Bring Some 'Heat' to Your Portfolio

05/27/2013 8:00 am EST


Josh Peters

Editor, Morningstar DividendInvestor

This propane provider has pleasantly warm yield and growth prospects, making it a recommendation of Josh Peters of Morningstar DividendInvestor.

In January 2012, AmeriGas (APU) swallowed the former propane business (Heritage Propane) of Energy Transfer Partners ETP in a $2.9 billion deal, which boosted AmeriGas' share of the retail propane market from 10% to 15% and brought large cost-cutting opportunities.

As part of the transaction, AmeriGas provided an immediate payback for partners, with an extra 3% distribution increase atop its usual 5% annual hike.

AmeriGas has a lucrative business with high customer-switching costs and a cash flow profile that allows it to pay out most of its earnings. Switching costs stem from the fact that most of its customers don't own their tanks, but instead rent from AmeriGas. To defect, they have to incur a fee and arrange for AmeriGas to swap tanks with the new provider, which is a frustrating process.

Switching to an alternative fuel isn't frequently a viable option, either. Natural gas is often unavailable in the rural areas where propane is prevalent-the principal competition is often from electricity, especially for home heating. While fuel oil can be comparable in price, appliances are built to use either propane or oil, and switching would mean buying new appliances.

For these reasons, customers tend to be sticky, and AmeriGas earns high returns on invested capital. We do expect higher-than-normal defections in the wake of the merger, but no major shift in the relationship between end user and seller.

Propane is a mature but highly fragmented industry, and the bulk of AmeriGas' growth before the Heritage deal came from acquiring smaller distributors. Upon acquisition, AmeriGas can cut much of the managerial costs and duplicate truck routes, while managing inventory more efficiently.

However, as the industry consolidates and larger distributors search ever more hungrily for acquisitions, average deal prices might drift upward, and AmeriGas' increased size makes it harder to offset internal volume declines.

The 2011-12 winter heating season brought record warm weather, which hurt volume and AmeriGas' cash flow. Coverage of cash distributions fell from a historical range of 1.2 to 1.5 times to just 0.7 in the September 2012 fiscal year.

While 2012 results underscore the variability of any one year's results, we expect that weather trends will average out over time. Data for the 2012-13 heating season (October through March) show 5% fewer heating degree days than normal, but a 15% improvement on year-ago levels.

This reversion supports AmeriGas' forecast for fiscal 2013, which should see distribution coverage rebound to a healthy 1.3 times and sharply improved credit metrics. (Our credit rating is BB+, one notch below investment grade.)

The demand for propane has been gently falling in recent years, and AmeriGas currently expects only flat to slightly increasing demand. At the same time, the partnership's business model calls for 3% to 4% average growth in EBITDA and 5% growth in distributions, which is in line with past performance even in a period of declining industry volume.

It helps that increases in per-gallon markups are generally equal to or slightly ahead of inflation (the latter being helped by the customer-switching costs noted earlier).

We expect a ninth consecutive annual distribution increase in late April, likely matching the partnership's 5% target. Given a current yield of 7.1%, we anticipate long-run total returns around 12%.

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