all have to be distributed).

The formula for the split is as follows: up to 33 cents/quarter, the general partner gets 1.9% and the balance goes to the common unit holder; between 33-37.5 cents/quarter , the split is 15%/85%; from 37.5-45 cents/quarter, the split is 25%/75% and finally over 45 cents per quarter, the split is 50%/50%. Using this formula, on the current share base (27.3 million shares after the recent financings), yields a common unit payout of 57 cents/quarter. However, a more conservative approach involves making the assumption that NRGY does an additional offering since the current debt/cap is above management’s normal range of 50%. Using an assumption of an additional 4 million units at $33 unit, say mid-2005, gives me a payout of 55 cents/quarter to the common.


While some propane MLPs trade at much higher yields (such as FGP), they trade at those yields because they are not growing their distributions. Other energy-related MLPs, which grow their distribution (such as VLI), trade at much lower yield spreads to the 10-year treasury (approx. 200 basis points) and this is where NRGY has been valued prior to the star gas deal. I am estimating a $2.20 distribution for 2005 (which includes no further acquisitions, though there likely will be some and assumes the 4 million share offering I mentioned above). I am also estimating a distribution of $2.60 for 2006. This assumes a moderate amount of synergies that take hold during the 2005-6 winter where Inergy and Star have overlapping footprints as well as additional acquisitions.

Using the 6% yield that Inergy attracted prior to the acquisition of Star (as well as comps such as VLI which trade at yields even below this), the upside here is that NRGY trades to approx $43 over the next 12 months as investors put the units to a 6% yield on my fiscal 2006 estimated distribution of $2.60/unit. This provides appreciation on the unit of over 40% over the next 12 months, plus the yield itself. One can hedge out the interest rate risk if one chooses. I do not see much downside here, aside form the very remote possibility that the deal doesn’t close (and even if that were to occur, the units should be valued only 10% below current levels, at about $27, given that is where they were trading prior to the deal’s announcement and given that interest rates are about where they were at that time as well.)


Catalyst(s)
The star gas acquisition and related financings should serve as the catalyst for the stock as investors realize how additive it will be over the 2005-2006 time frame and how that could translate into a dramatic increase in the distributable cash flow.


Risks/Negatives
1) Star gas acquisition doesn’t go through or is poorly integrated
2) winter weather this year or next could be unusually warm
3) interest rates go up (assuming you do not hedge this risk)

Catalyst

The star gas acquisition and related financings should serve as the catalyst for the stock as investors realize how additive it will be over the 2005-2006 time frame and how that could translate into a dramatic increase in the distributable cash flow.