Star Gas Subordinated Units SGH
January 06, 2005 - 7:00pm EST by
2005 2006
Price: 4.23 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 14 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Summary: With an intrinsic value of less than $1 and a current unit price above $4, SGH is one of the most compelling short opportunities that we have ever come across. A fundamental market misunderstanding of the rights of this subordinated security (especially post the sale of the propane business) and the likely belief by some investors that SGH is merely a leveraged play on SGU have created a tremendous opportunity for anyone willing to tackle the complexities of this situation. The recommended short position in SGH is made even more attractive when hedged against a long position in SGU.


Before you continue, please read the write-ups on Star Gas Partners, LP (“SGU”) and Heating Oil Partners Income Fund (“HIF-U CN”) posted (by us) on VIC last month (December 2004). These two write-ups and all subsequent postings will provide a great deal of background information on the heating oil industry and necessary details regarding the Star Gas situation specifically.

Security Description

• What are SGH units? SGH units are publicly traded Senior Subordinated units in Star Gas, as opposed to the publicly traded Common units which trade under the symbol SGU. There are currently 3.2M SGH units outstanding (9% of total ownership) and 32.2M SGU units (89% of total ownership). There are also 671K Junior Subordinated and General Partner units which are not publicly traded.

• Why issued? These units were effectively designed to serve as credit support and were issued to Petro Class A common stock holders upon the acquisition of Petro (current heating oil subsidiary) by Star Gas in February 1999.

• Rights? In short (described in further detail herein), SGH units are generally subordinated to SGU units in the ordinary course distribution waterfall, but may receive additional incentive distributions (greater than pro rata) above certain targets (primarily that distributions of available cash must exceed target levels of $2.42 per year – a scenario not currently likely post the sale of the propane business). SGH units are convertible to SGU units if a series of tests are met (further described below), which generally cannot be satisfied before September 30, 2007.

• Holders? Approximately 98K units or 3% of the SGH units are held by current management (half of that amount is held directly or indirectly by Irik Sevin, Chairman & CEO). Sevin and his family do hold another 532K units, but they are all Junior Subordinated and General Partner units.

Investment Thesis

• Why is SGH worth FAR less than SGU?

- Subordination: Section 5.4 of the SGU Limited Partnership Agreement (“LPA”) provides a waterfall schedule for the priority of distributions of Available Cash from Operating Surplus (see below for detailed definitions). This section states clearly that any such distributions must first 100% satisfy the Common Unit (SGU) Minimum Quarterly Distribution (“MQD”) – currently $0.575 per unit (or $2.30 annualized) – and 100% of any Common Unit Arrearages resulting from unpaid MQDs before the Subordinated (SGH) units receive any distributions at all.

- No mechanism to adjust SGU MQD for propane sale: Although SGU was historically able to maintain paying the MQDs of $2.30 (annualized) to Common Unit holders for some time, the cash flow generation potential of the business just changed dramatically (by roughly half) with the sale of the propane segment in December 2004. As a result, SGU is expected to generate normalized distributable cash flow of between $0.80 and $1.20 per fully diluted unit over the next few years. However, there is no mechanism to adjust the MQDs downward to compensate for the asset sale (adjustments are only provided for in Section 5.6 regarding unit issuances or splits and Section 5.8 regarding potential changes in entity level taxation). As a result, SGU unitholders should receive 100% of all Available Cash from Operating Surplus for the foreseeable future and all shortfalls (below $2.30 per year) will continue to cumulatively accrue and will have priority payment status over all subordinated units, effectively blocking SGH from receiving any distributions at all. This fact also effectively increases the value of SGU units by approximately 10% as most investors are likely valuing the units based on a yield of distributable cash flow per fully diluted unit (a concept that is only valid when MQDs are satisfied), when in fact 100% of distributable cash flow will go to SGU holders.

- Conversion of SGH units to Common Units: Section 5.7 of the LPA sets forth a provision that SGH units will effectively automatically convert to SGU units (with some residual differences) upon the expiration of the Subordination Period (defined in full on page C-16 of the LPA and paraphrased in detail in the definitions section below). In essence, three tests would have to be met for this to occur: 1) distribution test – distributions must meet or exceed MQDs for 12 straight quarters; 2) financial test – Operating Surplus must meet or exceed MQDs (fully diluted) for 12 straight quarters; AND 3) there must be no Common Unit Arrearages. Given the recent suspension of distributions, conversion could not occur by this definition until at least September 30, 2007, but likely much beyond that timeframe given that arrearages will accrue for any SGU distributions below the $2.30 MQD.

The Subordination Period would also end if the General Partner were removed without cause (as long as not more than one MQD was missed in the preceding 18 month period). Removal of the GP would require a 66 2/3% vote of all non-GP units and an opinion of counsel that removal would not result in a loss of limited liability to the LPs or cause SGU to be treated as a corporation or otherwise taxed as an entity for federal income tax purposes. Such a scenario is highly unlikely.

• Where should the units trade? Assuming no distributions are made in 2005 (a very likely scenario) and $1.00 of distributions in 2006, growing at 5% per year thereafter, cumulative Common Unit Arrearages would not be fully repaid until 2038. That would therefore be the first year in which SGH unitholders would receive any distributions at all. SGH units would then meet the Subordination Period tests and the units would effectively convert to Common (with limited differences), with an implied 2038 distribution of $4.37 using the above assumptions. Based on a 12% future yield and discounting the future value back to the present using a 12% discount rate, SGH units have an implied current value of only approximately $0.90. SGU units, using the same assumptions, are worth approximately $12.00 today.

• So, why have SGH units not yet fallen further? Given the complexity of the distribution rights, it is likely that many current SGH unitholders have not yet understood the implications of the propane sale on the value of their units. Furthermore, it is our belief that much of the recent price support (SGH units have rebounded more than 80% from their low of $2.31 at the end of October) is the result of sophisticated investors looking for a leveraged investment in SGU. As of that point, SGH units had fallen 90% versus only 70% for SGU and it is likely that investors new to the situation (and the MLP structure) believed that there was more upside in the SGH units given a recovery in the overall business. However, as laid out above, this is a fundamental misunderstanding of the rights of these securities.

• Can / should you hedge the SGH short position? There is a perfect natural hedge in any SGH short position by merely going long the SGU units. We believe SGU to be a very strong long in its own right (as illustrated in detail in the SGU write-up), but an even larger position as a hedge against an SGH short position is extremely compelling in our view. Nearly any probable scenario which would accelerate the payment of distributions to SGH units (and therefore greatly increase their value) – i.e., a large accretive acquisition or faster than expected organic recovery – would have a similar positive effect on the SGU units and would likely more than offset any losses in the short position.

Risks / Issues

• Conversion to common units: The criteria for determining the end of the Subordination Period (laid out above and in detail below) does not seem likely to be satisfied within the next three years (and probably significantly beyond that timeframe).

• SGU disburses remaining propane sale proceeds to all unitholders: Such a distribution in the face of weakened operating results would likely largely constitute a distribution from Capital Surplus (as opposed to Operating Surplus), which would be subject to pro rata distribution to all unitholders (as opposed to the priority waterfall outlined in Section 5.4) as provided for in Section 5.5 of the LPA.

In accordance with the terms of the indenture relating to SGU's 10-1/4% Senior Notes, SGU is obligated, within 360 days of the propane sale, to apply the remaining net proceeds of the sale either to reduce indebtedness or to make an investment in assets or capital expenditures useful to the business. To the extent that any net proceeds that are not so applied exceed $10 million, the indenture requires SGU to make an offer to all holders of the Senior Notes to purchase for cash at par that portion of the Notes that may be purchased with excess proceeds. Only if that offer to purchase is rejected would SGU then still have any excess proceeds remaining for a potential distribution.

However, such a distribution would almost certainly still be disallowed under the terms of the new $260M credit agreement just recently negotiated with JP Morgan. Although the terms of this agreement are not public, the most recently filed 10-K states that, “The revolving credit facility and, as applicable, the bridge facility or the senior secured notes, will impose certain restrictions on the Partnership's ability to pay distributions to unitholders.” As such, we believe a distribution of this kind to be highly unlikely.

• SGU generates distributable cash flow (from Operating Surplus) in excess of MQD and all arrearages on SGU: As SGU is currently expected to generate between $0.80 and $1.20 per unit over the next several years (versus Common MQD obligations of $2.30 per unit), this scenario is highly unlikely in the near-term, but in any event would be mitigated by a long position in SGU (which would be worth upwards of $20 in such a scenario).

• Liquidity: There are currently only 3.2M SGH units outstanding, however, they do trade quite frequently – approximately $500K in value per trading day. As of the last reported figure (December 15), only about 85K units (2.7% of the total) were held short. We have found that there is ample borrow available to short the SGH units in moderate size.

• SGH holders are insiders: As mentioned above, about 98K units (or approximately $420K in value) are currently held by SGU insiders (in addition to larger holdings of other subordinated classes of units). There is some risk that management could attempt self-serving actions (potential exploitation of unforeseen LPA loopholes, etc.) that could possibly increase the value of the SGH units relative to SGU units. To the extent that a shareholder vote would be required to ratify any such actions, the 89% ownership held by SGU (Common) unitholders would soundly triumph.

• Complexity: There currently exist uniquely profitable opportunities in both the SGU long position and the SGH short position due to the fundamental misunderstanding of the current operating situation and the rights of the individual classes of securities. This misunderstanding arises largely from the complexity surrounding the issues identified in this and the preceding write-ups. Given these complexities (both legal and tax-related), we would strongly suggest that any investor new to these situations seek advice from their own legal and / or tax counsel. To facilitate further diligence, the LPA may be found as Annex C of the Star Gas Prospectus filed March 24, 1999 in connection with the Petro acquisition. There are at least 3 subsequent amendments, none of which seems to us to materially affect the above investment thesis.

Potential Catalysts

• Realization by long-time SGH unitholders that subordinated distributions will be substantially delayed even once Common distributions are resumed

• Realization by new sophisticated investors that SGH is not a leveraged play on SGU

• Any negative news concerning SGU’s operations or liquidity

Key Definitions (paraphrased – see LPA for exact / complete language)

• Available Cash: (a) the sum of (i) all cash and equivalents on hand at the end of each Quarter and (ii) all additional cash and equivalents on hand on the date of determination of Available Cash with respect to such Quarter resulting from Working Capital Borrowings subsequent to the end of such Quarter, less

(b) the amount of cash reserves that is necessary or appropriate in the reasonable discretion of the General Partner to (i) provide for the proper conduct of the business (including reserves for future capital expenditures) subsequent to such Quarter, (ii) provide funds for distributions in respect of any one or more of the next four Quarters, or (iii) comply with applicable law or any debt instrument or other agreement or obligation; provided, however, that the General Partner may not establish cash reserves for SGH distributions unless the General Partner has determined that in its judgment the establishment of reserves will not prevent the Partnership from distributing the Minimum Quarterly Distribution on all Common Units and any Common Unit Arrearages thereon with respect to the next four Quarters.

• Capital Surplus: all Available Cash distributed from any source will be treated as distributed from Operating Surplus until the sum of all Available Cash distributed since the commencement of the Partnership equals the Operating Surplus as of the end of the Quarter prior to such distribution. Any excess Available Cash will be deemed to be Capital Surplus.

• Common Unit: SGU units

• Common Unit Arrearage: the excess, if any, of (a) the Minimum Quarterly Distribution then in effect with respect to such Common Unit over (b) the sum of all Available Cash distributed with respect to such Common Unit.

• Interim Capital Transactions: (a) borrowings, refinancings or refundings of indebtedness and sales of debt securities (other than Working Capital Borrowings and other than for items purchased on open account in the ordinary course of business); (b) sales of equity interests; and (c) sales or other dispositions of any assets other than (x) sales or other dispositions of inventory in the ordinary course of business, (y) sales or other dispositions of other current assets, including receivables and accounts in the ordinary course of business, and (z) sales or other dispositions of assets as part of normal retirements or replacements.

• Minimum Quarterly Distribution (“MQD”): $0.575 per Unit, subject to adjustment in accordance with Sections 5.6 (regarding unit issuances or splits) and 5.8 (regarding changes in entity level taxation).

• Operating Surplus: (a) the sum of (i) $20,340,600 plus all cash on hand as of the close of business on the Initial Closing Date, (ii) all the cash receipts for the period beginning on the Initial Closing Date and ending with the last day of such period, other than cash receipts from Interim Capital Transactions and (iii) all cash receipts after the end of such period but on or before the date of determination of Operating Surplus with respect to such period resulting from Working Capital Borrowings, less

(b) the sum of (i) Operating Expenditures for the period beginning on the Initial Closing Date and ending with the last day of such period, and (ii) the amount of cash reserves that is necessary or advisable in the reasonable discretion of the General Partner to provide funds for future Operating Expenditures.

• Senior Subordinated Unit: SGH units

• Subordination Period: Ends upon the first to occur of the following: (a) first day of any Quarter in which (A) (i) distributions of Available Cash from Operating Surplus on each of the various units equaled or exceeded the MQD for each of the three previous non-overlapping four-Quarters and (ii) the Adjusted Operating Surplus generated during each of the three immediately preceding non-overlapping four-Quarter periods equaled or exceeded the sum of the MQD on all of the various units on a fully diluted basis with respect to options or other incentive compensation and (B) there are no cumulative Common Unit Arrearages; and

(b) the date on which the General Partner is removed upon the requisite vote by Limited Partners under circumstances where Cause does not exist; provided, however, that if the General Partner is removed during the Subordination Period within 12 months after the end of a six-Quarter period in which the MQD was not made on the Common Units with respect to more than one of such Quarters (excluding payment of any Common Unit Arrearages) and the first Quarter in such six-Quarter period that the MQD on Common Units was not made occurs after March 31, 2001, then the Subordination Period will not end.


• Realization by long-time SGH unitholders that subordinated distributions will be substantially delayed even once Common distributions are resumed
• Realization by new sophisticated investors that SGH is not a leveraged play on SGU
• Any negative news concerning SGU’s operations or liquidity
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