AmeriGas Partners (APU): The Gold Standard of Propane MLPs Is Still a High-Risk Proposition

Master Limited Partnerships, or MLPs have been an increasingly popular stock sector in recent years thanks to their preferential tax treatment that results in a business model that pays out the majority of cash flow in the form of very generous high-yields.

 

However, as with most high-yield stocks on Wall Street, one needs to be extra careful because MLPs, like many industries, have their own risk factors to keep in mind.

 

In addition, investors need to carefully research any individual MLP to make sure that a sky-high yield doesn’t signal that a stock is a value trap (i.e. its business is in distress).

 

This brings me to America’s largest and most popular propane MLP, AmeriGas Partners (APU). This stock offers a mouthwatering 8.0% yield and represents arguably the highest quality name in its niche industry.

 

But before you run out and load up on units of this propane giant, be aware that some industries can be so precarious that even their best-in-breed names can’t represent safe high-yield income investments for long-term dividend investors.

 

Let’s take a look at AmeriGas Partners to see what kinds of risks and rewards it offers investors.

 

Business Description

AmeriGas Partners is America’s largest distributor of propane, selling 1.5 billion gallons to 2.4 million customers in all 50 states.

 

The vast majority of its business is to residential (41% of retail gallons sold) and commercial (36%) clients who use propane to heat and provide backup power to their homes and businesses.

 

The general partner and manager is UGI Corporation (UGI), which is one of America’s largest distributors of propane and liquefied petroleum gas, or LPG.

 

Source: AmeriGas Partners Investor Presentation

 

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.

 

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 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 (FGP) and Suburban Propane Partners (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).

 

 

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.

 

Dividend Safety Analysis: AmeriGas Partners

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

AmeriGas Partners has a Dividend Safety Score of 40, indicating the distribution’s safety is somewhat below average. While the current payout may in fact be relatively secure, there are some troubling trends to be aware of, specifically when it comes to the MLP’s distribution coverage ratio (DCR):

 

Year	DCF	Distributions (including GP IDRs)	DCR
2012	$339.2 million	$277.3 million	1.22
2013	$566.2 million	$335.9 million	1.69
2014	$594.5 million	$355.9 million	1.67
2015	$561.4 million	$377.7 million	1.49
2016	$490.9 million	$395.3 million	1.24

Sources: Earnings Releases, 10-Ks

 

While any DCR above 1.1 is generally considered safe and sustainable, in the context of an MLP with a highly cyclical business model, which is not protected by long-term contracted cash flow, AmeriGas’ four years of declining coverage ratios portends potential trouble for the MLP’s 12-year track record of rising distributions.

 

That’s especially true when you consider the highly leveraged balance sheet, which itself might put the distribution in more jeopardy than the still high DCR might indicate.

 

MLP	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
AmeriGas Partners	4.41	3.43	66%	0.59	BB-
Ferrellgas Partners	-5.49	-2.78	132%	0.79	B
Suburban Propane Partners	5.63	NA	63%	0.72	BB-
Industry Average	2.25	NA	37%	1.61	NA

Sources: Morningstar, Fast Graphs

 

When you compare AmeriGas’ balance sheet to its peer’s two things immediately stand out. On the plus side, AmeriGas’ existing cash flows allow it to still service its debt but its many years of acquisitions have still left it with a lot of debt, which has resulted in a junk bond rating that means higher borrowing costs and thus higher overall costs of capital.

 

And while its current debt load doesn’t yet put the MLP at risk of violating its debt covenants, the volatile nature of the business, which can see EBITDA fall substantially in any given year, does mean that investors need to be concerned that the debt load may put the existing payout at risk in the future (remember Ferrellgas Partners’ recent distribution cut). That’s because AmeriGas’ debt agreements impose certain restrictions on its cash distribution policy if its credit metrics rise too high.

 

In other words, even if the coverage ratio were to remain firmly above 1.0, there’s still a chance that the MLP’s creditors could force a distribution cut in the coming years.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

AmeriGas Partners’ Dividend Growth Score of 22 shows that the MLP is capable of some distribution growth, as seen by its impressive track record of 12 straight years of payout increases. The company has consistently increased its dividend by 4-5% per year over time.

 

 

However, the combination of a declining coverage ratio in recent years and a rising debt load means that being able to continue this rate of distribution growth may become increasingly difficult.

 

After all, AmeriGas is already America’s largest propane distributor and due to the secular decline in propane demand of around 2.5% per year, management will have to either find ways of further boosting its margins or finding enough acquisitions to keep its current sales, EBITDA, and DCF flat, much less growing at the same pace as the distribution.

 

The problem is that in a commodity business such as propane, there is a hard limit to how much the MLP can increase prices on customers before it risks losing market share.

 

So while AmeriGas is likely to continue to grow its payout for the next year or two, especially if management’s 2017 guidance of around $620 million in DCF proves true, the distribution growth runway for this MLP seems to be far more limited than with other, more stable kinds of MLPs.

 

Valuation

Because of how MLPs are structured for tax reasons, earnings and thus the P/E ratio are not the best valuation metrics to use. Rather cash flow and yield is what you want to focus on.

 

Despite a very strong past year, in which APU units have generated a 30% total return, AmeriGas is currently trading at 8.9 times trailing operating cash flow, which is 8% below its historic 9.7 mean P/CFO ratio.

 

However, given that MLPs are mainly owned for their high-yield, another way to see if one is over/under or fairly valued is to look at how the current forward yield compares to its historic norm.

 

For example, over the past 13 years AmeriGas’ yield has ranged from 5.5% to 11.3%, with a median value of 7.4%. From a price to cash flow and distribution yield basis, AmeriGas is trading at around an 8% discount to its historic norms.

 

Normally such discount might warrant investors opening an initial position, and then adding on dips. However, given the high-risk nature of the propane MLP industry in general, as well as the likely growth challenges AmeriGas is likely to face in coming years, I can’t recommend anyone but the most risk tolerant investors own this MLP, at any price.

 

Conclusion

Don’t get me wrong. As far as propane MLPs go AmeriGas is by far the best one that long-term investors can own, with the strongest balance sheet, the best management team, and the most secure payout.

 

That being said, I generally don’t advise investors allocate their capital to industries in secular decline. If you are comfortable with the risks inherent to this industry and want to own a small stake in AmeriGas Partners as part of a well-diversified dividend portfolio, you may want to wait for a more attractive price so that the risk/reward ratio is more heavily tilted in your favor.

 

However, I don’t have any interest in owning the partnership in our Conservative Retirees dividend portfolio.