INERGY LP NRGY
March 21, 2012 - 11:37am EST by
gary9
2012 2013
Price: 16.20 EPS $0.32 $0.10
Shares Out. (in M): 132 P/E n/m n/m
Market Cap (in $M): 2,130 P/FCF 8.5x 10.1x
Net Debt (in $M): 1,612 EBIT 155 140
TEV ($): 3,742 TEV/EBIT 24.0x 26.0x

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  • MLP
  • dividend cut
  • Highly Leveraged
  • GP/MLP

Description

Overview:  NRGY is an MLP that earns its cash flow in an equal split between:  1) propane distribution to retail customers on the East coast and 2) midstream / pipeline operations (primarily Marcellus transport and storage assets).  NRGY has historically been known as a Propane MLP (a sector currently suffering from an abnormally warm winter).  However, NRGY is currently undergoing an underappreciated transformation through a “drop down” strategy of its high-growth midstream cash flow to its newly-IPO’d daughter MLP, NGRM.  NRGY’s drop downs to NRGM generate cash proceeds, allowing NRGY to sell assets at 10x EBITDA, pay off debt, and retain nearly 50% of the EBITDA (through NRGY’s ownership of NRGM units and the general partner of NRGM, which is currently at the 50% split level on its incentive distribution rights (IDRs)

If you have followed the sagas of GP DivCo’s over the last year (KMI/EP, ETE/SUG, WMB/WPZ, TRGP/NGLS), you know the value of a GP of a MLP at the 50% splits with further “drop down” opportunities.  This highly favorable structural transformation ongoing at NRGY (starting with NRGM’s Dec IPO and initial drop downs) has been overlooked because of extremely weak recent performance at NRGY’s traditional propane assets.  Further drop downs to NRGM will help NRGY de-lever and rapidly grow its GP, which will have increasing relevance to NRGY’s valuation in the out years.

Target Price:  We target a 35% total return for NRGY over the next 12 months (a $20.60 unit price target + $1.44 in dividends).  Our target yield is 7% yield for NRGY, on a new FY9/13 distribution level of $1.44 (1.3x distribution coverage).  This estimates a 100 bp tighter cap rate relative to pure-play propane peers given NRGY’s substantial midstream cash flow, GP ownership of NRGM, and excess coverage relative to peers at 1x.  Our unit price target represents 11x DCF / unit and 11.5x EV / EBITDA (post near-term drop downs of $400M). 

Why NRGY is Cheap & Opportunity Summary

  • Heavy selling by retail / yield-oriented investor base.  NRGY announced Jan 31st that it was resetting its dividend level (to be declared in late April).  This has led to multiple analyst downgrades and selling by traditional MLP investors who had enjoyed NRGY’s $2.80 dividend.  Management is guiding to 1.2-1.3x excess coverage in its dividend reset and has introduced a 3 month period of uncertainty (other propane MLPs have recently given near term dividend guidance and we believe NRGY will shortly).
  • Pessimism over retail propane Demand.  2011-12 was the 4th warmest winter since 1900 (20%+ reduction in heating degree days in NRGY’s highest-margin NE areas) leading to 20% y/y declines in gross profit $’s on NRGY’s propane business.  NRGY’s East Coast territories were disproportionately affected vs other propane MLPs.
  • Perception of NRGY as an over-levered, propane pure play.  NRGY’s once-favored management team was an aggressive consolidator of the propane space, but NRGY’s 4.7x ND / EBITDA leverage ratio left it poorly positioned for the warm winter and unable to bid for ETP’s Heritage assets (recently bought by APU for ~11x EBITDA).

Variant Perception

  • NRGY is 50% Midstream.  NRGY’s growing midstream business will be 50% of EBITDA by the end of this year, with significant new growth opportunities in its Eastern Marcellus asset base ($380M of 2012 expansion CapEx for $55M in EBITDA (7x multiple), w/ a high mix of regulated and fully-contracted fee business).
  • “Drop Down” Potential Fixes the Balance Sheet.  NRGY received $372M of proceeds related to NRGM’s Dec IPO and purchase of assets from NRGY.  The NRGY parent still holds $75M of midstream cash flow that is targeted for drop down to NRGM, which should generate $680M in tax-free proceeds.  $400M of this value is targeted for a drop down over the next year ($40M of the $75M in EBITDA, which is from the high-quality West Coast NGL storage & Marcellus-area “US Salt” businesses).  The initial $400M drop down (likely to come in two transactions over the next year) will put NRGY within its 3x-4x targeted leverage ratio, even at the currently depressed levels of propane cash flow.  NRGM is under-levered at less than 1x ND / EBITDA and has the funding availability for the $400M drop down ($80M drawn on its $500M revolver).  NRGM will likely start issuing new units in early 2013.
  • Undervalued on likely forward dividend ($1.44 / unit) given GP Ownership of NRGM.  We believe NRGY will reset its distribution to $1.44 / shr, which will leave 1.3x distribution coverage assuming normalized weather.  (We show the math behind this large dividend cut later on.)  NRGY will be able to grow this dividend at low single digit rates off of this base even assuming that the conservation headwind of propane use (-4% annually) continues going forward.  Significantly higher dividend growth is possible if the daughter MLP (NRGM) continues to trade well, offers new units, and expands its capital projects in the Marcellus aggressively.  NRGY participates in NRGM’s cash flow through ownership of 56M NRGM units and the GP of NRGM (this total is currently 27% of NRGY’s cash flow but will be near 40% in 2 years, assuming only currently announced NRGM growth projects).  NRGM is already at the 50% splits on the IDR’s held by NRGY. 
  • NRGY is valued at a discount relative to other Propane MLPs, even though 50% of its cash flow is growth Midstream cash flow, and >10% of its cash flow will be from the NRGM GP interest in a few years.  NRGY trades at a discount on DCF / unit, dividend yield, and EV / EBITDA metrics to lower quality propane comps that have no GP ownership or midstream component (see below).  It should be noted that growthy midstream / Marcellus assets like NRGM can trade at 12-14x EBITDA (note WPZ’s $2.5B acquisition of Caiman Midstream this week at 13x FY13 EBITDA).    

Asset Base Overview

  • Propane Distribution Assets:  $163M in FY12 EBITDA, 48% of total.  NRGY is the 4th largest retail propane distributor with 338 customer service centers and 700k customers, which are primarily spread throughout the east coast, Michigan, and the south east.  NRGY has made over 80 propane distributor acquisitions since 1996 (often at 6x EBITDA or better after synergies).  NRGY’s gross profit $ / gallon is ~20% above peers because of its high concentration in Northern rural markets (the highest margin areas) and management’s strict focus on cost reduction after acquisitions.  The propane distribution sector overall is still 60% independent retailers, but consolidation has increased over the last year as APU went from 9% share to 15% after the acquisition of ETP’s Heritage Assets.  The top 10 retailers now control 40% of the market.  The propane distribution business has suffered declining organic retail volumes as propane costs have soared over 60% over the last 10 years and customers have conserved usage.  NRGY has churned a substantial amount of its customer base over the last 7 years to be left with a higher-margin, stickier rural customer base.  Before the extremely warm 2011-12 winter, the industry had been able to maintain distribution margins and raise retail prices in line with wholesale costs as petrochemical demand and exports pushed up propane prices (40% of total propane use).  Spot propane is now -13% q/q in 1Q12 (greater than normal seasonality), and new NGL wells in the US are expected to bring NGLs (ethane & propane) back into a balanced market over the next 1-2 years.  In the past, NRGY has been able to keep added margin from propane price declines.  We are estimating flat propane margins and -4% annualized customer churn (at the high end of management guidance).  Material propane spot price declines would be bullish for NRGY.
  • Remaining NRGY Midstream EBITDA (eligible for drop down):  $75M in FY12 EBITDA, 23% of total.   $20M is from the West Coast NGL terminal biz, $20M is from US Salt / NGL Storage operations in the Marcellus, and $35M is from the TX area storage (“Tres Palacios”).  The West Coast NGL & US Salt operations have high current utilization and potential expansion projects (guidance of 10x EBITDA valuation in a drop down to NRGM).  The TX area storage EBITDA should be $35M this year and faces moderate near term declines in EBITDA as 20% of its 39Bcf in storage rolls off to lower rates.  In total, this “undropped” EBITDA grew >10% y/y in the last quarter and the $40M of NGL & US Salt EBITDA is eligible from drop downs to NRGM over the next year because of its strong growth profile.
  • EBITDA from NRGM unit & GP ownership:  $87M of FY12 EBITDA, 27% of total.  NRGY’s highest quality midstream EBITDA was dropped down to NRGM in association with NRGM’s Dec 2011 IPO.  All of the EBITDA comes from Marcellus-leveraged transport and storage assets.  1/3 of NRGM FY12 EBITDA is transportation related (100% contracted, FERC-regulated, coming from the North-South Pipeline & Marc I pipelines which tie into major-area pipes such as TGP and Transco).  NRGM’s storage assets are backed by utility customer contracts (built w/ 95% contract coverage).  NRGM’s $380M in growth CapEx will add ~$55M in EBITDA over FY12-13.  A few weeks ago, NRGM announced a new greenfield interstate pipeline JV (partnering w/ UGI as an investor and anchor shipper) which will deliver gas from NRGM’s Marc I pipeline to the Baltimore market.  This is $333M of CapEx net to NRGM (cash flows will start in 2015), and it proves NRGM’s ability to find organic growth projects out of its existing Marcellus footprint.  We believe our 6% LT dividend growth estimates for NRGM are conservative. 

Management Background

  • CEO John Sherman (56) moved to NRGY in 1997 after selling his propane distribution business to Dynegy.  On average, key management tenure is 10 years.
  • Management owns 20% of NRGY equity (having sold the old GP of NRGY back to the company in exchange for equity a few years ago).  The CEO will take home $22M / year in NRGY dividends (vs a cash salary of $800k), assuming the divs get reset to the lower level.  Management is highly incentivized to continue growing NRGY’s divs & valuation.
  • NRGY’s management team was previously the favorite team in the Propane space (known as the acquirers with the best cost management and highest margins).  Their credibility has been damaged since NRGY spent $725M to buy Tres Palacios in 2010 (the TX storage asset now under pressure).  NRGY over-distributed in FY11 (like its comps), but is being forced into a much larger distribution cut than peers because of its high leverage and desire to maintain excess coverage and de-lever.
  • Management was also criticized for the aggressively-priced IPO of NRGM, which IPO’d at the 50% splits level on IDRs (owned by NRGY’s GP).  This shows a clear “GP” mentality, however, which ultimately benefits NRGY.  NRGY knows the value of GP at the 50% splits, and purposefully set NRGM’s IPO that way to benefit NRGY’s GP from future NRGM drop downs and CapEx increases.  Management believes NRGY’s new structure advantage is underappreciated in the current valuation.

Comparable Valuation

  • Bloomberg estimates on the propane MLP space still outdated.  Below are metrics for NRGY’s propane sector comps based on fresh street model updates.
  • Note that NRGY’s assumed coverage of 1.2-1.3x is more conservative than comps (comps are still guiding to roughly 1.0x coverage on a normalized winter).
NRGY Comps Price Div Yield FY13 Div Distrib Cov P/DCF EV/EBITDA Norm Grwth
APU $40.41 8.0% $3.22 1.05x 12.0x 11.2x 5%
FGP $15.12 9.3% $1.40 1.03x 10.5x 10.9x 0%
SPH $42.10 8.1% $3.42 0.99x 12.5x 11.7x 2%
Heritage (APU bot from ETP) EV $2.9B         11.0x  
               
NRGY $16.20 8.9% $1.44 1.30x 8.6x 9.8x 4%
               
Note:  Based on most recent updates to street estimates & pro-forma for APU's 10/17/11 acquisition of Heritage.
APU's GP is owned by UGI.  FGP does not have a GP.  SPH has an external GP but is at the low splits in its IDRs.
NRGY is shown PF for $400M in drop downs.

Risks

  • Re-acceleration of rising propane prices & re-acceleration of customer conservation.
  • Delay in further “drop downs” to NRGM (although NRGY should be able to clear its 5.25x ND / EBITDA covenant even if another drop down doesn’t get done).
EV Summary                
Price $16.20   Notes          
   Units Out 131.5   5.8M in class B mgmt units (PIK divs), vesting near   term.
   Mkt Cap 2,130              
Total Debt 1,711              
   NRGM Debt 80              
Adj Debt 1,631   4.66x as-reported NRGY leverage ratio at 1Q.
   Gross Cash 19   5.25x EBITDA covenant.  No near term maturies.
Net Debt 1,612              
   Minority Int 0              
Enterprise Value 3,742              

 

  FY 9/09 FY 9/10 FY 9/11 FY 9/12 FY 9/13 FY 9/14 FY 9/15 FY 9/16
Inergy Total Asset Adj EBITDA 297 326 372 340 385 381 385 398
                 
A) NRGY's Propane EBITDA 214 215 212 163 173 166 160 153
      Growth -1% 1% -1% -23% 6% -4% -4% -4%
   Note:  Retail Margin / gal $1.17 $1.13 $1.19 $1.01 $1.02 $1.02 $1.02 $1.02
   Note:  Retail Vol y/y -7% 10% -4% -18% 6% -4% -4% -4%
                 
B) NRGY's "Undropped" Midstr EBITDA 111 111 160 75 55 33 32 32
   Note:  EBITDA at NRGM       102 157 182 193 213
   Note:  Total Midstream Asset EBITDA   111 160 177 212 215 225 245
                 
NRGY's Cash Flow from NRGM Ownership:                
   Cash Flow from 56M NRGM Units Owned       84 94 100 106 112
   2% GP Mgmt Fee Stake       2 2 3 3 3
   IDR Cash Flow       1.5 15.5 24.5 34.6 46.0
C) NRGY's Cash Flow from NRGM Ownership       87 111 127 143 161
                 
NRGY Total EBITDA (A+B+C)   326 372 325 340 327 335 346
   % of Cash Flow from Midstr & NRGM   34% 43% 50% 49% 49% 52% 56%
   % of Cash Flow from GP       1% 5% 8% 11% 14%
                 
NRGY DCF:                
   Int Expense   91 114 98 77 69 69 69
   Maint CapEx   14 16 16 16 16 16 16
NRGY DCF:   221 243 211 246 241 250 261
   DCF / Shr   $1.68 $1.85 $1.60 $1.87 $1.84 $1.90 $1.99
      Growth     10% -13% 17% -2% 3% 5%
                 
NRGY Div Est:                
   Coverage Est       1.15x 1.30x 1.25x 1.20x 1.20x
   Dividends $2.64 $2.79 $2.82 $1.40 $1.44 $1.47 $1.58 $1.65
   Div Growth   5.7% 1.1% -50.5% 3.3% 1.9% 7.8% 4.5%
                 
NRGY EOP Net Debt       1,411 1,211 1,211 1,211 1,211
       Note:  Drop Downs During Year       200 200 0 0 0
       Note:  Other Cash Burn       -20 0      
ND / EBITDA at EOP       4.3x 3.6x 3.7x 3.6x 3.5x
                 
Valuation                
   P / DCF       10.1x 8.6x 8.8x 8.5x 8.2x
   EV / EBITDA on Current Bal   Sheet       11.5x 11.0x 11.5x 11.2x 10.8x
   EV / EBITDA on EOP Bal Sheet       10.9x 9.8x 10.2x 10.0x 9.7x
   Div Yield       8.6% 8.9% 9.1% 9.8% 10.2%
 
Note:  NRGM Dividends & IDRs: Current     FY 9/12 FY 9/13 FY 9/14 FY 9/15 FY 9/16
NRGM Initial Distr Rate (=50% IDR Split Level) $0.37              
   Ann Rate $1.48              
   Total NRGM Units Out 74     74 78 82 85 88
   NRGM Units Held at NRGY 56              
NRGM Div / Unit       $1.50 $1.68 $1.78 $1.89 $2.00
Div / Unit over the 50% Split       $0.02 $0.20 $0.30 $0.41 $0.52
NRGY's IDR Cash Flows       1.5 15.5 24.5 34.6 46.0
 
Note:  NRGY Remaining Drop Downs   EBITDA Mult Proceeds Comments    
   West Coast NGL   20 10x 200          
   Salt   20 10x 200          
   Tres Palacios   35 8x 280   EBITDA declining ~7% y/y, recontracting.
FY12-13 Drops       400   NGL & LPG.  NRGM has revolver capacity.
Total Potential Drops       680          
 
Expansion  Projects   Total Remaining Multiple In Service Total EBITDA
NRGM   CapEx              
   North-South Project   75 8   6.0x 1/1/2012   13  
   Finger Lakes LPG Expansion   65 22   7.0x 6/1/2012   9  
   MARC I Line   240 183   7.2x 7/1/2012   33  
   UGI JV, Baltimore Pipeline   333 333   8.5x 1/1/2015   39  
NRGY                  
   West Coast Expansion   21 11   5.5x 4/1/2012   4  
 
 
 

Catalyst

Catalysts

  • Late April:  Div declaration at the new quarterly rate.  Resetting of NRGY dividend level to a new base, from which NRGY can achieve reasonable coverage & growth given “normalized” weather.
  • 8/12, 1/13:  Drop downs (likely in 2 deals of $200M each) of $40M total EBITDA to NRGM of NRGY’s West Coast NGL & US Salt businesses.
  • Fall / Winter 2012:  Stabilization of propane demand & margins with typical winter temps (with positive y/y comps in the 2012-3 heating season).
  • 1/13 & beyond:  Anniversary of NRGM’s IPO & ability to offer new units and increase Marcellus-directed CapEx projects.
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