Star Gas (SGU)

Star Gas is a post-reorganization, turnaround situation that suffers from a great deal of name-fatigue and is underappreciated by the market.  It trades at less than 7.5x an EBITDA – capex figure that we think understates the true earnings power of the company going forward.  While SGU competes in a commodity business and is not a low-cost operator, it can earn very good returns in periods of stable industry conditions.  Management is highly incentivized and the company’s healthier balance sheet gives it the ability to resume accretive acquisitions without leaving SGU teetering on the brink of disaster should industry conditions significantly worsen. 

 

Star Gas Partners LP is a heating oil distributor and services provider that operates in the Northeast United States between Northern Virginia and Massachusetts.  The company has been written up on VIC in the past and had a very active thread which I encourage you to read.  Many people followed the SGU saga pre-restructuring and many hedge funds played both the bonds and stock after the stock’s massive fall in late 2004.  Even Dan Loeb got involved by filing a colorful public letter with a 13-D.  SGU’s restructuring in 2006 was the last straw for even the most resilient of shareholders, as the company rejected a superior restructuring proposal from Soros Group and, shockingly, refused to extract a meaningfully better bid from its suitor, Kestrel Energy, in the process.   Why would management do such a thing?  Hmm, not totally sure, but an 8-K filed in July 2006, after the recapitalization was completed, gives us a clue:  50% of the incentive distributions otherwise distributable to the GP units were given up by Kestrel and put in the management incentive plan.   Thanks, guys! 

 

While most investors have given up on Star Gas, I think this is the perfect time for a fresh look at this name.  To me, SGU suffers from classic name-fatigue: Everybody knows the SGU story and is tired of it, the restructuring has already occurred so there is no impending “event” to send the stock up or down other than earnings, the stock has already run over 100% from the rights offering price, management has burned investors in the past, and the business is generally perceived as a very very bad business.  Few sophisticated investors will take the time to study SGU, because of the above issues, and the result is a valuation that I think makes no sense.      

 

Is Star Gas a wonderful business with a wide moat that protects it from competition?  No.  But it is a simple business that is easy to understand and is, in the end, an okay business that has generated decent returns on assets in the past and can do so in the future.  The long-term vision for SGU - they want to position themselves as a slightly higher-end service-focused distributor – might be a little bit optimistic, but despite what people say about SGU, there is room in the heating oil distribution business for economic profits.  Good management and operational execution are critical, and I think SGU is primed to benefit from its highly incentivized and rejuvenated management team.  As we will discuss below, SGU currently trades at under 7.5x EBITDA – capex for the twelve months ending in 9/06.  That period featured a warmer-than-average winter and the management team was busying itself with the financial restructuring of the company.  I believe that going forward, with management focused on the business, earnings power should improve greatly.  Additionally, the financial health of the company should allow it to resume rolling up small mom and pop operations at low multiples of cash flow.  In fact, just this past month, SGU filed an 8-K disclosing that its lenders had loosened the restrictions on acquisitions in the credit agreement.            

 

Some SGU History for you:

 

1)      In 2001, SGU acquired Meenan for $131mm, as well as an additional 12 dealers for $52mm.  Since then SGU has only made $44mm worth of acquisitions, most coming in 2003.  Before acquiring Meenan, SGU’s heating oil revenues were around $550mm and EBITDA minus Capex was about $40mm.     

2)      Prior to fiscal 2004 winter season, SGU tried to redesign its business processees by centralizing and rebranding many of its formerly local oil dispactch and customer care functions.  The company experienced difficulties with the initiative, which caused steeper declines in the customer base.   

3)      SGU sold the Propane business in December 2004 (FY2005 Q1).  The company used proceeds to pay off debt and, unbelievably, stuck investors with the tax liability. 

4)      The stock plummeted when its dividend was suspended in fall of 2004, but the real disaster was that winter:  FY 2005 EBITDA fell from $53mm to $700k. 

5)      In FY 2006 winter, SGU recapitalized through an equity financing from Kestrel Heat.  Kestrel bought shares at $2.50 and the company did a rights offering at $2.00 per share.  The company also converted $27mm in notes at $2.00, repurchased another $65mm at face and refinanced the remainder.

 

Valuation

   

At $4.05, our TEV is about $385mm.  This includes Irik Sevin’s severance, the deferred tax asset and an estimate of excess cash.  During the 5 years post-Meenan, SGU put up EBITDA numbers of $52mm, $52mm, $53mm, $700k and $55mm.  The company requires only about $3.5mm of maintenance CAPEX, so EBITDA is a decent proxy for earnings power.  The one disastrous year was a double whammy.  You had the high-price service-oriented competitor suffer through a massive and volatile increase in oil prices which the company failed to fully hedge, a national fixation on conservation and a huge internal operational disaster that made their service awful.  Obviously there was huge flight to the lower cost Mom and Pop’s.  If we ignore that year, this company is trading at about 7.8x average EBITDA – CAPEX.  And this is BEFORE management really focused on improving operations.  I think they can easily put up $55mm of EBITDA-CAPEX, which at a higher multiple (10x) would be a $6.20 share price. 

 

Churn has been an issue, but I think it is also greatly overrated.  I think without the customer service fiasco, SGU would have suffered 2004 with a lot of churn, but nothing like the 7% number they posted.  Attrition has settled down under 5% and has fallen for 4 consecutive quarters.  Additionally, there is just not a huge focus on conservation like there was last year.  Check out this interesting quote from NOAA about January 2007:

 

“The warmer-than-average temperatures in the eastern half of the nation helped reduce residential energy needs for the nation as a whole. Using the Residential Energy Demand Temperature Index (REDTI - an index developed at NOAA to relate energy usage to climate), NOAA scientists determined that the nation's residential energy demand was approximately 3 percent lower than what would have occurred under average climate conditions for the month. This was much less than the estimated 20 percent temperature-related reduction in residential energy demand that occurred during the record warm January last year [2006].”

 

SGU does not look cheap on an LTM basis because the 1^st quarter of FY 2007 (3 months ended this past December 31^st) featured a record warm winter that resulted in a 25%+ decline in volumes.  On an LTM basis, SGU still trades at under 10x EBITDA – capex, despite first quarter EBITDA of $16mm (including 7.2mm of weather insurance gains) versus $29mm the previous year.  The unseasonably warm winter continued through January until cold kicked in from February through mid-April.  (There is actually a nice bonus baked into this late cold winter, because SGU’s weather insurance contract ran from December until the end of February.  Thus, SGU should manage some insurance gains that are not reduced because of the very cold March and April.)  

 

Evidence of Management’s Capability

 

A large part of the thesis is that management will surprise the market by delivering better than expected results.  Here are some data points supporting my assertion that management is really beginning to make operations more efficient:

 

SGU earned EBITDA margins per gallon of 22 cents for the 1^st quarter of FY 2007 (on poor volume) versus 14 cents for FY 2005 and 9 cents for FY 2004. 

 

LTM Fixed Assets beginning in Q4 of 2005:

 

Q4 2005	Q1 2006	Q2 2006	Q3 2006	Q4 2006	Q1 2007
317,246	321,388	309,550	309,344	305,551	290,434

 

LTM Cash flow from operations:

 

Q4 2005	Q1 2006	Q2 2006	Q3 2006	Q4 2006	Q1 2007
(256,698)	(198,903)	(118,286)	(45,603)	17,326	125,490

 

 

LTM Cash flow from operations net of Working Cap:

 

Q4 2005	Q1 2006	Q2 2006	Q3 2006	Q4 2006	Q1 2007
(23,970)	19,344	21,505	25,607	38,363	34,955

 

LTM EBITDA:

 

Q4 2005	Q1 2006	Q2 2006	Q3 2006	Q4 2006	Q1 2007
700	41,528	42,520	41,301	55,408	42,523

 

 

Conclusion:

 

SGU operates a fine business that has generated decent returns on assets in the past and will continue to do so in the future.  The company has had one disastrous year (under a previous CEO) that was marked by a huge customer service fiasco and rapidly rising oil prices.  I think the market reads into this horrible year too much, and dismisses Star Gas as a business with low switching costs that will get crushed as consumers flee to lower priced alternatives.  I just don’t see it that way.  If you back out the call center fiasco, SGU numbers have been fine, even with periods of rising oil, high customer attrition and a very unfocused management teams led by previous CEOs Irik Sevin (who’s shortcomings are listed in Dan Loeb’s letter) and then Joe Cavanaugh (who was near 70 years old).  New management is capable and focused and we can buy into their upside at only 7.5x past EBITDA – capex.            

 

 

Things to be aware of: 

- Minimum annual customer attrition is at 1%-2% a year due to natural gas conversions, since new homes are rarely built with oil heat.    

- In periods of sharply rising oil prices, attrition grows as customers flee to lower cost mom and pop operations.

- Management is suspect.  The new management team has *already* stolen the company, however, and I think now we can make money alongside them. 

- Increased conservation and more energy efficient homes may threaten growth. 

- A sustained multi-year period of high oil prices could reset consumption to lower levels like in the 1970s when 68 degrees became the new standard for room temperature versus 72 degrees.

- Oil heating customers skew to a less affluent demographic to which energy costs are more of a focus.