Business Analysis
Propane is a tough business because the industry is facing a secular decline as customers move to alternative forms of heating and powering backup generators, most notably natural gas.
Overall, the industry is expected to face a decline in demand volumes of around 2.5% annually over the next five years, and it has been in decline since 1998 (1).
However, the highly fragmented nature of the industry (APU is the largest distributor yet has just 15% market share) allows for continued growth through consolidation.
AmeriGas Partners, L.P. (NYSE:APU) has proven itself to be the industry’s best capital allocator when it comes to such growth, thanks to the disciplined management style of UGI CEO Jerry Sheridan, who got his start at AmeriGas, serving in both the COO and CFO roles.
Thanks to AmeriGas’ large economies of scale and management’s continued efforts at cost cutting, the MLP is by far the most profitable propane MLP in America, with margins and returns on shareholder capital far in excess of its two largest rivals, Ferrellgas Partners, L.P. (NYSE:FGP) and Suburban Propane Partners LP (NYSE:SPH).
| MLP | Operating Margin | Net Margin | Return On Assets | Return On Equity | Return On Invested Capital |
| AmeriGas Partners | 18.3% | 7.2% | 4.1% | 15.5% | 9.47% |
| Ferrellgas Partners | -26.2% | -32.3% | -31.8% | NA | NA |
| Suburban Propane Partners | 8.6% | 1.4% | 0.6% | 1.8% | 0.71% |
| Industry Average | 11.3% | 4.0% | 1.5% | 5.5% | NA |
Source: Morningstar
That being said, unseasonably warm winters over the past few years (2016 was 15% warmer than usual) have resulted in substantial declines in sales, earnings, and distributable cash flow, or DCF (which is what funds the distribution).
Source: Simply Safe Dividends
In addition, while AmeriGas Partners’ large tank leasing business has a small moat that gives it some pricing power, the company operates in a commodity business in which weather and propane prices dictate how profitably it can operate. Recently these exogenous business factors have been against the MLP, driving down margins and its DCF.
This brings us to the most important thing for long-term income investors to focus on, the risks involved in this highly cyclical and slowly declining industry.
Key Risks
As with any industry in secular decline, industry consolidation is the most obvious answer to investors’ growth concerns.
However, while AmeriGas has proven itself the master of accretive acquisitions, both large and small, at the same time such a growth strategy does come with some major drawbacks, most notably a highly leveraged balance sheet.
AmeriGas’ current ratio (0.59), debt/equity ratio (2.44), and interest coverage ratio (2.6) all show a highly indebted MLP.
And while that may have been fine over the past eight years when interest rates were near zero, in today’s rising rate environment AmeriGas might find its high debt levels greatly reducing its financial flexibility going forward.
Specifically, its ability to do major needle-moving acquisitions could be blocked, resulting in merely small bolt on acquisitions (six in fiscal 2016) that merely offset its demand decline numbers.
Also don’t forget that as an MLP, AmeriGas is dependent on being able to sell additional equity to raise growth capital. Recently that’s been very difficult given its low unit price, and as long-term Treasury yields rise over time, investor demand for high risk, high-yield investments such as this might decline, further limiting the MLP’s growth opportunities.
However, perhaps the biggest risk to AmeriGas investors is the troubling nature of the distribution profile, which has been deteriorating in recent years.
