Suburban Propane Partners (NYSE:SPH) is a good business operating in a gradually declining market. It is the third-largest retail distributor of propane and fuel oil, with a 5% market share. Among the three industry majors, which are all publicly owned, SPH has been the best managed. Its largest competitor, AmeriGas Partners, was acquired by UGI (UGI) in 2019 after it became overleveraged and saw its unit price implode. SPH’s second-largest competitor, Ferrellgas Partners (OTCPK:FGPR), filed for bankruptcy in January 2021 and emerged in April 2021.
With its proven best-in-class operating model, we believe SPH can continue to grow or at least tread water over the coming years and provide an attractive total return to unitholders.
Retail Propane Distribution Industry Background
SPH distributes propane and fuel oil primarily to residential and commercial customers throughout the U.S. Its operations are concentrated in the Northeast, Midwest, and West Coast.
Propane and fuel oil are used for heating and cooking purposes, though they’re slowly being replaced by natural gas and electricity. Most propane and fuel oil customers lack natural gas infrastructure while converting to natural gas or electricity can be prohibitively expensive. The EIA estimates that 4.8% of homes use propane as their heating fuel source. Propane usage is concentrated in New England, the Great Plains, and the Rocky Mountain regions.
SPH is far more exposed to propane than to fuel oil. Propane accounted for 94% of the past four years’ average operating income. Fuel oil accounted for 3%, while electricity and natural gas accounted for the remaining 3%.
SPH’s weighting toward propane is a positive as fuel oil usage has experienced a protracted decline that has spanned decades. The decline is attributable to new construction opting to use cleaner-burning propane over fuel oil, as well as consumers switching from fuel oil to propane. In contrast to fuel oil, propane use has remained steady, though its share of the home heating market has fallen over recent decades. This phenomenon can be seen when propane consumption is plotted against the number of U.S. households.
Demand for propane used in heating is seasonal, with approximately two-thirds of annual consumption occurring from October through March. It is also heavily dependent on the weather, with colder weather boosting demand. While propane used for heating varies from year to year, it is fairly resistant to recession since it is essentially a utility.
In recent years, increasing U.S. propane exports have complicated the demand picture. Exports have consumed excess domestic propane production since the shale boom accelerated after 2010.
U.S. propane exports have increased amid surging global demand, primarily for use as a petrochemical feedstock. Higher propane prices abroad have made exports profitable for the U.S. Gulf Coast petrochemical complex. The following chart shows how prices in Asia and Europe have remained sustained above U.S. prices, providing a profitable arbitrage for domestic propane marketers.
Recently, high exports combined with reduced NGL production in the wake of the 2020 downturn have depleted domestic propane inventories.
Lower inventories have put upward pressure on prices, and the recent energy price surge that occurred after Russia invaded Ukraine has triggered a spike. This threatens to temporarily crimp industry margins due to the lag with which higher wholesale prices are passed through to retail.
If higher propane prices are sustained, they will make propane less competitive relative to home heating alternatives. They will become another headwind for increased propane adoption relative to natural gas and electricity, which comprise 49% and 41% share of the home heating market, respectively, according to the U.S. Census Bureau.
The forces that have tempered domestic propane adoption are likely to continue. The industry is banking on propane-powered vehicles such as lawnmowers to accelerate growth. Still, increasing vehicle use will not fully offset the volume declines stemming from reduced propane use in home heating.
With SPH in a slowly declining market, management has pursued a strategy of gaining share by purchasing high-quality independent distributors. The retail propane distribution market is highly fragmented. The four largest distributors have only 26% combined market share, leaving the remaining 74% to the approximately 5,000 independent operators. Fragmented, low-growth markets tend to consolidate, and SPH is poised to be a leader as consolidation continues.
SPH has also invested in other fuels that it could distribute through its system. In December 2020, it acquired a 39% stake in Oberon Fuels. Oberon is a development-stage producer of low-carbon dimethyl ether, an alternative to petroleum-based diesel. Then last week, on March 10, SPH announced its acquisition of a 25% stake in Independence Hydrogen, a supplier of gaseous hydrogen. It also created a new subsidiary, Suburban Renewable Energy, LLC, to build out its renewable energy platform.
We tend to be skeptical of attempts by entrenched operators in stagnating markets to anticipate and successfully invest in emerging technologies. We find these dollars are more often wasted than delivering an attractive return on investment. We have no expertise in home heating technology and won’t try to render a judgment on SPH’s renewable fuel distribution prospects. If they work out for the company, so much the better, but in our analysis, we ignore all but their negative impact on the company’s cash flow.
We think SPH’s opportunity lies in acquisitions. It has numerous competitive advantages in pursuing growth that its competitors lack. For one, it isn’t hobbled by debt. AmeriGas got in trouble after running up a huge debt load to fund acquisitions and then running into two consecutive unusually warm winters in 2016 and 2017. After its stock cratered and the company was on the verge of a distribution cut in 2019, it was purchased by UGI. Ferrellgas similarly ran up massive debt while incurring an unending string of losses and paying out too much in distributions. Ferrellgas’ leverage ratio averaged a sky-high 6.5-times from 2016 to 2020, before it filed for bankruptcy.
Ferrellgas has to dramatically reduce debt over the coming years, which constrains its capital spending flexibility. By contrast, AmeriGas has emerged as a stronger competitor after UGI acquired it. UGI has implemented a business transformation for AmeriGas focused on improving operational execution and financial performance.
It’s All Comes Down to Gross Operating Margin
Success in the propane distribution business is measured by a company’s ability to keep maintenance capital expenditures low, operating expenses flexible, and the ease with which it can pass on fluctuating propane prices to customers. Ultimately, SPH’s competitive advantage is derived from the continuous success it has demonstrated in managing sourcing, pricing, hedging, and operating expenses. Performance on these measures is most apparent in the gross operating margin: the more stable the margin, the better the business model.
We can compare SPH with Ferrellgas to demonstrate the relative strength of SPH’s operating model. SPH’s superiority can be seen on a long-term basis, with higher and more stable gross operating margins in the years beginning in 2017.
SPH’s superior performance can be seen on a quarterly basis as well.
SPH’s superior financial position and operating model will enable it to better capitalize on growth opportunities in a market where acquisitions are a primary means of sustaining and growing cash flow. Since Ferrellgas will be addressing its excessive leverage for years to come, while showing no signs of operational improvement, we count UGI’s AmeriGas subsidiary as SPH’s primary competitor.
Fortunately for both players, the market is large enough and sufficiently fragmented that neither should have trouble finding attractive acquisition candidates. We expect both to continue to grow through acquisitions of high-quality independent operators.
SPH units are cheap. We value them in the range of $21 to $26, implying 57% upside at the middle of the range from the current $15 unit price.
Investors have been turned off from SPH after two large distribution cuts. The first was a 33% cut in 2017 that was made to cushion the adverse financial impact of warm winters in 2016 and 2017. While it was a prudent move, it came after management had assured unitholders that the distribution was safe only a few months before the cut. The second distribution cut, from $0.60 to $0.40, was made during the 2020 downturn.
Unlike many of our midstream bull theses, we don’t expect SPH to be a story of increasing distributions. Management intends to keep SPH’s distribution around the current level while it allocates free cash flow toward paying down debt. While the company is not overleveraged, with a net debt to Adjusted EBITDA ratio of 4.0-times, management is seeking to lower the ratio to 3.5-times. Since we assume Adj. EBITDA stays flat or slightly declines over the coming years, we believe the company will have to pay down debt to reduce leverage.
Assuming management continues to allocate free cash flow toward investments in renewable technologies, which management claims is now a cornerstone of its strategy while assuming further that distributions remain flat, SPH will generate around $75 million of cash flow annually that it can use to pay down debt. The chart below shows the free cash flow increase that occurred after the most recent distribution cut, which impacted fiscal year 2021.
Paying down debt by $75 million per year won’t get SPH’s leverage ratio down to 3.5-times until 2027 or 2028. For that reason, we don’t expect distribution hikes for the foreseeable future.
SPH’s unit price is trading as if to acknowledge this, having reduced SPH unit price so that its 8.7% yield is in line with pre-distribution cut levels. However, a company’s value is comprised of more than just distributions. SPH’s falling market price has put its units squarely into bargain territory based on Adj. EBITDA and free cash flow.
For our Adj. EBITDA valuation, we assume SPH earns $260 million of Adj. EBITDA in 2022, which then declines by 1.5% each year to 2026. Our assumption of declining Adj. EBITDA reflects our expectation that higher domestic oil and NGL prices make propane less price competitive with home heating alternatives. It also reflects the likelihood that consumers reduce their propane usage and switch to alternative fuel sources.
Our valuation also assumes that SPH pays down $50 million of debt in 2022 and $75 million annually thereafter, and that distributions remain flat. As usual, we want to err on the side of conservatism in our valuations.
Even this conservative valuation implies a value of $22.88, which equates to a 61.2% total return upside from the current unit price. Including capital appreciation and distributions, the return increases to 96.3% in 2026.
Turning to free cash flow, our valuation implies greater upside than our Adj. EBITDA valuation. We assume operating cash flow declines by 1.5% each year, the unit count grows, and maintenance capital expenditures tick higher.
Our valuation implies a fair value of $24.65, a full 73.0% higher than current levels. Implied total return increases to 87.7% by 2026.
Lastly, our discounted cash flow scenario assumes free cash flow declines by 1.5% each year through 2031. It implies a value of $26.24, for 81% upside.
All these values for SPH units are within their trading range before the company’s 2020 distribution cut. We think SPH shares were fairly valued back then, as both Adj. EBITDA and free cash flow were in the neighborhood of today’s levels.
SPH units currently offer a safe 8.7% yield. Also, the units are clearly undervalued, offering a large margin of safety against permanent loss of capital. The only thing that keeps us from getting more bullish on the name is the lack of a catalyst to drive the unit price higher. SPH units have traded at a high yield throughout their history and we don’t expect that to change. Therefore, the most surefire catalyst is likely to be a distribution increase. But in light of management’s stated deleveraging goals, we don’t see that occurring for many years.
That said, SPH’s distribution stands at reduced levels relative to free cash flow and is safer than it has ever been. In the future, distributions are far more likely to increase than decrease. We recommend investors who seek to diversify their income portfolio into a recession-resistant name buy and hold SPH units for the long term.