Description

Overview

Star Group, L.P. (“SGU”, “Star” or the “Company”) is a scaled operator in the secularly declining business of home heating oil and propane distribution and services.

Despite the secular headwinds causing organic revenue to decline annually, the stock has performed well over the past decade. The Company has produced substantial levered free cash flow which it uses to buy smaller operators (at 3.0x-5.0x EV/EBITDA) to offset the natural attrition it has been experiencing, buy back shares (which has resulted in the Company retiring 40% of outstanding shares over the last decade) and paying out ever-growing quarterly distributions to its remaining investors (they have increased the distribution per share each year since 2017, most recently increasing the distribution in April).

The stock price has appreciated from $5.50 a decade ago to just over $10.00 today, while also increasing its annual distribution from $0.37 per share to $0.69 per share (or LP unit). Unitholders over the last decade have enjoyed a compound annual total return of 14%, despite the stock price being down over 20% in the last year.

The heating oil industry has historically been characterized by 10-12 operators of relative scale (SGU being the largest amongst them) and thousands of mom and pop competitors. Since 2019, Star has been investing heavily in technology, which it can do profitably due to its scale. This has, in turn, increased their relative advantage over smaller players in an already consolidating industry. However, the true impact of these investments has yet to be seen as COVID and historically high diesel prices have impacted customer attrition and gross margins. The Company just reported their Q2 FY 2024 and gross margins expanded by 400 bps over the FY 2023 period.

Star has a market cap of $360mm, $136mm of Long Term Debt and a GP interest which I estimate to be worth ~$30mm, based off of this permanent capital the company trades at slightly over 5.0x EV/LTM EBITDA and a 7% levered free cash flow yield to market cap. Assuming some modest improvement off of decade-low gross margins (largely caused by mean-reverting, exogenous factors), continued share repurchases and the same EV/EBITDA multiple as today, I believe SGU will be worth close to $15 by FYE 2026, representing a total return of 60% and a 24% IRR.

Company History

SGU has been written up on VIC five times before; however, the latest write up was almost a decade ago. With that said, a number of currently active VIC members engaged on this name in the past so I would be very interested in their perspective.

Each of those pitches cited that the company was extraordinarily cheap, and yet, the Company still remains very ordinarily “cheap”. Notably, this pitch does not assume any multiple expansion.

In the mid-aughts the business ran into a series of problems. They ended up selling their rather large propane business (and stuck their investors with a massive tax bill), received a sharply worded letter from Dan Loeb, declined an offer from George Soros, and pursued a recapitalization with Kestrel Heat, which is now the GP of SGU. Kestrel owns all of the GP units, appoints all the directors to indefinite terms and receives a cut of any quarterly distributions above $0.07 (10% of any quarterly distribution above $0.0675 per quarter and 20% of any quarterly distribution above $0.1125).

The business got into financial trouble in the GFC, largely due to having a very high percentage of fixed price contracts that they could not entirely offset through hedges. At the time, over 40% of the business was based on fixed price contracts with customers, today only 6% of the business takes this form. 

Historically, the business had a complicated corporate structure, existing as a MLP that sat on top of some OpCo C-Corps – hence, the vestigial “L.P.” at the end of the Company’s name. However, in 2017 the Company elected to begin being treated as a C-Corp for tax purposes through a standard “check the box” election.

There have been three CEOs since Kestrel took over. The current CEO, Jeff Woosnam, took over in 2019 after the previous CEO unexpectedly died in late 2018. Mr. Woosnam has been with the Company for over 20 years. He has been a particularly effective corporate leader. Under his watch the Company abandoned their previous “concierge” service where, for a subscription fee, customers could have SGU provide all manner of home services – plumbing, security, HVAC, etc. The service never gained traction and was a loss-maker for several years. In addition, he’s shown a keen eye for pruning non-core assets that are not generating sufficient returns on capital. In recent years he has sold a propane business in the southeast and small heating oil businesses in New Hampshire and Maine. Collectively the sales generated just $15mm, but they represent an institutional imperative to return capital to shareholders rather than empire build.

Since FY 2020, the Company has bought back $117mm of shares, at an average price of $9.55, and the company has paid out $91mm to LPs in the form of distributions. Collectively, those payments represent 52% of the average market cap of the Company during 2020.

Business Description

Star is now focused on the northeast US. From the Company website:

The Company services 450,000 heating oil and propane customers, and an additional 26,000 gasoline and diesel customers (down from 500,000 customers a decade ago – a (1.3%) CAGR from FY 2014 – FY 2023). Their footprint represents 82% of the home heating oil users in the entire United States. Heating oil continues to thrive in the northeast as topography and urban density limit natural gas distribution, and where natural gas could theoretically be distributed houses are too dispersed to justify the investment. The Company sees ~1.0% of customers convert to natural gas each year.

Star maintains local brands after acquisition. There was a period in the early 2000s where the Company tried to unify every acquired company under a single banner, centralizing customers service, and eliminating local presences – this resulted in catastrophe. Learning from that experience, the Company maintains the local brands post-acquisition these days.

Star is coming off of two very warm winters (fiscal 2023 was the third warmest in NYC, Star’s core market, in 123 years) and historically high pricing per gallon, both of which have caused the company to have its lowest gross margins in a decade in 2022 and 2023. 

However, they are already seeing this mean revert. For the first six months of FY 2024 gross margins per gallon expanded over 500 basis points year-over-year.

The first two quarters of the fiscal year (Oct-Mar, i.e. the winter) represent over 100% of a typical fiscal year’s earnings.

The Company has also been consciously building out its propane footprint. After the sale of its historical business, Star had to wait out a non-compete. Then from a standing start the Company acquired and started de novo propane companies. As of FYE 2023, propane customers represented 17% of the Company’s customer base. The Company only began reporting the customer base this way in 2018.

Propane businesses routinely command a high single digit multiple (3.0x-4.0x higher than Star’s current multiple), including SGU’s legacy propane business which it sold in 2004 for 9.5x EV/EBITDA.

Additionally, as mentioned, at least since 2019, the Company has been investing heavily in technology. They have invested in customer facing technology to improve the experience. They have invested in a CRM system and tracking systems that keep the Company more in tune with customers’ usage levels so that they can proactively refill tanks. And they have been investing in tracking technology to improve route density and relieve some of the pressures on their CDL drivers.

By management’s assessment, there are only 10-12 scaled operators in the space. The other thousands of local heating oil companies are mom and pop. Management only began speaking about the tech investment in 2018-2019. There is no way that small operators, servicing only single municipalities, can afford to make the fixed cost investment into technology that SGU has been making. I believe the pandemic and the historically high diesel prices have obfuscated the inherent improvement the company has made in the singular metric, most under their control, that drives value – customer attrition.

Periods of rising prices, as was the case from 2020-2022, typically cause customers to shop for better terms, which based on the bevy of competitors, results in customers usually finding someone offering lower prices than their incumbent providers. However, customers tend to be much stickier in periods of declining price levels. In 2014-2015, against generally lowering price levels, SGU posted its best customer attrition metrics in the last decade. Ideally, with prices now more in line with historical averages, the Company will see improvement in customer attrition.

As a dying industry, the heating oil industry has been consolidating for years. Even with these technology improvements, on an organic basis, the Company loses customers each year.

However, the increasing emphasis on technology and capital required in the business should tip the scales even more so in the favor of the biggest players. Star being the biggest in the industry.

Capital Allocation

Net working capital swings wildly throughout the year as the company builds inventory into the prime heating seasons and then collects receivables into the summer, and while these are important for quarterly numbers, the Company utilizes a $500mm revolver to finance these items. As such, I have excluded the working capital impact on normalized FCF (but included all interest costs in my levered free cash flow calculation).

Regarding CapEx, the Company has far less capital requirements than you may initially presume. The fleet is depreciated using a straight-line method with an assumed average life of 15 years. And based on conversations with operators, in a recessionary environment it would be quite easy to postpone investments in the fleet. True maintenance CapEx for the business should be less than $5mm annually.

Below find the total CapEx by category for the last decade:

As mentioned, The Company has increased its quarterly distribution each year since 2017, most recently on 4/18/24. Below is SGU’s historical LP units outstanding and its annual distribution amounts per unit:

This has all been fueled by the Company’s ability to buy up smaller competitors for 3.0x-5.0x EBITDA. The Company averages 3-5% organic net attrition, assuming constant EBITDA margins (given the absorption of the smaller companies into a larger company with less attributable fixed costs), the payback period for each of these acquisitions is 5-6 years. Any cash flow created by acquisitions after this initial payback period is completely accretive. 

Meenan Oil, one of Star’s largest brands, was founded over 50 years ago.

Regarding shareholder base, the board collectively owns ~10% of the outstanding shares. Bandera Partners also owns ~10% and has been a holder basically since Kestral took over. And there are a few other institutional holders with large ownership stakes in the LP units.

While management has consistently avoided the question on capital allocation priorities, always demurring by saying that they weigh each decision independently. I have modeled it out assuming, in order of priority, the Company first pays out a generally constant dollar level of dividends (increasing on a per share basis each year due to the buyback program), then buys in shares, and, lastly, makes acquisitions with any residual cash.

Valuation

The Company’s credit agreement expires in July 2027. As such, I have modeled out through FYE 2026 assuming that all FCF generated above mandatory debt servicing accrues to the benefit of the equity. In the base case, I assume 2.0% net customer attrition in the out-years, and 100bps of gross margin expansion each year.

Overall revenue increases in FY 2026E as the residual cash is used to make acquisitions, which more than offsets the natural organic 2.0% volume decline.

These base case assumptions result in the following FYE 2026 valuation metrics:

And the following return profile:

In a bear case scenario, I assume margins remain depressed. I think this is a particularly draconian estimation, as the gross margins have already come back, and are generally mean reverting, but for conservatism this is how I modeled it. In this scenario, the Company continues to make quarterly distributions; however, they decline each year as the Company produces less and less distributable cash. The Company uses essentially all cash production to pay distributions and does minimal share repurchases and no acquisitions. The GP determines the level of cash that can be distributed each year, after taking into account the ongoing needs of the business.

Resulting in the following valuation metrics:

And the relatively benign downside return profile (significantly helped by the ongoing distributions):

Risks/Mitigants

Risk: This is a secularly declining business.

Mitigant: This is true. New homes are certainly not being built with a prejudice towards installing heating oil. In addition, if you read the 10-K you will see the numerous acts of legislation, largely being contemplated but some recently implemented, which would threaten the long-term survival of this business. However, hundreds of thousands of homes still rely on heating oil to survive harsh winters, with essentially no alternative sourcing. Nat Gas lines can’t economically run through much of New England. 

To paraphrase Twain – the reports of heating oil’s death are greatly exaggerated. 

Furthermore, Star will be the last to die. Mom and pops will increasingly decide that they would rather just retire than have to buy up another winter’s worth of inventory. Alternatively, they will sell out and SGU is well positioned to take advantage – either organically or inorganically.

And lastly, I think many people just assume that dying industries linearly go to zero. However, it is my experience that there is often some installed base that has extremely high switching costs and as the industry declines there starts to be a leveling off, as the marginal propensity to switch decreases with the total number of remaining customers. If that dynamic remains true, it could be that attrition naturally levels off and the tail is far longer lasting than the market anticipates. Acquiring the Company at essentially 5.0x cash flow, the business doesn’t have to persist that indefinitely to make the investment attractive.

Risk: There is execution and integration risk related to the highly acquisitive nature of the business.

Mitigant: Star has averaged over four transactions annually for the last decade. They have a good understanding of the marketplace and have identified essentially every relevant acquisition target in their ecosystem. The business development function is fully formed at this point. From an operational perspective, SGU largely leaves businesses as they acquired them, limiting the impact on their day-to-day operations. From a financial perspective, the Company aggressively amortizes acquired customer relationships due to the experienced attrition, and this results in D&A generally outpacing CapEx plus normalized acquisition investment. I believe the Company reports fairly conservatively, and I do not have any concerns about acquisition accounting obscuring true economic earnings.

Risk: The Company relies on aging employees (including CDL drivers) that are leaving the workforce and not being replaced at a sufficient level to keep pace with demand.

Mitigant: As the largest Company in the industry SGU has the capacity to train employees. (Another element of its large revenue base allowing the Company to spread out a fixed investment to make it a lower percentage of revenue versus their smaller competitors.) Mr. Woosnam has focused on identifying talent within the Company’s ranks and investing in their people. But the Company has definitely experienced wage pressures and shortage of labor, another core reason for expediting their investment in technology.

Risk: The Company relies upon M&A to achieve their financial targets, consummating transactions may be difficult in a “higher for longer” rate environment and sellers may have anchored purchase price expectations from previous lower interest rate periods.

Mitigants: As noted, sellers in this industry are often mom and pop’s looking to secure their retirement. While interest rate environments may cause them to delay their decision by a year or two hoping for better prices, it isn’t really an option to permanently forego the decision. Also, there are hundreds of possible targets that Star has had active conversations with over the years and they only need to transact on a handful each year to achieve their goals. Star competes with other heating oil companies and there are some lower middle market PE firms that have purchased operations in recent years, but there are only a few buyers that make sense for these sellers. It is, and remains so, a buyer’s market. 

For both Star and Star’s shareholders.

Catalyst

Continued Share Repurchases

Continued Increases of Quarterly Distributions

Cold Winters