Value Investors Club / SPRAGUE RESOURCES LP (SRLP)

Description

Long SRLP. Sprague Resources (“SRLP”) is one of the largest independent wholesale distributors of refined products

in the Northeast United States with a network of 19 terminals aggregating over 14 million barrels of

capacity. SRLP also purchases, sells and distributes natural gas and has a materials handling business.

Structured as an MLP whose GP is the private Swedish industrial concern Axel Johnson, Sprague has

been in business since 1870.The Company became part of Axel Johnson in the 1970s. The MLP went

public in 2013 at $18 per share. The minimum quarterly distribution at the time of the IPO was $0.4125

per unit. The most recent quarterly distribution was $0.5175 and distributions are expected to grow at a

12% growth rate. Currently, the units are trading around $18.50 with a yield of over 11%. Given

expected double digit distribution growth and a 2x coverage ratio this is cheap. When compared to

peers, we think SRLP should trade at a yield of 8% or around $29 per unit in a year or so. Add in

anticipated distributions of $2.22 and returns would be in excess of 60%.

The Opportunity

SRLP has been caught up in the turmoil inflicted on the MLP market given the fall in commodity prices.

However, lower commodity prices are not necessarily bad for SRLP. In fact, lower commodity prices

arguably are better for SRLP as they encourage higher volume purchases by SRLP’s customers.

The mild weather in the Northeast has, on the other hand, impacted SRLP’s business in a negative way

with heating degree days this year so far over 10% lower in 2016 as compared to 2015. Even so, SRLP’s

2015 results were good given the mild fourth quarter and profitability has not deteriorated this year to

such an extent that distributions are (even close to) threatened: coverage ratios are strong at over 2x

and the long term outlook for distribution growth is healthy. I’m not a meteorologist, but I believe that

in the long term, hot and cold seasons should even out over time. Be that as it may, recently provided

adjusted EBITDA guidance for 2016 of $105 to $120 million may be disappointing to some given 2015

results came in at $110 million. This guidance assumes a warm (and presumably weak) first quarter.

The Business

Refined Products – 62% of adjusted gross margin (adjusted gross margin is a cash margin that removes

the impact of unrealized commodity hedges)

Sales in the Refined Products segment consist of distillates (72% of volumes), gasoline (13%), and

residual fuel oil and asphalt (15%). Distillates consist of heating oil, diesel, kerosene and jet fuel. Sales of

refined products are to wholesalers, retailers, resellers, commercial and industrial accounts including

federal and state agencies, municipalities, transit authorities and corporations. Sales are made under

rack agreements and contracts with index-based pricing terms and are typically made from a terminal or

other storage locations owned by SRLP. SRLP uses derivatives and forward contracts to maintain a

position that is substantially balanced between purchases and product sales.

The Refined Products segment has over 1,100 customers and sold 1.7 billion gallons of product in 2015.

Natural Gas – 18% of adjusted gross margin

SRLP delivers natural gas to customers through utility interconnections of pipelines and manages

interactions with utilities pursuant to fixed price, floating price and other structured contracts.

Derivatives are used to manage natural gas commodity price risk. In order to manage supply

commitments and provide operational flexibility and arbitrage opportunities, SRLP has supply contracts,

leases for pipeline transportation capacity, leases for storage space and other physical delivery services.

Customers in the Natural Gas segment are commercial and industrial concerns such as hospitals,

universities, apartment buildings, manufacturers, pharmaceutical companies, and chemical and

processing companies.

The Natural Gas segment had over 14,000 customers and sold almost 57 Bcf of gas in 2015.

Materials Handling – 17% of adjusted gross margin

The Materials Handling segment moves raw materials and finished goods through waterfront terminals

that SRLP owns. The terminal network is used to offload, store and prepare for delivery a large number

of liquid products, bulk and break bulk materials, and provide other handling services to many of the

same customers that acquire refined products from SRLP.

Services include ship handling, crane operations, pile building, warehouse operations, scaling and

transportation to the final customer. SRLP plays the role of a distribution agent and, because the

products handled are generally owned by customers, SRLP has virtually no working capital

requirements, commercial risk or inventory risk. In addition, materials handling contracts are typically

long-term and fee-based.

Other – 3% of adjusted gross margin

Other operations include the marketing and distribution of coal (Sprague’s origins lie in this business),

some commercial trucking activity, and a small heating equipment service business.

To a certain extend SRLP is a roll-up story and the company tries to acquire terminal or marketing

businesses that are synergistic with its existing operations. Since going public, SRLP has acquired five

similar businesses including one “drop down” from Axel Johnson.

2015 Financial Data ($ in Millions)

Revenues 3,481.9

EBITDA 127.4

Adjusted EBITDA 110.4

Net Income 78.0

Distributable Cash Flow 89.7

Maintenance Capital Expenditures 8.9

Total Capital Expenditures 14.9

Equity Market Capitalization 400.0

Permanent Debt 275.0

Total Enterprise Value 675.0

Commentary on Financials

SRLP’s GAAP financial performance appears somewhat volatile given that the Company includes gains

and losses on hedges in cost of sales. SRLP allows for this by removing the unrealized portion of hedges

from its financial performance when reporting Adjusted EBITDA. This makes sense as long as the

Company is running a matched, not speculative, hedge portfolio. SRLP uses Adjusted EBITDA for the

purposes of calculating distributable cash flow too. Net income is not presented on an adjusted basis so

PE multiples are not always that meaningful (although for 2015 net income per limited partner unit

came in at $3.71 which would make SRLP screen cheap at a PE of 5x). Capital expenditures for the

business as a whole in 2015 came in at around $15 million of which about $9 million was designated

“maintenance”. Distributable cash flow in 2015 was almost $90 million. This amount compares to 2015

distributions of about $40 million. True free cash flow (using all capital expenditures as opposed to just

maintenance capital) is about $84 million which also provides for additional coverage security (and a

cash flow multiple on the equity of 4.8x). The bottom line is that SRLP has a strong free cash flow

business, even fully loaded for capital expenditures, that provides a significant buffer to cover the

existing distribution and grow it in the future.

So what is that growth? The board has committed to growing the dividend at $0.015 per quarter for

now. That would get SRLP to a $0.5775 quarterly dividend in a years’ time, a future annualized dividend

of $2.31 per unit, a 12% annual growth rate, and a forward yield of over 12%. Now, if only the Board

could be persuaded to pay out a little more of the cash….

Owing to the seasonality of its business, SRLP has some pretty meaningful working capital requirements

and swings. On the recent earnings call, management stated that permanent leverage was 2.5x adjusted

EBITDA or about $275 million. With an equity market capitalization of about $400 million, SRLP’s total

market capitalization works out to be about $675 million. Using EBITDA of $110 million, SRLP trades at

6.1x. Adjust for $15 million of capital expenditures then the unlevered free cash flow multiple is 7.1x.

Now, if only the weather got a bit colder….

Also on the recent earnings call, management stated that the Company had paid down $93 million of

permanent debt in 14 months, essentially covering the purchase price of the third party acquisitions

made since the IPO.

Comparables

A peer group for SRLP is listed below. None of them is a particularly close comparable.

Company Yield LTM Coverage LTM EBITDA Multiple Yield Growth

APU 8.8% 1.0x 9.1x 4%

ARCX 17.1% 1.2x 9.3x NA

BKEP 12.0% 1.3x 9.2x 0%

FGP 13.2% 1.0x 11.4x 0%

GLP 13.6% 2.0x 7.3x NA

SGU 4.8% 3.6x 4.1x 8%

SPH 12.1% 0.8x 9.9x 1%

SRLP 11.0% 2.3x 7.1x 12%

TLP 7.3% 1.4x 10.5x 1%

WPT 8.5% 1.3x 8.5x 0%

Some notes: ARCX is involved in litigation relating to a material amount of its cash flow. To allow for

acquisitions, ARCX’s multiple is based on 2016 projections. GLP recently cut its distribution. SGU pays

corporate taxes. SRLP’s reported EBITDA multiple on Bloomberg is 7.3x. TLP’s GP was recently acquired

by ArcLight, a private equity firm, which is anticipated to improve growth potential. Data sourced from

Bloomberg.

So where should SRLP trade?

With a free cash flow yield (to the equity) of some 20% and some growth anticipated, one could argue

that SRLP should be a double without accounting for distributions. If it were to trade for an 8% yield in a

year’s time a target price would be around $29. An 8% yield is at the lower end of comparables that

have higher multiples, lower distribution growth, and lower coverage. Add distributions of $2.22 and the

total return on an investment at $19 is 64%. All things considered, a trading price today in the mid $20s

is completely reasonable. At $25 SRLP’s yield would be 8.3%.

What could go wrong?

A rogue trade in the hedge book.

Irrational pricing by competitors.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

MLP market becomes more rational.

show sort by

			2016	2017
Price:	18.50	EPS	3.71	0
Shares Out. (in M):	11	P/E	5.0	0
Market Cap (in $M):	400	P/FCF	4.8	0
Net Debt (in $M):	275	EBIT	110	0
TEV (in $M):	675	TEV/EBIT	7.1	0