Value Investors Club / SUBURBAN PROPANE PRTNRS -LP (SPH)

Description

Winter is coming.

After 2 years of unseasonably warm winters, the US is feeling more like Winterfell than Dorne. (Apologies to anyone who doesn't follow Game of Thrones...). The US is now on pace to have a winter that is in line with 10-year historical weather patterns. This presents us with a nice potential catalyst for SPH, a propane distributor that has under-performed over the past two years due to unseasonably warm winters.

While not screamingly cheap, this winter could lead to a revaluation of SPH's business which currently trades at a 9.5% dividend yield ($0.60 distribution per quarter that I believe is well-covered). I peg fair value at closer to $30 per unit based on what earnings could be if US temperatures go to 10-year historical levels (which we are currently on track for). So an all-in return including the dividend of ~28%.

Business

SPH distributes propane and other refined fuel products to 1 million customers in 41 states. It's business is primarily propane (421mm gallons of propane sold vs. 31mm gallons of fuel oil and other refined products sold in FY 2017).

Putting aside wholesale propane (10% of SPH's propane volumes), 44% of the retail propane sold was to residential consumers while the balance was sold to commercial, industrial, and a small amount of agricultural customers). Most of this propane is used for heating purposes driven by residential and commercial clients which form most of SPH's demand (Propane is used as the primary heating fuel source for about 5% of US households). Industrial customers use propane for purposes such as motor fuel for vehicles and forklifts.

The business model involves SPH operating regional stores with large on-site propane storage tanks and propane is then delivered directly to customers vis truck. It's a fragmented industry with a lot of smaller players, and while SPH is not the largest player, they are the 3rd largest retail propane distributor and so have the size to get preferential treatment from wholesalers and the attendant large company professionalism to compete effectively on quality / reliability. Commodity prices will of course impact the business, but SPH has been historically able to pass through costs to customers (as a side note, expansion of US propane production as byproduct of the current US petrochemical supply growth should at least help keep a cap on pricing - which ultimately is good for propane demand and SPH).

Weather

Heating degree days (HDD) (https://en.wikipedia.org/wiki/Heating_degree_day) represent a good way to look at the overall US need for heating fuels and thus propane.

* Note CY17 value in chart above is estimated

If we look at historical HDD in the US, we can see that it's been declining over time (just as a note, the decline is not purely climate-driven since these HDD figures are population-weighted and over the past few decades US population shifts have favored the warmer West):

In any case, I think it's fair to say that weather has been getting warmer over time. However, even when accounting for structurally lower heating degree days, I think there's a strong argument to be made that the past two winters are still unseasonably warm.

Management has been resetting business cost structure around a lower average number of HDD - using the recent 10-year HDD average. Weather in the short-term is always hard to predict, but this does seem to be reasonable.

Long-term propane demand

You have a few competing forces at play here. On the positive side you have increased housing starts, continued conversions of fuel oil-heated residences, a relative lid on propane pricing as a result of US production growth, and some (more speculative imo) upside from vehicle engine conversions to propane.

On the negative, there's long-term efficiency gains at the end-user level, continued market share loss to electricity heated homes, and market share loss to natural gas utilities infrastructure expansion.

Industry publications have been recently throwing out 1% CAGR demand increase for propane over the next 10 or so years, but I think a flat near-term demand picture is more likely, In the long-run, I think it's reasonable to assume some structural decline in propane demand.

Valuation

I think SPH is worth about $29 - $30 / share. A high-level DCF is shown below:

	2018	2019	2020	2021	2022
"Normalized" EBITDA	325	325	325	325	325
(-) Maintenance capex	(35)	(35)	(35)	(35)	(60)
Unlevered Distributable Cash Flow	290	290	290	290	265
(+) Terminal Value					2,789
* Based on 2021 Cash Flows
Total Cash Flows	290	290	290	290	3,054
NPV	3,099
(-) Net Debt	(1,269)
Equity Value	1,827
Value per Unit	$29.68
Diluted Units Outstanding	61.5
r	7.5%
Terminal growth rate	-2.0%

Two things to touch on, normalized EBITDA and maintenace capex.

- FY17 ending 930 EBITDA was $243mm. However, if HDD revert to 10-year norms (as this winter is trending towards: November had 17% higher HDD, December 3% higher, and this Jan will likely be 20%+ higher), then SPH earnings power would be closer to years 2013-2015 when SPH was generating $330-$340mm of EBITDA. Therefore, a higher normalized EBITDA figure around $325mm seems reasonable.

- To be frank, I think their current levels of maintenance capex spend is probably too low. SPH spent $28mm in total capex in FY17 of which $11.3mm was classified as "maintenance". I am somewhat skeptical of all growth capex being truly "growth" capex here, so total capex spend is probably more realistic and mgmt has guided to $35mm in total capex for 2018. (For context avg. last 5 year total capex spend was $35mm). Furthermore, looking at PP&E I think $60mm is probably a more truly fully-baked maintenance capex figure, so I assume $60mm in the out-years. I suspect part of the delta has been management's drive to integrate their store base as a result of 2012 Inergy acquisition (leading from 750 to the current 653 stores) which can lead them to "roll-off" portions of PP&E if they don't need to be replaced 1 for 1. Perhaps the assets are truly longer-lived than I give them credit for or there are other structual reasons justifying the spend... But I doubt it.

Comps

As a sense check, we can compare with SPH's closest comp, AmeriGas (APU). APU trades at 15.9x EV/EBITDA and a 7.9% dividend yield but with worse dividend coverage than SPH. That's a 30%+ valuation premium on EV/EBITDA and 7.9% dividend yield vs. SPH's better-covered 9.5% dividend yield (if winter goes well this year, I think it is possible we see future distribution raises). So if SPH trades to a 7.9% dividend yield the units are worth $30+, and if SPH gets the same EV / EBITDA multiple premium as APU (which I am neither saying is appropriate or necc. what I believe SPH should get) then we get SPH per unit prices in the high $30s.

For FY ended 9/30/17	AmeriGas	SPH
FY 17 EBITDA	551.3	243.0
Debt	2,712.3	1,272.2
Equity (market value)	6,043.2	1,554.6
Cash	7.3	2.8
Debt to EBITDA	4.9	5.2
EV	8,748.2	2,823.9
EV/FY17 EBITDA	15.9	11.6
Common Units	93,050
Adj. Units for GP	125,743	61,542
Unit Price	$48.06	$25.26
Total capex	98	28
Distributable Cash Flow (EBITDA - capex)	453.1	215.0
Distributions*	398.9	147.7
*SPH distribution based on current quarterly $0.60 dividend
Dividend Coverage (Dividend as % of Dist. CF)	1.14	1.46

Ways to Hedge:

- Well, if you live in a place that actually experiences winter you're already naturally hedged. How much would you pay to not have another "bomb" cyclone?

- It's not cheap to do so, but I suppose if you are a real bear on the admittedly real long-term issues facing propane you could consider shorting AmeriGas Partners (AGP) which trades at 15.9x TTM EBITDA (vs. SPH at 11.6x TTM EBITDA). APU also has worse dividend coverage than SPH.

Risks:

- Greater than expected declines in propane demand

- Management has mentioned it is considering potential future non-propane investments that are less weather-sensitive. I understand the motivation, but this of course presents capital allocation risks (although capital allocation risk is mitigated to an extent by distributions).

- Warmer than expected winters going forward

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

Catalyst

A cold winter:

“Oh, my sweet summer child," Old Nan said quietly, "what do you know of fear?" Fear is for the winter, my little lord, when the snows fall a hundred feet deep and the ice wind comes howling out of the north. Fear is for the long night, when the sun hides its face for years at a time, and little children are born and live and die all in darkness while the direwolves grow gaunt and hungry, and the white walkers move through the woods”

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			2018	2019
Price:	25.26	EPS	3.73 (distributable cash flow)	0
Shares Out. (in M):	62	P/E	6.8	0
Market Cap (in $M):	1,554	P/FCF	6.8	0
Net Debt (in $M):	1,269	EBIT	0	0
TEV (in $M):	2,824	TEV/EBIT	0	0