I get a lot of questions about master limited partnerships (MLPs) when it comes to the topic of dividend safety.
Many dividend investors are attracted by the high yields and steady cash flows offered by MLPs.
A number of these businesses have paid uninterrupted dividends for decades as well.
However, like any industry, not all MLPs are created equally. Some are better-capitalized and more effectively managed than others.
As readers know, I consider myself to be a conservative dividend investor. I like simple businesses with time-tested operations, consistent free cash flow generation, reasonable balance sheets, and sensible management teams that have shown a commitment to paying dividends.
It’s true that a handful of MLPs possess these traits. Magellan Midstream Partners (MMP) and Spectra Energy Partners (SEP) are two examples that come to mind.
However, many MLPs possess risks that make me a bit uncomfortable. You can review some the key risks here.
Ferrellgas Partners (FGP) was the latest MLP to rock investors. The company’s stock has fallen over 40% since the end of August, including a plunge of 30% since Tuesday this week when it reported earnings.
Management also indicated that the company’s distribution would likely be cut at least 50% in the next quarter, although no official announcement is expected until early November.
Ferrellgas is the second largest retail distributor of propane in the country and is well-known for its Blue Rhino grilling tanks. The company also has some midstream operations engaged in crude oil logistics.
Its mix was 100% propane in 2014 and was targeted to be split 50/50 between propane and midstream operations by 2018.
Source: Ferrellgas Factsheet
The company has been in business for more than 75 years and paid uninterrupted dividends since it went public more than 20 years ago.
Such dividend longevity appeals to almost any conservative dividend investor, but it is not the only factor that impacts dividend safety.
Let’s take a closer look at the factors that resulted in Ferrelgas’s slump and pending dividend cut. Understanding how Ferrelgas destroyed shareholder value can help us learn what to watch out for with future investments.
Ferrellgas had a Dividend Safety Score of 12 at the time of its disappointing quarterly earnings release. Scores below 20 get my attention and can be a signal that there is something unhealthy about a company’s business.
Of course, no scoring system should ever be blindly followed, nor will any system ever by completely correct (learn more about Dividend Safety Scores and view their real-time track record here).
Instead, further investigation should be done for low-scoring businesses to decide if their risk is worth taking.
Reviewing a company’s recent quarterly results, skimming its earnings call transcript for information about the dividend’s coverage, and flipping through its investor presentation (when available) don’t require much time but can provide important clues.
In Ferrellgas’s case, much of its pain was self-induced. The company’s propane distribution business has been a reliable cash flow generator, but its results were volatile based on weather conditions.
Warmer than usual weather reduces demand for propane, and management was interested in diversifying the business to create smoother results and opportunities for growth.
After a very mild winter in 2012, FGP began searching for ways to diversify. The company acquired a salt water disposal business for $127 million in 2014, setting the foundation for its midstream operations.
Then, in June 2015, Ferrellgas went big and acquired Bridger Logistics, a provider of trucking, pipeline, rail, and maritime transportation logistics for oil. FGP paid $837.5 million for the company, taking on significant debt to boost its oil transportation operations.
Financial leverage is one of the most dangerous factors that can destroy a stock (see five other tips on how to find safer stocks here).
Companies will protect their credit ratings and make debt payments before paying dividends. If a business falls on hard times and doesn’t have the cash to continue financing its operations, its stock price can plunge.
Unfortunately for Ferrellgas, propane demand dropped this past year due to record warm temperatures. Here is what founder and interim CEO James Ferrell said:
“As we highlighted last quarter, record temperatures across the nation continue to have an adverse impact on the propane sector of our company and low oil prices have seriously damaged our midstream sector. In particular, unusually warm winters over the past two years drove down propane sales across all our geographies, and low crude oil prices have negatively impacted our midstream logistics business.”
The company’s leverage ratio increased to roughly 5.5x debt / EBITDA, which was the limit allowed by its creditors.
As seen below, FGP’s long-term debt to capital ratio has steadily increased over the past decade. As of last quarter, the company held just $5 million in cash on hand compared to $2 billion of debt and $138 million in interest payments over the last year.
The company also relied on issuing new units to fund the business. This can work unless investors lose confidence in the business, sending its stock price plunging and raising the cost of equity too high.
If Ferrellgas hadn’t made its ill-timed entry into the midstream sector for diversification purposes, it likely would have been able to weather this storm.
However, its timing and choice of acquisition were far from ideal.
The purchase of Bridger Logistics stretched the balance sheet too far, a number of very complicated management and legal issues arose, and low oil prices made some its midstream operations of little value (it was no longer as economical to deliver oil by rail, and a major player decided to stop making payments on a key minimum volume commitment contract).
Sean Kellmurray explained the various complexities and shortcoming of the deal very well in his Seeking Alpha article here.
The end result was that Ferrellgas drastically needed to reduce its leverage, and the fastest and easiest way to do that is by reducing its quarterly distribution.
In my opinion, there are four main takeaways from Ferrellgas’s implosion this week:
1. Financial leverage is dangerous
Different types of businesses can handle varying amounts of leverage, but a stretched balance sheet can be disastrous. All it takes is a bout of unexpected weakness in cash flow (e.g. warm weather reducing propane demand plus the slump in oil hitting midstream results) and/or restricted access to capital markets for a highly leveraged firm to run into serious trouble.
The company’s equity value (i.e. stock price) will get hit the hardest, even if the dividend makes it through to the other side.
2. Major capital allocation decisions are game-changers
Ferrellgas’s management team saw opportunity to diversify the company’s revenue stream with its midstream deals in 2014 and 2015. While the intention was good, the outcome has proved to be a nightmare.
Unless the management team has an outstanding capital allocation track record, large deals should really be scrutinized – especially if they fall outside of a company’s wheelhouse (e.g. distributing propane versus crude oil transportation logistics).
3. Small cap companies are especially volatile
Small cap companies are usually defined as businesses with a market cap no greater than $2 billion. Since they are smaller, many times their revenue is concentrated in a very small handful of activities.
In other words, unexpected developments can really make or break some of these businesses. Small caps can also have a harder time gaining access to capital markets, depending on the circumstances.
For these reasons, small caps are usually much more volatile than their large cap brothers and should be approached with extra caution.
4. Commodities are unpredictable
Ferrellgas wagered on a set of assets that proved to be more sensitive to energy prices than management might have anticipated. Commodity markets are cruel and unforgiving. No one can accurately make forecasts, and there are many interconnected variables that are constantly at work.
Be aware of any commodities that materially impact companies you hold. While times could be good now, always expect the unexpected. Make sure your businesses have the balance sheet strength and cash flow generating capabilities to survive the next storm. It could very well be closer than anyone thinks.
These lessons overlap some of the habits of highly effective dividend investors I wrote about here. I know interest rates are extremely low and yield is hard to come by, but it’s more important than ever to scrutinize firms with high dividends and even higher financial leverage.