Description

Recommendation:

I recommend shorting shares of Suburban Propane Holdings (SPH).

Thesis:

A complicated deal structure and retail investors' focus on yield have created the opportunity to short a business  in secular decline that is trading at 17x TTM EBITDA, has an overleveraged balance sheet, faces the risk of a covenant breach and may be forced to cut its distribution cuts due to lack of coverage.  

Background:

On 4/26/12 SPH announced the acquisition of Inergy LP's Propane Business. Until the deal was announced Inergy (NRGY) was a peer/competitor to SPH that diversified into midstream assets and launched a new, midstream focused MLP (NRGM) in December 2011 as a way to de-lever NRGY's balance sheet given the high leverage and deteriorating fundamentals of propane that were subsequently exaggerated by the abnormally warm winter of 2011-12.

In exchange for NRGY's propane business, SPH would assume $1.2b of NRGY debt and issue NRGY $600m of SPH units for a total consideration of $1.8b. The debt assumption was achieved via a bond exchange whereby bondholders received a combination of cash and new bonds with somewhat similar terms to the ones they held. The bonds were initially going to be exchanged into substantially similar bonds with SPH as the obligor instead of NRGY, but after failing to receive adequate participation, SPH increased the consent fee and coupon (50 bps), and the covenants were enhanced. NRGY committed to distributing the SPH shares received to NRGY shareholders as soon as possible (originally upon closing, now within 30-45 days post close).

At the time of the deal announcement, SPH announced an intention to offer up to $250m of new units in a secondary offering to fund the cash portion of the bond exchange and pay down their revolver to keep leverage in check. The market did not cooperate as poor earnings reports from SPH/NRGY propane and stock market volatility caused SPH's stock to decline. As such, they were forced to draw on a 364 day bridge facility to be paid off with an equity offering. The additional consent fee further increased leverage as a drain on cash.

Key issues:

1. Business in secular decline:

I don't want to over-emphasize this point because it is not the crux of my thesis. With that said, it's worth noting that the retail propane business faces secular headwinds.  As customers improve energy efficiency, move onto the natural gas grid, and/or use other heating sources (electric that get cheaper with natural gas), propane volumes decline. Ex-acquisition volumes have historically decline 3-9% per year. Propane distributors have offset much of this decline with increasing margins per gallon but continuing this practice eventually creates room for alternative solutions. Re-accelerating foreclosures would exacerbate declines, but new home starts would provide some tailwind.

2. Excessive leverage

The real crux of my thesis is that SPH has overleveraged their balance sheet and will have difficulty shoring it up because of the equity overhang, excessive leverage, risk of covenant breach, re-financing needs.

Below is SPH's PF Capital structure:

• $1b bonds converted from NRGY to SPH.
• $250m prior SPH bonds
• $225m drawn on a 364 day bridge loan
• $100m drawn on revolver
• Less ~$125m cash on hand.
• PF for acq TTM basis they are levered 7.57x gross and 7.22x net (excluding assumed synergies).

 3. Pressing need to raise equity:

Because of the $225m 364-day bridge loan, SPH needs to raise equity capital regardless of whether they breach covenants or not. It is nearly impossible to create a scenario where the company can meet the repayment needs of the bridge loan organically, and the stepped down leverage ratio requirements mean refinancing the loan with new debt is unlikely. As such, the company has a base minimum need to raise equity $225m (through a combination of equity and cash flow in excess of distributions).

A more realistic estimate of SPH's equity needs would be to assume that they want to de-lever down to the leverage ratio of APU (close peer who closed a similar transaction earlier this year) who is at 3.8x net leverage on 2013 estimates. Using the same analyst's estimates (one of few to revise estimates for SPH and which assumes normalization from the weak 2011-12 winter) would require SPH to raise ~$430m in equity -- over 10m units in addition to the 14.2m paid to NRGY as consideration.

4. Issuing equity will be difficult:

The easiest solution is to issue equity. However, I believe SPH could have difficulty issuing equity as a result of NRGY's decision to distribute SPH shares received to shareholders. This means 14.1m shares (less the ~12.5% owned by the NRGY CEO that are subject to a lock-up) will hit accounts in the next 30-45 days (if not sooner).

http://investor.inergylp.com/phoenix.zhtml?c=132026&p=irol-newsArticle&ID=1721509&highlight=

NRGY has agreed to distribute approximately 14.1 million of the SPH common units it received to NRGY unitholders of record on a pro rata basis at a future record date to be determined by the board of directors of NRGY’s managing general partner, which management expects to occur within the next 30-45 days. The distribution of the 14.1 million SPH common units would represent a distribution ratio of approximately 0.1067 SPH units for each NRGY limited partner unit currently outstanding.

As a result of the distribution cut and sale of the propane business, I believe the NRGY shareholder base has turned over in the last six months from a base of yield-driven investors to one more focused on value and increasingly focused on the GP valuation discrepancy at NRGY (GP trading wide of the MLP and very wide of GP peers). As such, I expect substantial selling pressure upon distribution of SPH shares. In the meantime, what investor wants to buy a secondary ahead of 14.1m / 49.6m shares being released to new investors (ADV ~130k shares)? Finally, there is very little overlap of the shareholder bases.

5. Risk of Covenant breach in 1Q 2013

The company's covenants are as follows (7.0x leverage ratio for Sept/Dec 2012; Stepping down to 5.75x for March 2013-December 2013). From 8K dated 8/2/2012:

(b) Total Consolidated Leverage Ratio. Permit the Total Consolidated Leverage Ratio as of the end of any fiscal quarter of the Parent to be greater than the ratio set forth below opposite such fiscal quarter (the “Maximum Total Consolidated Leverage Ratio”):

The two companies' TTM EBITDA was $211m excluding one-time items.  The credit agreement allows for the inclusion of assumed synergies in the amount of $20m at September 2012, $15m at December 2012, $10m at March 2013, $5m at June 2013, and $0 thereafter. As such, the PF adjusted EBITDA leverage goes to 6.92x/6.59x gross/net. This obviously doesn't leave much room for error.

The company doesn't distribute meaningful volumes in the quarter ending September 30, so the leverage ratio won't be much different at the end of the quarter. I expect Q1 FY 2013 (qtr ending December 2012) to start off slow because of the weakness in Q2/3 FY 2012. Consumption was likely down at the end of the season because of an exceptionally warm winter. Therefore, volumes for replenishment are likely to be relatively low in the beginning of the season and put EBITDA at risk of falling year over year -- and causing a breach of the credit agreement.  

6. Even raising equity won't alleviate covenant concerns immediately:

The credit agreement has a unique feature (at least in my experience) whereby an equity raise doesn't alleviate leverage ratio concerns -- the maximum leverage ratio falls as equity is raised. As a result the company only gets partial relief as equity is raised. Assuming they can raise $250m, the maximum leverage ratio at a given time falls by 0.75x (so no credit is given if EBITDA is ~$330m or greater).

Using TTM EBITDA + assumed synergies, the company would not receive relief until they had raised $535m of equity. Assuming Q1 (December) EBITDA recovers by $40m, the company would not create breathing room by raising equity capital until they had raised $460m.

Using the estimated $330m of EBITDA, the company only needs to raise $30m to create breathing room, but they would still need to raise $225m+ to repay the bridge loan.

Below immediately follows what was pasted above with regard to maximum leverage ratio:

; provided, that if a Triggering Event (defined below) occurs during any fiscal quarter (each, a “Triggering Event Quarter”), the Maximum Total Consolidated Leverage Ratio shall be reduced, effective as of the Fiscal Reporting Date occurring in the fiscal quarter in which the Triggering Event occurs, by the aggregate amount of the reductions attributable to all Triggering Events occurring during such Triggering Event Quarter; provided, further, that the Maximum Total Consolidated Leverage Ratio shall in no event be less than 4.75 to 1.00 (5.00 to 1.00 during any Acquisition Period).

As used herein, a “Triggering Event” means Parent’s receipt, at any time after April 25, 2012, of Net Cash Proceeds from the issuance of Common Units in a cumulative amount of $100 million, $200 million, and $250 million, respectively, and the occurrence of the first Triggering Event shall result in a .25 reduction of the Maximum Total Consolidated Leverage Ratio, the occurrence of the second Triggering Event shall result in a .25 reduction of the Maximum Total Consolidated Leverage Ratio, and the occurrence of the third Triggering Event shall result in a .75 reduction of the Maximum Total Consolidated Leverage Ratio. By way of example, Parent’s receipt of Net Cash Proceeds from the issuance of Common Units of $125 million on June 15, 2012 and $125 million on July 15, 2012 would result in the first Triggering Event occurring on June 15, 2012 and the second and third Triggering Events occurring on July 15, 2012.”

7. Distribution coverage at risk:

Because of the yield-oriented shareholder base, the sustainability of the distribution is key. The distribution isn't sustainable based on the TTM results and is not covered using street estimates. Between the lack of coverage and excessive leverage, the dividend could be at risk, particularly if the December quarter comes in light.

8. Valuation:

Despite the concerns laid out above, the stock is not particularly cheap on an absolute or relative basis at 11.9x/10.8x projected EBITDA and ~1.3x higher than its closest comp (APU). The yield may be attractive to investors, but if  yield is the primary determinant, FGP would be a better option with less leverage, in-line EBITDA valuation and a higher yield.

Risk / Reward:

What I like particularly well about this name as a short is that a number of things can go right to make the idea work particularly well (NRGY supply weighing on shares, equity raise, covenant breach, challenges refinancing the bridge loan, distribution cut, warm weather) but that the company's need to raise equity to fund the bridge loan repayment effectively caps the upside. So if the stock rallies past $45 on a cold snap (or any other reason), I would expect the company to tap equity markets

Risks:

• Extremely cold weather
• Propane margins improve as a result of lower NGL pricing (mostly pass-through, but wholesalers could benefit).
• Borrow is not plentiful, but puts are traded and priced at low implied volatility.

Potential Catalysts:

• NRGY shares distributed
• Equity raise
• Covenant Breach
• Distribution cut

Catalyst