DISCLAIMER:  I currently hold short positions in Ferrellgas.  I may change my position at any time without posting an update.  The views expressed here are merely the opinion of the author.  This is not a recommendation to buy or sell any securities.

The Opportunity

On January 27^th Inergy announced that due to its 0.68x distribution coverage ratio and a lack of foreseeable improvement in their propane business, a distribution cut to a level supported by cash flows was being evaluated. The stock sold off 24% that day. I believe a similar announcement and more precipitous sell off is very likely for Ferrellgas sometime in the next three to six months; possibly as early as March 9^th when FGP reports earnings for the quarter ended January 31^st. I believe that FGP is currently trading at a <5% yield on its run rate distributable cash flow. Its current distribution is not sustained by ongoing cash generation (it hasn’t for years) and multiple debt covenants will force a cut. Using a 10% yield on a generous view of normalized distributable cash flow I think fair value is ~$11/share, 42% below the current price.

The Business

Ferrellgas is the second largest propane distributor in the US. Their end users consist of retail customers who use propane for space heating, water heating and cooking and agricultural consumers who use propane for crop drying, irrigation and weed control. Ferrellgas also is the operator of Blue Rhino, the nation’s largest distributor of by portable tank exchange appliances. They do not break out the tank exchange business, but I do not believe it is a significant component of EBITDA. In an average year EBITDA breakdown by quarter looks like the following: 1/31 – 50%; 4/30 – 35%; 7/31 – 5%; 10/31 – 10%. The lion’s share of the business is selling propane which is used for heating.

The Industry

At a high level, the U.S. retail propane industry is in a secular decline which is being exacerbated by low natural gas and coal prices making propane increasingly expensive compared to substitutes. Currently it is more than twice as expensive for households to heat their homes with propane versus electricity (July 2011 Citi report titled “Retail Propane…The Fall is Coming”). The fact that this winter has been 15% warmer than both last year and historical averages has only compounded the decline.

Since 2005 the number of homes using propane as their primary heating source has declined 2-3% each year. While the industry remains somewhat fragmented, considerable consolidation has occurred over the last several years. Industry players including Inergy, Suburban Propane, Amerigas and Heritage (recently acquired by Amerigas from Energy Transfer), have executed multi-year rollup strategies that have benefitted from local economies of scale (buy competitor, take out duplicative costs and raise prices). In the past, the opportunities to make these accretive acquisitions have offset volume declines. However, as the low hanging fruit gets picked and curtailing EBITDA declines, which are growing in absolute and relative terms, becomes more difficult, the game has pretty much come to an end. All of these dynamics are well covered by the aforementioned Citi report.

This “Winter” Season

The most widely quoted indicator of heating demand is heating degree days. You can track heating degree day data here: http://www.cpc.ncep.noaa.gov/products/analysis_monitoring/cdus/degree_days/.

Below is a quick summary of what you will find:

Though temperatures have varied across the country, pretty much every state east of Colorado has experienced temperatures +10% warmer than last year (which was a slightly colder than average year). For a map of Ferrellgas’ locations see this link, page 12: http://www.ferrellgas.com/Resource_/PageResource/JP%20Morgan%20Investor%20Conference%20030111.pdf  

Through December, heating degree days were down 12% year over year. This, combined with the existing secular declines, had a pronounced effect on the profitability of Ferrellgas’ peers. The following highlights y/y changes in adjusted EBITDA for the quarter ended December 31 (Ferrellgas has a 1/31 fiscal quarter).

 Though each of these companies operates in slightly different regions and business profiles are not exactly the same (the biggest differences being +40% of Inergy’s EBITDA coming from its midstream business and the fact that Ferrellgas does more agricultural sales than comps), I believe it is safe to assume that FGP’s EBITDA declined ~25% for the quarter November through January.

The Distribution

Ferrellgas has distributed $2.00 per share every year since 1995. I am very confident that 2012 will mark the end of this run. With 79MM shares outstanding following a January equity raise, FGP has an annual unit distribution bill of $158MM. In round numbers they pay $95MM in annual interest and securitization fees and have roughly $17MM a year in maintenance cap ex requirements. Thus, FGP needs to generate $270MM in annual EBITDA to cover its existing distribution. The last time they generated this much EBITDA was…never. FGP’s trailing twelve months EBITDA peaked in July 2010 at $266MM and has pretty much been in free fall since then. Including the quarter which will be reported on March 9^th, FGP has seen six consecutive quarters of y/y declines (considering that we just wrapped up a February that was 17% warmer than last year in terms of heating degree days, a seventh y/y decline is a certainty). Through the end of October, LTM adjusted EBITDA was $223MM ($1.40 DCF per share; 70% coverage for a year that included a particularly cold winter). My estimate for the quarter ended 1/31 EBITDA is $90MM (25.5% y/y decline). This will bring LTM EBITDA to $191MM ($1.00 DCF per share). Unless March brings a dramatic cold spell (the current 6-14 day forecast indicates this is not likely), LTM EBITDA through April could fall to $174MM ($0.78 DCF per share), assuming a 15% volume decline for the quarter ended 4/30 and stable margins. I am highly confident that Ferrellgas will never generate enough EBITDA to cover their current distribution.

The Covenants

The notion that Ferrellgas is not generating enough cash to cover its distribution is not new; it hasn’t been sufficiently covered for years. What’s different now is that there are multiple debt covenants that will restrict FGP’s ability to continue paying a distribution level that has no regard for the underlying business’ profitability. These covenants are as follows:

• For the 2020 Sr. Unsecured notes, if the consolidated fixed charge coverage ratio of the partnership is less than 2 to 1 then FGP is prohibited from incurring any additional indebtedness. With ~$100MM in LTM fixed interest charges, I believe Ferrellgas is currently prohibited from incurring additional debt.

• For the bank loan, the debt to EBITDA covenant is 5.5x . As of the quarter ended 10/31 the ratio was 4.5x (just over $1B of applicable debt). Through the quarter ended 1/31 the ratio was likely just north of 5.3x. Looking out to the end of the current quarter it is very likely going to exceed 5.5x.

• For all unsecured debt, if the consolidated fixed charge coverage ratio less than 1.75x then FGP cannot distribute the lesser of currently available cash or $25MM ($0.32/share).

While I am not certain how these covenants will result in the finale of this game of “distribution shortfall whack-a-mole”, the end appears to be quite near. Assuming Ferrellgas somehow manages to avert a breach that restricts their ability to make distributions, I believe they will run out of cash after paying the distribution for the quarter ended July 31^st.

Timing

On 2/23 FGP announced that they would be making their regularly scheduled $0.50 distribution for the quarter ended January 31^st. The stock rallied 5% through the end of the week. While I was expecting the distribution announcement to be accompanied by a statement similar to NRGY’s, I still think that this quarter’s earnings announcement may be the time for Ferrellgas to take its medicine. There is likely not going to be a better opportunity considering the stock is at its highest level in two months. Furthermore, the $50MM equity raise in January (half of which was FGP’s ESOP purchasing the stock 5% above market prices) and recently announced layoffs (http://www.bizjournals.com/kansascity/news/2012/01/17/ferrellgas-partners-cuts-jobs-in.html) suggest the company might be coming to the end of the road.

Given their situation, a significant capital restructure is necessary. On the last conference call the CEO indicated that the desired debt to EBITDA ratio was 3.5x. In order to get there FGP will need to raise ~$400MM of equity. While I frankly have no idea what the share price would be if they were to take this route, $15/share (20% below the current price) seems more than conservative. The addition of 30MM shares, after fees, and savings of ~$35MM/yr in interest expense would leave ~$125MM for equity distributions at a $200MM/yr EBITDA level, or $1.15/share at a 1x coverage. Applying a 10% yield (NRGY trades at 10% yield and is a much better business) would derive a price of $11.50…on second thought they probably won’t get the raise done at $15.

The alternative is for Ferrellgas to distribute as if none of this is happening and then cut the distribution completely when they run out of cash/breach covenants. In that scenario a price in the single digits is quite plausible.

Risks

The only real risk I see to the thesis is the cost to borrow and the cost of the distribution. All in, we are paying around 16%. Considering that I expect a catalyst in short order I am not too concerned by this. Ferrellgas has sold of more than its distribution in each of the last four quarters.

Because many industry observers are calling for consolidation in the space, I suppose a merger or acquisition should be mentioned. However, with Ferrellgas at 13.5x EV/EBITDA, financially constrained peers and somewhat limited geographic overlap to offer synergies, a sale seems out of the question (it won’t be accretive to anyone).