Published on June 15th, 2017 by Nicholas McCullum
In today’s low-yield environment, many investors are willing to take on riskier positions to increase their portfolio’s average dividend yield.
This can be very dangerous.
Higher dividend payments create a higher payout ratio (all else being equal), which reduces retained earnings and creates a more narrow ‘margin of error’ for the company in the event that operations experience poor performance.
That’s why investors should perform thorough due diligence before purchasing any high dividend stock.
Suburban Propane Partners (SPH) is an example of this phenomenon. The company has an eye-popping 14.4% dividend yield, making it a leader among the short list of stocks with 5%+ dividend yields.
Suburban Propane’s high dividend yield is enticing, but is it sustainable?
This article will analyze the investment prospects of Suburban Propane in detail.
Suburban Propane is a national marketer and distributor of energy products, including propane, fuel oil, and refined fuels. The company has 3,400 employees and operates in 41 states, where it delivers service to more than 1.1 million customers via 675 company-owned locations.
Suburban Propane was founded in 1945 as the Suburban Propane Gas Corporation and has been operating as a master limited partnership (MLP) since 1996. The MLP is headquartered in Whippany, New Jersey.
Suburban Propane operates a diversified business model. The company’s different operating segments, geographic regions, and customer types can be seen below.
Suburban Propane has experienced operational difficulties in recent years because of record high temperatures.
The company’s largest business line (propane) experiences a significant decline in demand during periods of elevated temperatures. The company commented on this during their recent analyst conference call.
“Looking at our first and second quarters combined, the heating degree day index was reported at 14% warmer than normal and that compares to the prior year which was 18% warmer than normal. However, the weather pattern in this year’s heating season was much more challenging than last year. The 2016, 2017 heating season consisted of record warm temperatures in each of the first two months of the first and second quarters and two separate three weeks stretches of cold weather towards the end of both December and March.
As we’ve stated throughout this extended stretch of record warm temperatures the fundamentals of our business continue to be sound, meaning we have a flexible operating model which allows us to be nimble. We can see to manage and control our costs and capital spending, our field personnel have done an excellent job managing margins during evolvement of commodity price environment and our customer base has benefitted from our growth and retention initiatives.” – Suburban Propane Second Quarter Conference Call
While the current stretch of elevated temperatures does not permanently impair the long-term viability of Suburban Propane’s business model, these temperature troubles should be considered by any prospective investor in this company.
Suburban Propane is one of the largest players in its industry along with AmeriGas Partners (APU).
With that said, there are still many regions of the United States that lack an operating presence from Suburban Propane.
The company’s operating footprint can be seen below.
The propane distribution industry is highly fragmented and as one of the larger market participants Suburban Propane has a considerable opportunity to grow organically (using its economies of scale) or acquire smaller operations and integrate them into its national business model.
This will drive the company’s growth for the foreseeable future.
Suburban Propane actively manages their balance sheet to ensure it is growing without over-extending itself while also minimizing interest expenses.
This was seen in the company’s most recent quarter when it refinanced a meaningful ($350 million) amount of senior debt at a significantly lower interest rate.
“First, during the quarter we took advantage of the continued low interest rate environment to refinance our previous 7 3/8% Senior Notes which were due to mature in 2021 with a new issuance of 5 7/8% Senior Notes due 2027. This refinancing extended the maturity on $350 million of senior debt by nearly six years and reduces our annual interest cost by approximately $5 million.”– Suburban Propane Second Quarter Conference Call
As the company continues to expand, its willingness to seek the most appealing sources of incremental capital will help it to generate shareholder value over time.
Competitive Advantage & Recession Performance
As mentioned in the last section, Suburban Propane benefits from meaningful economies of scale which allows it to have higher margins than its smaller competitors.
The company’s low-cost structure extends beyond its size.
Importantly, Suburban Propane has to incentive distribution rights (IDRs), which is unusual for an energy MLP. Incentive distribution rights give an MLP’s general partner an increasing proportion of the partnership’s cash flow as it grows. No IDRs means that Suburban Propane’s growth accumulates directly to the limited partner’s unitholders.
With that said, this stock should not be seen as a defensive position in an investor’s portfolio. The company has a BB- credit rating from Standard & Poor’s and a Baa2/Baa3 credit rating from Moody’s, both of which disqualify the company from the investment grade credit rating universe.
Further, the company’s dividend is not well-covered by its earnings, which means that a dividend cut is possible if a recession occurs or the company experiences isolated financial difficulties (likely due to elevated temperatures). This is discussed in more detail in the next section.
Valuation & Expected Total Returns
For various reasons, MLPs cannot be meaningfully analyzed using the traditional price-to-earnings ratio.
One alternative to conventional valuation techniques is to compare the MLP’s current dividend yield to its long-term historical average. If the current dividend yield is elevated, the company is undervalued; conversely, if the current dividend yield is lower than normal, the company is likely overvalued.
Suburban Propane currently pays a quarterly dividend of $0.8875 which yields 14.4% on the company’s current stock price of $24.57.
The following diagram compares Suburban Propane’s current dividend yield to its long-term historical average.
Suburban Propane’s current dividend yield is 14.4% and its long-term average dividend yield is 8.6% (shown in the diagram above). Based on this, it appears that the company is meaningfully undervalued at current prices.
However, is this 14.4% dividend yield sustainable?
We can assess the viability of Suburban Propane’s dividend by looking at its payout ratio.
The company reported diluted earnings-per-share of $1.36 in the most recent quarter. Suburban Propane currently pays a quarterly dividend of $0.8875, giving it a payout ratio of 65% in the most recent quarter.
Suburban Propane’s dividend was certainly sustainable when considering the most recent quarter in isolation.
We should also look back further and consider Suburban Propane’s payout ratio during the entirety of fiscal 2016. The company paid total dividends of $3.55 in fiscal 2016 and reported earnings-per-share of $0.24. Clearly, the company’s dividend was very unsustainable in fiscal 2016 and Suburban Propane would have been required to cut its dividend if performance did not improve.
The reason for this poor financial performance is very clear.
Record high temperatures in many of Suburban Propane’s operating geographies have reduced demand for propane and negatively impacted this company’s financial performance. This can be seen below.
Source: Suburban Propane Fact Sheet
So, Suburban Propane’s dividend payments were covered in the most recent quarter but were unsustainable in fiscal 2016.
What are investors to make of this company’s dividend moving forward?
I believe that this company poses a serious risk of a dividend cut and investors ought to avoid it for the time being. Here’s why.
Suburban Propane reported cash and cash equivalents of just under $7 million at the end of the most recent quarter. This is shown below.
Source: Suburban Propane Partners 10-Q
For context, the company had paid total distributions of ~$108 million year-to-date, or more than $50 million per quarter.
Given that the company has only $6 million in cash right now, I believe that additional quarters of poor financial performance will leave Suburban Propane unable to cover its dividend, resulting in a dividend cut.
Source: Suburban Propane Partners 10-Q
To sum up, Suburban Propane appears to have compelling double-digit total return potential. However, if warm temperatures persist then the company will likely reduce its dividend, which would trigger an automatic sell using The 8 Rules of Dividend Investing.
Suburban Propane’s double-digit dividend yield is enticing for investors looking to generate additional dividend income from their investment portfolio.
However, some investigation reveals that the company had an excessively high payout ratio in 2016 and does not carry enough cash and cash equivalents on its balance sheet to cover a few quarters of further poor performance.
Thus, I believe the risk of a dividend cut is too large for this company. Suburban Propane should be avoided by dividend growth investors, although the company may present a different thesis for value-focused investors.