Suburban Propane: Attractive Ahead of Earnings

With the volatility in the market making it difficult even for the most experienced inventors to pick winners, I figured it would be a good idea to explore new ideas and broad investment themes. We discussed the importance of asset allocation in the previous newsletter and I would like to discuss an investment vehicle called a Master Limited Partnership (MLP) and then discuss Suburban Propane (SPH), a publicly traded MLP with a distribution yield of 9.5%. If you are familiar with MLPs, feel free to skip the next five paragraphs.

What are MLPs?

The reason I used the word distribution instead of dividend is on account of the fact that MLPs are not like regular corporations and do not get taxed on income. Instead they tend to return most of their income (typically 85 to 90%) to investors or partners through quarterly distributions. This shifts the tax responsibility to the partners, who are taxed at their ordinary income rates. Since ordinary income rates of investors are typically lower than the income tax rates of corporations, this proves to be advantageous to the MLPs and hence their investors. One of our portfolio companies, Marcus (MCS), paid 39.21% of its fiscal 2008 income in taxes. When you compare that rate against the rate you paid for your 2007 personal income, the tax advantages of MLPs are laid out in sharp relief.

Tax Consequences:

Since distribution income from MLPs is treated differently from dividend income from most stocks, at the end of the tax year, MLPs issue a Schedule K-1 to their investors. If the MLP pays out distributions in excess of the income it generates, the distribution is classified as a "return of capital" and tax deferred until you sell your shares or units. Please note that income from MLPs is often taxable even in retirement accounts like 401Ks and IRAs if the income exceeds $1,000. Hence investors tend to shy away from MLPs in retirement accounts and they are also not preferred by institutions.

Indirect methods to own MLPs:

There are certain indirect methods of investing in MLPs and avoiding the tax complications. The MLP Kinder Morgan Energy Partners (KMP) also has a counterpart called Kinder Morgan Management (KMR) that holds units of KMP and whose quarterly payout is treated like a regular dividend instead of a partnership distribution. Another alternative is closed-end funds like Kayne Anderson MLP (KYN) and BlackRock Global Energy and Resources Trust (BGR). KYN is currently trading at a 15.22% premium to net asset value (NAV) and a yield of 9.17%. In contrast BGR is trading at a 13.16% discount to NAV and a yield of 8.61%.

Most MLPs tend to be concentrated in the energy sector but there are always exceptions such as the private equity firms The Blackstone Group (BX) and Fortress Investment Group (FIG), which also happen to be set up as MLPs.

Analyzing MLPs using yield spreads:

One method of analyzing MLPs is to look at the spread between the average yield of the MLPs and the 10 year treasury note. A big spread when compared to historical averages could be construed as a favorable factor. The current yield on 10 year treasury notes is 3.81%. The yield of the Alerian MLP Select Index, which consists of the 50 most prominent energy master limited partnerships, was 9.78% as of October 30. The current spread between the two is 5.97% give or take a few basis points. Looking at the data going back to 2000, with the exception of last month, the spread between the two has never been this high, making this a great time to consider adding MLPs to your portfolio.

Suburban Propane:

Propane, a clean burning and non-toxic gas, is created as a byproduct of oil and natural gas processing and is used to heat homes, cooking and sometimes to power vehicles as Liquefied Petroleum Gas (LPG). According to the National Propane Gas Association, about 8.1 million households in the United States use propane to heat their homes as an inexpensive alternative to electricity. New Jersey based Suburban Propane services over 1 million residential and commercial customers in 30 states. Suburban Propane also provides customers the option to rent large propane tanks from them and since these tanks are often buried underground, switching to a different provider is not an easy option, giving Suburban Propane a "lock" on certain customers.

Suburban Propane has been on my radar for over two years since it showed up on a stock screen I ran in 2005. The stock lost nearly a third of its value in the second half of 2005 to $24.51 when the price of propane spiked and the company was not able to immediately pass on this increase to customers. The stock went on to nearly double from those levels to $48.83 by 2007 but lost a lot a ground over the last two months. At one point on October 6, 2008, Suburban Propane traded as low as $22.64. Since propane is a byproduct of oil refining, wholesale propane prices generally tend to follow oil prices. The important difference between the drop in Suburban's stock in 2005 and right now is that propane prices were rising back in 2005 but are actually dropping right now along with the price of oil.

The company hedges part of the propane it has in physical inventory by going short propane futures. When propane prices rose earlier this year, the company had to take a $14.5 million loss against its hedges in the fiscal third quarter ended June 28, 2008. This was right before oil hit its peak of $147 in July. If the company continued its hedging activity in its fiscal fourth quarter, which ended September 2008, the sharp decline in oil and propane prices during the quarter should prove beneficial to the company. Even if the company suspended its hedging program, the decline in propane prices should benefit the company as I do not see a significant drop in retail propane prices that Suburban Propane charges its customers. This is one of the key reasons why I find Suburban Propane attractive ahead of its fourth quarter conference call scheduled on Friday, November 14th.

The company also has a consistent history of raising quarterly distributions and has done so 19 times since 1999. Distributions in the recent past have been financed entirely through operating income and the company has built up its cash position to $118.6 million, while holding long-term debt steady at $548 million over the last three years.

If President-elect Obama raises the long-term capital gains rate and dividend taxation to 20% (for families earning over $250,000), the tax deferred status of MLPs is going to make them even more attractive to high net worth or high earning families. Check out the following links for additional reading about MLPs and related investments.

• What Is a Master Limited Partnership?
• Pipelines of Profits: Beating the Market with Master Limited Partnerships (MLPs)
• Income Pipelines
• Why Master Limited Partnerships (MLPs) Belong in Your Portfolio

Due to the tax implications of MLPs and the fact that the SINLetter model portfolio does not take dividends into account, I am going to add Suburban Propane to our watchlist instead and most likely leave it there for some time to come.

Comments

[john s. gordon:]

propane may be cheaper than kwh in some instances but is not cheap, my last fill in april 2008 was $4.08/gal. price is not necessarily comparable to gasoline since lbs/gal is less for propane.
> jack

2008 Nov 08 08:14 AM

[Universal H...:]

Great article, Asif, particularly the primer on MLPs. It's not easy to take a subject like that and condense it into four paragraphs that "read well" and make sense. SPH offers the consistency and stability that investors are looking for these days...

2008 Nov 08 04:30 PM

[Asif Suria:]

@john: Both propane and oil were on their way to their July peaks during your April 2008 fill. I wonder if the comparison will change this winter with the recent drop in prices.

@Huckleberry: I appreciate your comment. It was a challenge and my hope was that I would not lose readers by the time I got to SPH.

2008 Nov 08 08:08 PM

[Old Trader:]

I find it sort of interesting, that "suddenly", MLPs have been "discovered", given the fact they've been around for years (as the author noted, primarily in the energy area, but Alliance Bernstein (ticker AB) would be another example of one from the financial area, with a much longer track record than either of the PE groups cited by the author).

It sort of makes me recall the concept that the small, retail investor is ultimately, the last sucker in the food chain, although there IS some value amidst the current carnage in the markets.

2008 Nov 09 12:02 AM

[ripped off:]

I think the writer of the article is spot-on where he indicates Suburban will pocket the spread between falling wholesale prices and retail. They charged us $5.05 a gallon recently, plus they recently started charging for tank rental ($72/year EACH). This in comparison to another local company which I got a quote of $2.49/gallon (and this with no price-based on-use charges, nor tank rental fees).

2008 Nov 12 01:19 PM